Portfolio of duplexes - Commercial or Residential Valuation?

13 Replies

Hello all,

This past year I purchased a duplex to house hack using a VA loan. My plan was to stay in it a year and then buy another duplex using a second VA loan or FHA and rent the first one out completely. Then continue buying a new property once a year as long as I could save for a down payment and qualify for more loans.

Recently, I've been drawn to commercial multifamily real estate (many reasons) in lieu of small residential multifamily. So, I'm looking for a solid exit strategy and was wondering if the following would work:

Continue purchasing duplexes until I have at least three (6 units total) and then market the three (or more) properties as one commercial package. The reason for doing this would be to value the properties as one commercial package using NOI and cap rate versus valuing each individual property based on comps. From running the numbers on my current property I believe the value of my duplex would be worth a whole lot more if it was valued using NOI instead of comps.

Has anyone ever used this strategy and has it worked? I still have yet to purchase my second property but I wanted to go into it with a solid exit strategy. Any other thoughts or advice? 

Thanks in advance!

Nathan Angles, Real Estate Agent in Wisconsin (#85100-94)

Good thought process.

The key will be whether or not those duplexes are all next to each other.  Nobody will consider duplexes spread across the city an apartment.  However, if you own a bunch of duplexes on contiguous lots, yes, I have heard of people buying those as apartments.

There's people that sell portfolios (even of single family homes scattered about) as partial/whole. Not sure how the lending side works but there's some loopnet and every once and while redfin (KCMO and surround areas for example).

These were under separate MLS numbers... but if you dig about 30 of them were up for sell

https://www.redfin.com/KS/Olathe/1508-E-Leona-St-66061/home/83312494

Let's say you found a buyer willing to agree with your proposition, to pay more for a package than to pay less by buying individually (wouldn't have to be yours they buy one at a time). Now the buyer goes to the bank and is looking to get financing for this package so he can buy it from you. How do you think the bank is going to evaluate this package? My reply to that is most likely, the bank would use the most conservative approach, and when an appraisal is performed each duplex will be considered separately for valuation - because if they foreclose, they might just have to sell one by one.

Maybe somebody would pay all cash, maybe you seller finance - but the bank financing would expose to the buyer that they could do better. Some of the turnkey sellers have your approach working for them, so there could be buyers ...

Agree with @Steve Babiak

Residential properties (1 to 4 units) are valued using sold comparables, not NOI. Steve brought up a good point about the valuation issue on the lending side. Also, if you are selling a package of rental houses then you're more than likely targeting investors. As an investor why would I pay higher than comps? If anything I'm looking to pay LOWER than comps - isn't this the holy grail of residential rental investing?

I'm a relative newbie so someone can chime in here and correct me, but in general, when it comes to residential properties the comps values are usually higher than NOI/Cap values especially in a hot market. I have looked at a couple of these packages of SFR's for sale. The SFR's are actually priced slightly below comps. The motivation to sell as a package is more about saving on transaction costs (i.e. commissions, etc) than about getting a higher price.

Cheers... Immanuel

I personally would expect to get a nice discount if I'm buying a portfolio of properties.

Thanks all for the replies.

I guess I question why residential comps are the best way to value small multifamily properties. Especially with turn key properties.

For instance, after completing some cosmetic repairs I see comps going for around $170,000 for my current duplex.

However, when I purchased the property I was told by the appraiser and some real estate agents it would demand rents for $1,435 a month ($17,220 a year). I now believe I could rent for $1,835 a month ($22,020 a year). The operating expenses (including vacancy, repairs, cap ex, management, insurance, taxes, etc.) haven't changed and are about $716 a month ($8,592 a year). Using these numbers I have increased the NOI from $8,628 to $13,428.

One of the big aspect I like about commercial investing is valuations based off NOI, giving the investor more control of appreciation. Assuming I can get the higher rent, expenses stay the same, and a cap rate of 7% for my area, I could value the property at $191,000 this way (13,428/0.07).

Since I would be targeting investors, would they not see that this could be a good return for them with minimal work required? If they invested 20% ($38,000) they would have a debt service of $729/month ($8,748 a year) at 4% interest . This would bring a cash flow of $4,680/year. COC ROI being 12.3% (4,680/38,000).

