Relative to real estate, the term Fundamental Investor can be applied to those of us who hold property long-term for the present cash flow and future appreciation. Our ability to hang on to real property long-term is a function of the property generating income in excess of holding costs, which is most often accomplished through leasing.
All fundamental investors in the real estate market agree on this basic principal. However, not all of us agree as to what type of vehicle is best to accomplish our objective. Some are die-hard single family investors, while others focus on multi-family residential, or even commercial and industrial. All are viable strategies but each has advantages and disadvantages, which is the subject of this article.
The way I am going to attempt to tackle this is to compare and contrast each of the property types with respect to a number of considerations, which are of primary concern to me as a fundamental investor. These are:
- Ease of Purchase
- Consistency of Income
- Diversification of Income
- Ease of Management / Maintenance
- Ease of Liquidation
- Likelihood of Appreciation
As you can see in the table directly below, I’ve gone though and rated each of the property types with respect to each of the considerations in the range of between 1 and 5, with 5 being the best. I then tallied up the scores for each of the property types. This is not scientific in any way, but it does illustrate what I believe to be the general dynamic.
This table, as well as the analysis which follows, presumes 1 structure and 1 transaction. Furthermore, in the case of Multi-family and Commercial, this analysis presumes a structure with multiple rentable spaces.
Simply glancing at the scores will identify Multi-Family residential as the best over-all bet in my opinion. The Commercial / Industrial could either be excellent or extremely bad, depending on factors that I will discuss below, leaving the single family somewhere in the middle. Let us talk through each of the criteria to further understand the scoring.
1. Ease of Purchase
The single families scored the highest in this criterion. On balance, they are the most reasonably priced and the easiest to finance, which makes them the most accessible to small investors.
The multi-family scored 4 in this criterion, because while small buildings (4 units or less) are relatively easy to finance with a Fannie / Freddie salable note, presuming that you meet all of the qualifying standards, the larger buildings must be financed with either a commercial note or creatively, both of which require extensive knowledge and experience. Another reason multi-family residential scored lower than SFR in this criterion is because often these buildings carry a higher price tag, which can require a higher down-payment and better credit to bring them down. Thus, a combination of knowledge, experience, cash, and credit can make multi-family a bit more difficult to acquire.
Finally, commercial / industrial buildings are typically the most expensive and can be quite difficult to finance.
2.Consistency of Income
In this category commercial / industrial buildings can either be extremely good, or extremely bad, which is why I scored it in a range. If you are lucky to land an 5-star credit tenant who signs a 5, 10, 15, or even a 50-year lease, then obviously you can comfortably rest on that high horse of yours looking down upon the rest of us mere mortals. However, should you have a vacancy it can potentially take years to fill it, costing you a boatload in carrying costs. So, this is kind of a niche market and while some do very well here, others loose their shirt. In important point as well is that this type of an investment is much more micro-market driven. There are part of the country and World where commercial / industrial works very well, while in other locals it can be very, very difficult.
SFR and Multi-family each have strengths and weaknesses with respect to consistency of income. Most investors agree that tenants tend to stay longer in free-standing single family units – people like their privacy. However, when vacant the SFR really takes a bite out of the cash flow, because while there is no income being produced, the expenses still have to be met.
A multi-family building, on the other hand, by definition provides built-in diversification of income that is clearly not possible with SFR, which in my opinion offsets the potential higher vacancy rate. Furthermore, there are ways of choose your multi-families in a way that addresses unit desirability issues and results in people staying there longer.
One last thing I’d like to mention here is that while in the residential world we are dealing with an item of necessity – housing, in the commercial / industrial world real estate is often a desire more than a necessity. As such, commercial real estate can be much more susceptible to economic fluctuations.
3. Diversification of Income
Question: When going into battle, would you prefer to have one soldier on your side, or three?
I prefer to have three – if one goes down, I still have two others to get the job done, and for this reason I like multi-unit property. The only reason I scored multi-family residential higher than multi-unit commercial is again because commercial units can take a long time to fill when vacant.
4. Ease of Management / Maintenance
This is another area where Commercial buildings can either outshine the competition or completely tank. I am, of course, talking about the long-term triple-net leases which preclude no vacancies over prolonged period and place the burden of up-keep and maintenance on the tenant. If you are fortunate to own a building with 5-star credit rated tenants on 20-year triple-net leases, consider it maid. On the flip side, though, carrying and maintaining a 20,000 square foot facility that is sitting vacant is killer.
Relative to SFR and multi-family, the thinking is simple: if you need to own 120 units in order to achieve your investment objectives, would it be more convenient if they were all SFR scattered throughout, or would 6 twenty-unit buildings make more sense? For me, the multi-family makes sense here. There is a lot of efficiency.
Now, it may not be the best idea to own 6 twenty-unit buildings from the stand point income diversification since each one of those buildings constitutes 1/6th of your income. So, you may choose to split the difference and go with 30 four-units, or some other diverse combination of lager and smaller buildings. Plus, there may be another reason to own smaller multiplexes, which brings me to the next consideration.
5. Ease of Liquidation
The simple reality is that the SFR is by far the easiest to sell, which is why I rated it a 5. There are a lot of potential buyers, and there are great financing options available for those buyers.
Small multiplex (4 units or less), however, also rates very favorably here as compared to larger buildings. For one thing, in today’s difficult economic environment more and more folks are opening up to the possibility of becoming owner-residents in a small multiplex in an attempt to off-set personal expenses. Furthermore, there are a lot more investors out there who are able to bring down a 4-plex rather then a 20-unit, both in terms of down-payment requirement, availability of credit, and expertise. Thus, it seems that the market of potential buyers for your small multiplex is rather large as compared to larger structures.
Naturally, there are many fewer players in the commercial / industrial space as this is very much a niche market, requiring specialized skills and deep pockets.
6. Likelihood of Appreciation
Your guess is as good as mine on this one, which is why I didn’t attempt to evaluate this. Yes, we all hope that our buildings appreciate and we do whatever we can to ensure that they do. But the reality is that none of us have any control over the fiscal policy, the monetary policy, the job markets, or the consumer trends, all of which contribute to appreciation or lack thereof. We can speculate, but we can not predict the future…
While it is very difficult, if not impossible to say unequivocally that one is better than the other, I think it is evident that each type of property has its’ benefits and drawbacks. I hope that the thinking I put forth in this article helps you determine your comfort zone around the issue of SFR vs. Multi.
When choosing which path to take, you must remember that your priority should be Not to loose!
What is your preference? Single, Multi, Commercial? Why? Leave a comment below and let’s talk about it!
Photo: kevin dooley