Multifamily Properties- too good to be true?

12 Replies

Hey all,

First time poster here on BiggerPockets. Lately I have been reading a lot about multifamily properties. They seem to be much more profitable, dollar for dollar invested, than single family properties and possess a number of advantages from the investor's POV. However I am hoping the whole thing doesn't end up being too good to be true, or there is some huge disadvantage or roadblock that explains why the market has such high returns.

I noticed that lower income multi family properties have a much higher rent to purchase price income. When I first started thinking about buying property for investing, I was dreaming of a beautiful antebellum estate somewhere in the Charleston, SC. Okay, I don't think I have the cash to float that anyway, but we can all dream right? Turns out, the actual ROI per year on such property was around 4-7%. Why? Well, more liquidity means lower rents. People with money typically pay less for money. Look at NYC where its not uncommon to get 2-3% returns on investment properties. So anyway, I started looking into the economics of buying properties in the 80-120K range and the ROI was around 15-20% per dollar invested.

How do I get 15-20%? Say you invest 20K down on a 100K property, and that property has 4 units in it renting at $400 a month. I have actually found these properties myself on zillow and realtor.com. That's $19200 a year in rent. Now, apply the 50% rule. That's $9600 a year. Subtract mortgage and taxes ($4560+$1300). That's $3739 a year in profit. $20000/$3739 = 18.70%. That's almost triple the return you will get from running a single family home in an established market. Also that is after applying the 50% rule, which is a very conservative way of estimating rent loss, repairs, evictions etc. I think it might even figure in taxes too, so my return might be even higher than 18.70%. Paying cash for the property is actually less profitable, the lower down payment you make, the more profit you make as the real gains are to be made from the difference between mortgage and rent. Putting 50K down only yields a profit of 11%.

So... is this a real thing? On paper it looks great, but I may be overlooking some major risks that explain the high (potential) profit. 

Also, you would obviously need to acquire a large number of these. Nobody is going to be able to quit their day job on $3700 a year. That brings up the issue of financing. If I have saved 100K to invest in 5 of these, how do I get a bank to lend me the other 80K per house? The first and maybe second one will be easy for someone with good credit, but I have never owned more than one property at once and I'm not sure how this kind of financing works at all. I'd also want to keep acquiring them once I figure out what I am doing and turn them over to a management company, to create a large passive income stream. How do you keep the ball rolling once you run out of your initial savings?

Thanks again and I look forward to seeing what people on here think about this topic.

-Matt

@Matthew Thompson - You have all sorts of good questions and comments in here.  I was notified of your post because you mentioned Charleston, SC, which is my market.  

First, you are correct that multifamily on average has a higher cash flow relative to single family (if purchased correctly, there are always exceptions).  I think a lot of folks buy single family with so-so cash flow with the hope that the property will appreciate faster than multifamily, which is sometimes the case, and make their profits at the end with the sale.  Personally, I favor multifamily because you can get better cash flow and you can actually influence the price of the asset (force appreciate) much easier than you can with single family, which is far more reliant on the neighborhood and comps vs. income.

Second, you are talking about the difference of leverage: all cash, vs. most cash vs. little to no cash.  You are correct that the less money you put down, the higher return you have, which actually goes to infinity if you put no money down.  That being said, those returns do the same in reverse if the property is vacant, or goes down in value.  This is why so many folks lost properties in 2007-8.  They had very little money down, were over-leveraged on an under-performing asset, which makes a bad situation really bad.  The simple rule is use conservative numbers, which your 50% expense rule is a good start, and leave a cushion for positive cash flow.  For example, if after operating expenses of 50% and debt service, you only have $100/month cash flow, all it takes is one decent size repair to wipe out your cash flow for the entire year, or potentially 5 years if it's and HVAC or Roof.  So make sure to leave a cushion.  

A really helpful tool to choose your optimal amount of leverage is a sensitivity analysis, which will weigh how much leverage you use (0%, 10%... 90%) relative to adjusting 1 other item at a time, such as appreciation or rent growth rate etc... this will show you in each circumstance how your ROI changes based on how much money you put down relative to different performance such as appreciation or vacancy or rent growth rate. Just remember, leverage exacerbates the outcome both good and bad.

Lastly, with your $100,000, I would recommend trying to buy a $500,000 multifamily asset.  If you buy a mobile home park or Class C multifamily property, you can probably buy around $15,000 - $20,000/unit, so say 25 units +/-.  If you put down $100,000 (20%), then you are financing around $400,000, which works out to around $3,200/month ($38,400/yr assuming 180 month term at 5%) debt service.  If the property is a 10% cap rate, you should expect $50,000 before debt service, so your cash flow after debt service would be $11,600.  Takeaways here: if you paid all cash, your return would be 10% (AKA Cap Rate), however, you are leveraging 80%, and your cash on cash return is 11.6%.  Not a home run, but not bad.