Adding mortgage paydown, tax benefits, and natural appreciation, this could be a great investment. Any additional thoughts/comments? I appreciate all the help!

Nathan Angles, Real Estate Agent in Wisconsin (#85100-94)

@James Wise I agree it makes no sense to pay more just because there are more of them. 

I just believe valuing multifamily properties, even if just 2-4 units, should be done with an income approach instead of just finding similar properties that have sold recently. 

What if the comparble sale is managed poorly and doesn't raise rents and therefore the NOI is significantly lower? If the property is similar in size and shape, does this justify the same price for the property? Or would the property with higher income be worth more to an investor?

Again, thanks for the comments!

Nathan Angles, Real Estate Agent in Wisconsin (#85100-94)
Originally posted by @Nathan Angles :

@James Wise I agree it makes no sense to pay more just because there are more of them. 

I just believe valuing multifamily properties, even if just 2-4 units, should be done with an income approach instead of just finding similar properties that have sold recently. 

What if the comparble sale is managed poorly and doesn't raise rents and therefore the NOI is significantly lower? If the property is similar in size and shape, does this justify the same price for the property? Or would the property with higher income be worth more to an investor?

Again, thanks for the comments!

 I sell about 400 duplexes per year. So pretty well versed in them. It'll never happen that way.

1. The appraisal is a residential appraisal. At the end of the day the appraisal is the key to getting the deal done.

2. These properties are not solely used as rentals. Sometimes owners occupy a unit. Sometimes they are used for extended family etc.

3. If you only have 2 tenants what happens when one moves out during escrow. Is your building now worth half of what it was before? Of course not.

James Wise, Real Estate Agent in OH (#2015001161)
216-661-6633

@Nathan Angles   Can't agree more with @Steve Babiak , @Immanuel Sibero , and @James Wise

Your thoughts are in the right place, but in this case, you are thinking of it backwards. Duplexes will be valued based on comps. Yes, investors should (and do) look at NOI when valuing acquisitions, but anything under 4 units and you are in the comps business. Think about Costco - you don't pay more because you are buying more. You pay less. The same is true for what you are proposing. You should be looking to buy a portfolio of duplexes and then selling them off one at a time to maximize value.

@Nathan Angles

I see that you're looking at this from the single family vs. multifamily perspective and conclude that "comps" should be used for single family and "income approach" for multifamily. Unfortunately, for valuation purposes, the industry uses a different perspective which is residential vs commercial. In this case residential properties are valued using "comps" and commercial properties are valued using the "income approach". Also, somehow someone a long time ago decided that "residential" properties were defined as 1 to 4 units and "commercial" properties were 5-unit or more.  That's just the way it is.

I'm curious about this as well, why 4 unit as the cutoff? What's the big difference between a 4-unit and a 5-unit that one is valued using "comps" and the other using "income"? My guess is this has to do with owner occupiers. We all know that investors would invest in anything that spits out income whether it's an SFR or 500-unit apartment. So they're buying NOI and therefore only have one way to value the property which is NOI. On the other hand, owner occupiers are generally in the market for 1 - 4 units only but they buy the properties to live in them so their valuation calculus is different. They look at how big the yard is, which school district, whether it's in a cul-de-sac, the view, etc. The point is they don't value based on NOI but instead on various other variables including qualitative variables.

Cheers... Immanuel

The market is not willing to pay for NOI in a duplex the same way it is willing to pay for NOI with larger properties. Size matters. Whether it is real estate or any business, markets become more efficient with size and vice versa.

I can tell you based on my own experience that you can package up multiple duplexes on a single street and value them as commercial properties: we purchased 20 duplex buildings/40 doors all on one street as a commercial property. So it can be done.

We are right now pursuing a strategy of buying 1-4 unit buildings on a single street from different owners using cash/traditional financing and then refinancing into a commercial portfolio loan valued based on income once the street ownership is material enough.

Note that we are talking about 40, 50 doors at a time and not the six the original poster suggested, but it *can* be done.

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