Is owner/occupier a good starting path for mult-fam?

Question

hi, 
new to BP and have really enjoyed reading and learning. As we are about to make a first offer thought it might be good to get folks opinions of this plan. I am looking to start with a three family that I can occupy, reno, and hopefully use as leverage when I can afford to buy a second 2-4 family. Whether I stay or move to the new property, I expect my time frame on that to be 2 years or so, not quick but I think realistic to build equity. And I'm fine with a 10 year (not 10 month) goal.

I am in Brooklyn, a very expensive market, but due to a recent sale my wife and I are lucky to have a cash position, and I hope to grow it with a 3 family via cash flow, appreciation, and strong management and marketing. ( Vacancy is so low here the standards of how&what gets rented is kind of crazy, which I see as an opportunity. )

Right now we are looking at two 3 fams with similar numbers. I know these are not 'investment grade' numbers but understand my wife and I are also limiting ourselves to were we can live and work, so deals are leaner on this first step. In this scenario we are putting down a substantial downpayment to get the loan, but that also allows two rents to cover the note and keep our risk low while we save and learn. I don't expect real cash flow the first year, rather via putting our current rent into savings.

I would like to get your thoughts on this overall strategy of starting in one's backyard as a new investor, vs say renting here while the equity works somewhere else where opportunities might be more favorable. I would like to get into flipping here, but it's an expensive and competitive place to make mistakes as you learn the ropes and I don't yet have someone here I can learn from. I am including the numbers as well for one of the properties. Though we don't have a contract, this is what our target area is like.

many thanks for your thoughts!

-

Contract Price
$652,000 + $18,000 Closing Costs
Total Purchase Cost $670,000

Loan  $420,000
Downpayment $250,000
Cash Reserves for Reno $150,000
All In $820,000
ARV $900,000

NOI $53,000 ( with all three rentals at 2.5% vacancy rate )
CAP 6.5%  (after reno, seems in line with market here?)

Mortgage @ 4.78% $27,300 yr / $2,275  mo
Taxes $3169 yr / $267 mo 
Insurance $1300 yr / $109  mo
Utilities $3,200 yr / $300 mo
Holding Costs 
$35,412 yr / $2,951 mo

Gross  Rents 
for all 3 units = $64,800 yr / $5400 mo
2 units + us = $40,800 yr / $3400 mo

Kurt P. · Answer

Jon thanks for that.  I have heard that 'tax logic' is used to make something lukewarm seem hot, I'm sure thats worth considering.  Our first offer has just been given a pass, so now I can step back and consider the great points you've brought up. We're still thinking about this idea, but I'm going to also look into your advice to research what keeping things separate might mean. There is a red hot flipping market right now in the Bed-Stuy area of brooklyn that I might also dig into. I like the concept of applying investor math to our purchase, but it clearly means buying wholesale and as you mentioned that is no simple thing.

Jon Holdman · Answer

I'll have to work through that math when I have more time.  As an owner occupant, you do get the mortgage interest deduction.  Though, it appears its pretty likely that's going to be capped as part of this budget deal.  That can be used to offset other income, making the effective return on the deal higher.

However, when you convert this to a pure rental, you may have a limitation.  Rentals also get a depreciation deduction in addition to the interest deduction. However, you ability to use this passive loss to offset ordinary income is limited.  Unless you're a "real estate professional" (if you have a full time W2 job that's not real estate related, you're almost certainly not), this "special allowance" is limited to $25K a year, and even then only if your AGI is under $100K (even if married filing jointly).  Over $150K AGI there is no special allowance.  In between it phases out linearly.

Before you dive in, you should have a discussion with your CPA and understand the tax consequences.  Supposed tax advantages are often used to dress up a bad rental, only to have the landlord realize the limitations when it comes tax time.

Now, you can carry forward those disallowed passive losses and offset gains when you sell.  But there's another gotcha.  That is you have to pay tax at a higher rate on the unrecaptured depreciation when you sell, and then capital gains at the lower rate only once you're past that.

Kurt P. · Answer

Jon,

Thinking about this overnight - and at the risk of wearing out my welcome - here is another way to look at the return on that 400k, and what it buys.

First it gets a 430k loan at 4.78% being paid off by the property. even at the NOI you corrected, the $27k year payments are covered by the property. ( esp. as we are 37% of gross rents in this equation, and that shifts down the expense ratio somewhat I think. the bank will use 75% of gross but I guess that's high. )

Second the rental savings of $25k in reduced expenses is real. penny saved = earned.

so from this perspective it's a very tax advantaged 50k return on 400k in year one with no appreciation of rents or equity. that's a 12.5% return that will grow in time. I know this is only napkin math, but as wealth building doesn't it actually represent more than a 1.3% return?   I certainly respect that you have experience and knowledge that I don't yet!

Kurt P. · Answer

Jon  sorry didn't mean to paraphrase you incorrectly, just to think about where capital should go was my point.

Your take on birddogs and wholesalers is interesting, and I'll keep that in mind. I though that they might be a resource, but if I have a few specific areas I am looking in that I can personally cover it sounds like I might want to consider also trying to work them myself for leads via a combination of small mailings, and in person networking. Thats a whole thing to learn but then I've done a lot of the same actions in my professions.

the driving distance idea is also worth some research, there is a whole lot of density in my area that's for sure.

thanks again.