Here is where this gets fun.  Let's assume you found a good deal that rents are below market, so after 1 month you increase rents by $40/unit.  Now, assuming you purchased 25 units, you can increase your monthly cash flow by $40 x 25 units = $1,000/month or $12,000/year, so now your cash flow is $23,600, thus, a 23.6% return in year 1!

Not only that, you just increased the NOI of the property from $50,000 + $12,000 = $62,000, so at a 10% cap rate, you just increased the value of this property by (10 x $12,000 = $120,000) up to $620,000, in one month, by simply increasing rents $40. This is a highly simplified breakdown of everything, but the principles are the same whether it's 5 units or 200 units, but the more units you can get at once the better in my opinion, which is why I would suggest getting a property like the one I mention above. Also, the good news is banks will like you borrowing on this property more than on single family because you are effectively buying a business that throws off money (Banks will be looking at the Debt Coverage Ratio among other things) whereas single family is a little more challenging for lenders at this scale.

Lastly, you can still get these returns with single family homes if you come across the right deals, it just usually takes more physical and capital expenditures to improve their value, which takes a lot more time and energy, whereas with multifamily, you can hopefully exploit mis-management vs physical distress.

Good luck to you.  Let me know if you need help as you go down this road.

Cheers,

Roby

@Matthew Thompson

Yes that is the way investing in multis works. 

Your numbers might actually be a little better because you are deducting taxes twice, once in the operating expenses and a second time with the P&I. Or they might be a little worse if the area is rough and you will undergo a lot of vacancy and repairs. You would need to do a full analysis of a specific property to be sure.

2-4 unit multifamily properties are financeable with 30yr fixed mortgages, similar to owner occupied homes but at slightly higher interest rates. Lenders are very focused on your personal financial strength and less on the property. Each property needs to be seasoned for a couple of years before the lender will take it into account in your income for the purposes of acquiring more. Once you get to 5+ unit properties, or beyond the max number of residential investment mortgages, you need to look at commercial financing. This has completely different rules.

As to how to keep the ball rolling after you are out of cash, you can go one of three ways. You can save up profit from your rents (this takes a while). You can add value to the properties to raise their value, or hope the market will do that for you, then refi or get a line of credit. Or you can set up a syndication to attract outside investment - this is the hardest but also the fastest way to scale quickly.

@Matthew Thompson

What you're describing isn't an issue with multifamilies as much as it is an issue with the cost of the asset in your market.  Your market is more suited for cash-only investors who can jump into a $120k property with $150k, and they aren't bothered by the $20k return because to them, it's all cream (i mean you pay maintenance, repairs, and taxes, but you know what I mean).

Please don't use 50% analysis to actually look at the viability of a property.  You need to calculate the full PITIA, maintenance, repair, and utilities cost ... along with an adjustment for vacancy.

@Matthew Thompson Since you are interested in buying buying a Duplex, TriPlex, or a Four Plex, please consider the following. Many Realtors will suggest purchasing a property using a FHA Loan, to reduce your out of pocket money. If the property requires rehab, the Realtor and/ or Mortgage Broker will suggest applying, for a 203k Loan. A 203k Loan is where the purchase price and rehab costs are rolled into a single loan.

Assuming you have a respectable FICO you can buy, with a FHA Loan (3-5% down, a 30 year amortization schedule, and a residential loan rate). Because you closed personally, you will not have Asset Protection, in the form of closing in the name of a LLC. What happens if one of your tenants has a slip and fall, on your property, or something else happens to them? You are on the hook and can be personally sued, for everything you own. Some people will say, "Take out a quality Insurance Policy and you will be protected." Ambulance chasing attorneys know their way around and can legally navigate around Insurance Policies. Another downside is you loose on the advantages, of the Federal Tax Code, by not closing in the name of a LLC.

If you want to close in the name of a LLC, Mortgage Lenders will offer you Commercial Loan Terms (25-30% down, a 15-25 year amortization, and a ballon due in 5-7 years). This is what I am encountering, in the current Mortgage Industry.

If you think you will go FHA, 203k, etc. and then Quit Claim the property, to a LLC, or a Land Trust you run the risk of the lender discovering a Title Transfer occurred and activating the "Acceleration Clause" or "Due on Sale Clause" that requires the loan to be paid in full, within 'x' number of days. These clauses are contained, in all Promissory Notes nowadays.

