Are 5-6 unit properties worth it if I want to finance?

Question

I like the idea of a small multifamily for my first rental property. I'm looking at around 2-6 (maybe up to 8?) unit properties. I'm limiting it to this size because of the purchase price and not wanting to bite off more than I can handle for a first investment.  It feels to me like there there is very little on the ground difference between operating a 4-plex and a 5-plex, but I know the world doesn't agree with me when it comes to appraisal and financing these small commercial properties.

My RE investing goals are to build a buy-and-hold portfolio with solid cashflow in a few years while leveraging as much as I'm comfortable with while financing is still cheap and my wife and I have W-2 jobs to provide savings for reserves and down payments. I plan to make a cash offer using a HELOC, close quickly, pull most of the cash back out in a refinance and repeat.

I'm comfortable with residential mortgage financing but I needed to learn about commercial loans so I have just started reaching out to folks to learn about CRE loans, and I'm wondering how "the pros" hand the interest rate risk of the typical 5yr or 7yr balloon? To be clear, I expect to have to run my own numbers with estimates for interest in 5 and10 years. But I'm wondering now if the extra income from a 5-8 unit property justifies the complication and risk in financing. How do you folks deal with this on these smaller units?

Jon Q. · Answer

No, I'd say that's too small in most markets.  The property is unlikely to generate sufficient cash flow for you to pay a full time professional property manager and still generate a decent return.  There's also the problem with financing. Most commercial lenders aren't interested in lending less than a few million for multifamily deals.

That said, these smaller multis in high priced markets like SF, LA, and NYC could work so long as you acquire at an attractive price and it generates strong sufficient rental income to hire a decent manager.

Often new investors who buy these smaller deals end up self-managing because they have no other option.  That's not a position I'd personally like to be in.  I like my freedom which is one of the reasons I'm a real estate investor.

Terry Lao · Answer

@Kelly Byrd

The term used when paying all cash, close, and refinance, is " delayed financing. You may want to confirm that no seasoning is needed. If seasoning is need, then need to wait 6 months. Fannie Mae, for 1-4 units, can use delayed financing if original cash transaction is not borrowed money.

Overall, worst case scenario is wait 6 months, but with Feds raising rates in June, then refinance the sooner the better.

Terry Lao

Kelly Byrd · Answer

Thanks to all that have replied. Doing some thinking last night with my partner-in-crime/wife, we landed at the "buy several properties 3-4 unit range while 30yr rates are cheap" advice that @Jeff Kehl just gave.  Glad Bigger Pockets is here!

Jeff Kehl · Answer

@Kelly Byrd Knowing what I know now, if I were to go back in time I would try to buy 10 4-units as my first 10 properties just to take advantage of the terrific low-interest 30 year fixed rate mortgages.

But I have a lot of 5 year balloon 20 year amm financing and a quite a few of them I took out in 2011-2013 so last year, this year and next year are big refinancing years for me.

So to address your question about that specifically, it's definitely important to think about and plan for the maturities and the interest rate risk. But keep in mind large amounts of property is financed this way so I wouldn't let that deter you.

A few things to consider.

On a 20 year note, you pay down quite a bit of principle in 5 years. So if you start at 70-80% equity and then pay down a bunch you are going to be in an improved ltv position. Most banks are happy to see that and will be glad to extend you out another 5/20 which will lower your payment substantially if interest rates are the same or keep the payment the same and support a higher interest rate.

Also, if your property has appreciated in value/your rents are higher, your ltv is even lower and you are in a very good position. The key is to not get too greedy and pull out too much of that equity.

There are several hedge fund type lenders around now that will loan you 30 year fixed money on a commercial property at higher interest rates in the 7% range if you are that concerned about it. I did that on a small part of my portfolio and I regret it now as it was a painful transaction and interest rates haven't really moved much at all.

Kelly Byrd · Answer

Good point to bring up, but yea I've been since I'm new to this I expected a bank to look at my income regardless. Originally posted by @Terry Lao:

@Kelly Byrd

If you don't have to worry about debt ratios, total under 45%, then that means your income can fully support either 1-4, or 5-8. If you need the rental income to help qualify, then 1-4 is your best option. Also, in using rental income or 75% of lease agreements, then fannie mae wants you to have 2 years landlord experience, meaning 2 years of schedule E on federal tax returns.

Terry Lao

Terry Lao · Answer

@Kelly Byrd

If you don't have to worry about debt ratios, total under 45%, then that means your income can fully support either 1-4, or 5-8. If you need the rental income to help qualify, then 1-4 is your best option. Also, in using rental income or 75% of lease agreements, then fannie mae wants you to have 2 years landlord experience, meaning 2 years of schedule E on federal tax returns.

Terry Lao

Kelly Byrd · Answer

If all other things (like financing options) were equal, I'm attracted to 5-8 units. I like the vacancy mitigation, the income approach vs comp approach to valuing the properties, and what I hope are some economies of scale in the expenses.  My target area dictates that I'll likely end up in a something with 3-6 units for what I want to spend on this first property.

I'm new to RE Investing (I've been reading and podcast listening for months) so I was originally just targeting 2-8 without making a distinction between commercial or residential. I knew in the back of my head they were valued differently but to me, these all felt "sort of the same" so it wasn't until I started learning about commercial loans that I realized I had another problem to solve. That's real estate, a never ending set of puzzles to solve! Ok, I'll run some scenarios tomorrow and see if I think it's worth it for me.

Terry Lao · Answer

@Kelly Byrd

From your original post, are you leaning towards 1-4 units, or 5-8 units?

It's all about the financing at 5+, at which you will probably get some arm with balloon payment, amortized over 20 or 30 years. IMO, 1-4 units are better, can get 15 or 30 year fixed. More competition for 1-4's than 5+.

Terry Lao

Are 5-6 unit properties worth it if I want to finance?

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