Jon Holdman · Answer

I'm really not advocating long distance investing.  I would recommend against that to start.  But I would also recommend against buying a bad deal just to own something.  I would recommend trying to research within driving distance and see if you can find anything that's a possibility.  I do realize that might be very challenging.

Don't overestimate the usefulness of birddogs and wholesalers.  A large portion of the deals I get sent by these guys are no better than whats on the MLS.  Some are deals that ARE on the MLS and are being marked up by the wholesaler.  Finding a good deal is just plain hard.

Kurt P. · Answer

Jayme,

well perhaps buying 3 in Fresno is a better idea, I think long term that's kind of what Jon is trying to say to me.

as for living with your tenants, I certainly do understand its not ideal. but I am looking to start, which is always hard. however this is an area generally a bit more up market than the best cap rate zones in brooklyn, so frankly our renters would not be so different than us for the most part.

as for rents well a 2 bedroom in the Sunset Park area of brooklyn can be $1600 - $1900 mo. $3400 a month gets you 2bdr in manhattan just maybe.  it's just a different market. we used to have a 450 sq ft studio apt co-op in chelsea that we could sublet  for $2100 a month easy when we were out of town, which sounds great until you know the maint was 1k.

all that aside I take your warning to heart. and yes my plans would include $15,000 for reserves.
Jon will be relieved to know we missed the bullet on this one and our offer was turned down, they are going to get over 700k and not look back.  I think I might need to become my own bird dog to get a decent deal.  Probably not the first homeowner to flyer a zone looking to get lucky.

Jay Orlauski · Answer

I have to agree with Jon , that living next door to your tenants is a bum deal. On one hand , you can keep an eye on your tenants. On the other hand, you can keep an eye on your tenants. in other words, they never go away and you are mixing life styles. Also , if you get to know them too well, you may fall into the trap of being too lenient on late rents and what not, since you start to develop more of a relationship with them. I do my best to avoid my tenants unless it for maintenance purposes. But like Jon says, I am compromising my home, instead of optimizing it for the best rent.

I can say this much though, for the price of the triplex your looking at , I could have bought three of them. Do people really pay $3400/ month to rent someplace? That would be a pretty hard sell here in Fresno, obviously you are somewhere where even considering these numbers must be feasible , it's just hard to imagine. If one tenant is late, you will be paying their rent for them , so you may want to have a few month of mortgage payments set aside.

Kurt P. · Answer

Jon, yes certainly all areas are not equal and mine might be on the bottom of that line, though there are clearly many landlords making money in NYC. I grew up in a two flat, and actually 2 fams are the norm here, not SFR's. So the 'help pay the loan' idea is very common here if you can get the loan, over 80% of nyc rents. The rent vs buy thing here is a fine balance, or in-balance!

I do think starting long distance is difficult, but within an 90 minute drive there are many other options if I go that route.

I'd like to know how people are making money in nyc . Wonder if some nyc people have opinions? Sounds like you are staging up, and I am looking to figure that first stage I suppose, really appreciate you take. I know your like the top poster, but helping a first timer out like me is very generous!

believe it or not this property will probably go for much more than we'll bid. I think I might need to develop some wholesaler / birddog contacts to get a decent deal!

Jon Holdman · Answer

There are lots of places where its not profitable to own rentals.  I live on the west side of Denver but my rentals are on the very eastern side.  Rents are very similar between the two areas and the houses are actually a lot alike. But prices are significantly higher on my side of town.  And its hardly a ritzy area.  I don't know your area at all, but I suspect there are some areas, perhaps further away than you would like, that have more profitable rentals.

I started out thinking I wanted a multifamily.  I decided SFRs were a safer place to start.  If you decide you don't like landlording, there are lots of buyers for SFRs.  The only buyers for multis are investors.  Recently I've started again considering multis.  There's nothing around here, at least that I've found, that's priced anywhere near a reasonable price. So, I'm starting to look further afield.  My plan would be to try to acquire a building about 12 units.  Fifty would be better, though, because that's large enough to justify full time management.  That's just out of my range both in experience and cash.  For some of the prices I see in various locations, 12 seems do-able not too far down the road.  I wouldn't recommend starting out long distance, but I'm beginning to think that's where I may have to look to generate the profits I want.

Personally, I wouldn't want to live next to my tenants.  They have their lives and I have mine and I'd rather not mix our business relationship with being neighbors.

Kurt P. · Answer

Jon,

thanks for the walk through, your right its a lot of cash and equity into one place, which I guess is kind of why I'm posing here to get a sense of it from a non-homeowner perspective like yours.

the idea of 'combing' needs just creates compromises is an interesting one, maybe on target in general. However there are no 200k ranch homes in my town, I'd be looking at 400k for a 2 bdr condo maybe, so the relative difference of what loan I can get with an income prop is also what I am looking at, and the loan rate that is available to me via FHA now. My personal cash flow alone will not get me that 430k loan, its the downpayment that gets the ratio into conforming.

I agree we are in a postion with more choices than most beginners, and I want to be conscious of that and move as wisely as we can. I appreciate your help in that process.  Maybe these numbers don't stack up, but in general don't most most multi-fam investors start like this? I'd be interested to know that.