Many Realtors and/ or Mortgage Brokers will not tell you this information. Many, but not ALL are only focused on the commissions he/ she will earn and not focused, on your best interests. You many be asking yourself what can I do? Locate a Motivated Seller that will consider Seller Financing. You may have to put more money down (10-15%), but you can close, in a LLC, with no worries about banks. I have a lengthy Legal Opinion, from my seasoned Legal Team regarding this matter.

Medium company logo 300Thomas Franklin, ACT Investment Properties, LLC | 877‑886‑1273 | http://www.actinvestmentproperty.com/

Thomas said it. MF's hurdle is getting it financed. Few to no banks will do a commercial loan to a first time MF buyer. So folks end up in SFR due to getting financed.

Read the MF bloggers hete re getting started with zero experience.  It's possible.  We just got a $1M  mobile home Park financed as our first commercial deal. I feel it went through on the teams great W2 oncome, tax returns and deep portfolios.  It was a royal PIA even with all our W2 and assets.  

Leaving the low W2 low asset folks marketing for seller financed deals which in 2016 are like hens teeth.  Good luck. Set sky high goals then "just do it".  

Curt Smith, Sweetgum Properties | [email protected] | 678‑948‑7151 | http://GaREIA.com

It looks like you have figured out quite a bit from basic analysis.  Good for you.  There are excellent responses here for you already.  The one thing I did think about was how they may seem a little intimidating.  My best advice is spend time on the numbers, do as much work as you can doing a market analysis so you know where the market is trading and what the rents are.  One way a friend made buckets of money was to leverage interior upgrades and amenities to increase rents.  Adding laundry etc.  This may sound expensive but when you are talking about decent increase in rent it's the best money you can spend.  Don't get intimidated.  The business isn't that complicated. Ive owned many deals for a long time, have made tons of mistakes and I'm still here.  Main thing in this market is don't overpay. Seems so many are doing that.  

Wow, so many good posts here. Very interesting stuff. Thanks to everyone, I've learned a heck of alot reading this. 

Financing seems to be the main problem in making money here. And paradoxically, unlike most businesses, you make less return the more debt free you are. It's like the financial twilight zone, but it totally makes sense. 

@Robert Seed, I like the idea of owning a single C class 25 unit complex, as you mentioned- but as @Curt Smith mentioned, getting that commerical $500,000 loan for a first time investor might be tough. Is there any kind of loan I could qualify for that I could get my hands on that property with 100K and no prior experience? 

AFAIK (maybe its state dependent) but I read that 3-4 unit dwellings aren't seen as commercial property and can be easier to finance. However, does that mean I would have to 'season' each property over 2 years before I can get another one? Meaning it would take 10 years of running these properties before I could actually get my 18% of $100K?

@Thomas Franklin, motivated seller financing and buying as an LLC seems perfect, but I am guessing that is a rare situation that would not be always available.

Asset protection is really important. I am also planning on building a house with cash (maybe financing a small portion FHA/conventional for the first property with a really, really good insurance policy. That is unless there is another way?

Right now my plan is to start small. I have a decent job now working in a cubicle but I hate it, my plan is to quit it. I will have very few expenses (especially with the paid off house or tiny mortgage) and have a few income streams the properties being the biggest. I'll be living modestly at first, but I would like to increase those streams as time goes on and I find my footing. 

The reason the lower class properties appear (emphasis on appear) to cash flow better is because of the multiple levels of obsolescence you are dealing with. The market will not allow the price to be any higher due to these factors such as area, layout, condition etc. You need to calculate the IRR (internal rate of return) in order to know what your true return is. The newer nicer buildings look worse at first but a true realistic pro forma based on life cycles of everything imaginable from carpets to refrigerators to roofs etc, paints a different picture. The IRR of higher class properties are closer to the purchase cap rate or return than are the lower class. Simply put, things break and die more often in lower cost properties. There is also an unknown variable on the tenant class. Lower paying tenants typically equals more wear and tear. Become an expert on IRR before jumping in. You may soon find that the 7 cap A or B class building is much more profitable than the 12 cap C or D building. Look up videos podcasts and blogs by Ben Leybovich on BP and you will learn a great deal about this concept. Also don't forget that, even though appreciation is icing, there typically will be none on C and especially D properties even over the long haul. Some may exist on increasing NOI but not in land or improvements. Even if the NOI is increased lower class pricing has a saturation point.

Folks don't fall in love with MF just because someone showed you Proforma that showed 20% cash on cash!!!

