The best investment property type (and why).

[Greg Weik]

What I've learned since 2008 while managing properties: Those who can buy long-term SFRs (Single Family Residence) as an investment vehicle, buy them.  

SFRs are expensive. You need a lot of cash to make it happen. Underwriting guidelines require 6 months' reserves for all of your properties (yes, including your primary residence), plus at least 20% down on the rental, plus a favorable DTI. Banks don't make it easy to buy an SFR rental.

I see many BP posts dismissing SFR purchases as "not good enough" in terms of ROI, cash-on-cash return, and other excuses. This is all noise. If you can buy them, you buy them.

The surface-level challenges to successful SFR ownership are, however, true: SFRs in the broader Denver market "don't work" (in terms of positive cash flow) on paper in most cases with 20% down, especially if you are hiring a PM (which you need to do). 20% down and you'll still likely be in the red each month. In most cases, you need to put closer to 30% down on the property so as not to be in the red every month. More on this, with a real-world example below.

When you buy your next SFR rental, hire RES to manage it, and we will be even for all of this free information. :)

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Why SFR is superior to other options:

1) Liquidity. Ultimately, you'll probably want an exit strategy. SFRs (particularly the right ones) are the most liquid type of real estate. Your market is the entire home-buying public. Instead of dealing with spreadsheet investor buyers, your SFR buyer is likely to "fall in love" with a home. It becomes an emotional purchase. A place they can picture raising their family. If you keep it in excellent shape, you will have no trouble achieving a top-of-market sales price (and in some cases a bidding war) when the time comes. HELOCs are easier to come by, freeing up some equity for the next investment. More details on why this is the case are below.

2) Stability. Often undervalued in the investment community, is not having turnover at all.  SFRs attract tenants with children, and those families value stability.  They want their kids to grow up in the same neighborhood, go to the same school, make solid friends, etc.  The tenants for SFRs often stay put for many years.  This means zero vacancy costs, year after year.  Vacancy is the #1 killer of a rental property. 

3. Amortization paydown = wealth accumulation. SFRs are more expensive than other types of rentals. In the Denver market, you'll likely be paying $700k to get a good SFR. That's a tough pill to swallow. The good news is that every month you collect rent, you are building equity quickly, relative to other investment types. If your tenants are paying $4k/month or $48k/year, your equity builds at a nice, steady clip. Taking down your mortgage balance by large chunks at a time makes securing a HELOC in a few years an easy proposition, should you choose to go that route.

4. Revenue to expense ratio. RER. I'm not sure if I've coined this, but I've never seen anyone else talk about it. If you have a high-end SFR renting for $4k/month, that SFR has 1 of the following (in most cases): -Refrigerator, -oven, -dishwasher, -microwave, -hot water heater, -disposal, -HVAC. So that's $4k/month relative to the KNOWN likely expenses down the road. Contrast this with multi-family. If you have a duplex with $2k/month per side, you now have TWICE the anticipated expenses for the same revenue. This is some of the math most investors don't understand or choose to ignore.

5. Appreciation. You never know what your appreciation will be, so this has to be considered a bonus. However, in most economic conditions, an SFR in the right place is going to appreciate steadily, relative to multi-family. This is part of why SFRs are so expensive to get your hands on in the first place. The hidden story here is that you have a larger tenant base as a result of the high cost of acquisition. Many qualified renters can't swing buying the house they want, where they want, but they can rent it. Which leads me to...

6. Tenant quality.  Another often overlooked part of owning rental properties is understanding who is likely to rent them.  If you come to me with a $5k/month rental in Downtown Denver, I can tell you with relative certainty that your tenant will most likely be A) Young professional roommates or B) An affluent family new to the area.  If you come to me with a four-bedroom house in Highlands Ranch, it will be a family with stable income and decent (or better) credit.  If you come to me with a 4-plex in Denver, I will say good luck. 

7. Mitigated impact of anti-landlord legislation.  The truth is that being a landlord in Colorado is getting riskier and more challenging.  Just cause eviction legislation, the prevalence of ESAs, eviction timelines, eviction hoops/paperwork/mediation and costs, inability to use credit scoring as a metric to evaluate a tenant's risk profile if they have subsidized housing, portable tenant screening reports (PTSRs) which make evaluating the authenticity of a credit report dubious, and on and on.  Legislation on the horizon may limit landlords' ability to collect a security deposit entirely at move-in.  With SFRs, you're more insulated from these concerns than with other types of properties, because your tenant base tends to be more qualified to begin with.  

8. Move-outs. Another thing new investors miss when determining what to buy is the future turnover condition of the property. Good SFRs have good turnovers. A typical SFR turnover is both a move-out inspection and a move-in inspection at the same time, because the property is already move-in ready.