I just closed 2 SFRs just south of Chattanooga in GA that the cash on cash for each is 22%.  These are NICE houses in a good high school district.  You don;t have to take a huge risk on buying low priced houses in high risk areas in search of spread sheet gains (that never materialize in the 24 month look back).

True we jumped into commercial via a mobile home park, 18% cash on cash goiing in, high 20's in 2 years after build out.  So what, I'm doing 30% cap on my double wides on their own land, and Jan and Feb 22% each on stick builts in good areas.

Decent returns are possible even in SFR. You just have to know how.

So how does one make higher returns than other investors?  #1 don't buy in the same zips as 100's of other investors.  Find areas with few investors, good jobs and good schools.  I live in Atlanta and have worked areas 1-2hrs away for 3 yrs now,,, why? Because I hate competition and hate paying too much (more than I know I can which is my line in the sand).

Every area has pockets of emerging jobs, cheap houses and good schools. Find this area. Buy SFR, mobiel homes on their own land, MF or mobile home parks. Any asset will do well when there's few bidders, lots of customers, jobs and good schools.

Start by looking in smaller towns but right on major freeways and no more than 1/2 hr to a big city with good jobs.  Use city-data.com to find where jobs are in your area. 

For example: 

http://www.city-data.com/bs/?q=manufacturing&w=Ringgold%2C+GA

Poke around till you find small towns with jobs on major roads.  Then drive those areas, cull craigslist.org for sellers of MF, parks, SFRs.  Honest there's good deals being posted by old timers who don't like agents.  No harm culling zillow as well.

Curt Smith, Sweetgum Properties | [email protected] | 678‑948‑7151 | http://GaREIA.com

I've noticed and made the mistake in the beginning, of making low income property too nice. There usually is an education level that correlates with the income. Never put in carpets for an example, as no one will buy a vacuum. I bought a whole roll when I first started and paid very little for it but in 60 days it was shot in a lot of my units. I tried vct tile but again without proper care it doesn't look good in 8 months. Now it is all click flooring. For $1 per ft. Including pad it goes for several years. I go by the rule clean, safe, warm for my low income. For working class I will buy a little better light fixtures, faucets, and maybe the $1.29 flooring. A thick vinyl is much better than the thin stuff at Home Depot which lasts for one chair slide. Never use click flooring where water is likely, entrances, bathrooms and kitchens. Tile is a good option for long term. I have had good success with Walmart 15 yr color place paint, flat on ceilings and satin or semi- gloss everywhere else. Sometimes you can clean rather than repaint. Fix things right the first time and don't defer maintenance. That way your low income will stand above most of the others and your numbers will work well.  

I found starting out it was a good way to find owner financing on properties where landlords have given up and have no interest. Usually their numbers of actually collected rent is way under market value. Of course you buy on those numbers from their tax return and they are probably thinking that no one will want it. I had one 15 unit where I was able to more than double the collected rent within about 18 months. Just takes some vision and ambition. I found it takes about 2 yrs. to change a reputation or neighborhood if you own enough properties in the area. It will never become nice but the tenants will at least have self respect and stay.

I'm a new investor as well, so certainly don't have much to add beyond the great comments above. However, I wanted to mention something about the 50% rule and multi-family. Someone above mentioned not to use the 50% rule aside from a quick-and-dirty proxy or filter. In addition to that, based on podcasts I've heard and multi-family information from Ben Leybovich, Serge Shukhtat, and Brandon Turner (among others), multi-family expenses are really closer to 60-65% ... in a good year. 

So I think using when using the 50% rule as a quick-and-dirty proxy, for multi-family, it should really be the 60-65% rule.

Originally posted by @Aaron Sauceda :

I'm a new investor as well, so certainly don't have muc mih to add beyond the great comments above. However, I wanted to mention something about the 50% rule and multi-family. Someone above mentioned not to use the 50% rule aside from a quick-and-dirty proxy or filter. In addition to that, based on podcasts I've heard and multi-family information from Ben Leybovich, Serge Shukhtat, and Brandon Turner (among others), multi-family expenses are really closer to 60-65% ... in a good year. 

So I think using when using the 50% rule as a quick-and-dirty proxy, for multi-family, it should really be the 60-65% rule.

If that is the case, then I guess that would mean that lower income MF really is too good to be true. You'd probably be better off buying nice SFR property, or, just buying a lot of SPY exchange traded funds and letting them sit in your brokerage account.

Any other thoughts on this? I think 65% expenses "in a good year" would make me look elsewhere.

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