9. Cashflow. I put this here because it's sooooo misunderstood (in the context of long-term rental ownership anyway, which is my lane). Example property: $700k SFR. 20% down ($140k). 6.25 interest rate. 30-year fixed mortgage. Rents for $3400/month. Mortgage payment is $3500/month. Management fees are $200/month. Let's assume you're out of pocket $400 every month. Obviously, put more down and you're break-even or in the black, but for the sake of running the numbers, I'll prove how "losing" $400/month is the best investment you'll ever make.

If it's $400/month that you're subsidizing your mortgage, you're still winning.  By a lot.  (Just not on BP).  In the real world, however, you're bringing in $40,800/year towards your mortgage.  The way an amortization schedule works is that, with each passing year, more and more of that payment is allocated towards the principal.  Think of your negative cash flow as a payment on a used Kia.  

After 5 years of $3400/month in rent collected, that's $204,000 paid towards your mortgage.  It's quite likely this was all during a single tenancy, and you have not even had turnover yet.  After the first 5 years, you've paid nearly $40k towards principal (based on how the amortization table works on the data provided above).  

If that SFR appreciates at a conservative 5%/year, that means your $700k SFR is now worth $895k at year 5. So that's $195k in appreciation and $40k principle paydown, or $235k in wealth you created -in 5 short years- by paying $400/month out of pocket for your SFR.

More math: $400/month is $4800/year or $24,000 over 5 years, you would have paid out of pocket. 

If that $24,000 you paid out of pocket yields an INCREASE to your wealth of $235,000, is it worth it? That's nearly a 10x return (on the monthly subsidy, not taking into account the 20% you put down to buy the SFR). Feel free to check my math.

More math (sorry): If you include the initial $140,000 you put down to buy the house (your 20%) and you include $24,000 you paid over 5 years, that's $164,000 total you paid out of pocket to increase your net worth by $235,000. While I realize that the picture may be less rosy, keep in mind that my numbers are conservative, appreciation could be higher, and you still have MANY other financial benefits (such as the HELOC opportunity).

Those numbers are all pretty conservative. The rental rate on a $700k SFR could be more like $4k. Appreciation could be 7-9%.

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Using those same 9 points for non-SFR rentals, specifically multi-family, condos, townhomes (MF/C/T):

1. Liquidity. Multi-family is not liquid. When you want to sell, the buyer will be an investor, and they will twist your arm. There is not a huge pool of buyers for multi-family to begin with, so selling will take more time and more effort. Condos: ubiquitous, which also makes them hard to move. Same thing with townhouses, and both condos and townhomes often have HOA fees which drive buyers away.

2. Stability. MF/C/T are far less stable investment vehicles. Tenants are more transient.  Vacancy times are longer and more frequent, killing the bottom line. 

3. Amortization/paydown. Less money each month means less towards the principal. You need to buy more MF/C/T units to compensate, and that compensation is still thoroughly watered down by all the other points listed above and below. If you want a HELOC, it's more complicated and less accessible, as you have nickel-and-dime equity spread across a less-attractive and lower-appraised portfolio. You can't access your wealth nearly as easily with MF/C/T.

4. Revenue to expense ratio. RER. MF/C/T's rent at a lower price. $1500/month, and you still have 1 of everything to deal with replacing... and if you scale up to 5 or 10 units, now you have 5 or 10 of everything to deal with replacing.  These costs are death by a thousand cuts and it's what happens with a MF/C/T portfolio. 

5. Appreciation. Again, unpredictable, but when you have a ubiquitous commodity, such as a MF/C/T, you're going to be hammered by supply in the area. SFRs (especially the right ones) are in areas where there is not much open space to build, and they consequently see great appreciation.  

6. Tenant quality. MF/C/T tenant quality can be fine; it all depends on the unit and area, but it's not going to be as consistently high-quality as SFR tenant quality. Any investment property can have duds who make it through screening, but a nice SFR will result in many quality tenants to choose from.

7. Mitigated impact of anti-landlord legislation. Much of the anti-landlord legislation is directed at MF/C/T landlords and properties.  SFRs in 'The Burbs are largely out of the Colorado legislature's crosshairs.  

8. Move-outs. MF/C/T move-outs can be great (all depends on tenant placement), but generally speaking, there will be far more issues with damage, new flooring needed, new paint needed, junk removal, etc., on any non-SFR property. Security deposits may cover some of it, but you're still dealing with contractors painting, replacing flooring, repairing damage, etc., etc., at many turnovers.

9.Cash flow.  This is a generally misguided consideration without taking the other 8 points into account.  
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The bottom line is that all rental properties come with risks.  They all come with expenses.  It's not a passive way to increase wealth, and it's the classic conundrum of "it takes money to make money."  Many MF/C/T investors I work with underestimate the 8 points mentioned above at their peril.  There's only so much we can do as a PMC to mitigate those factors.  If you're going that route (MF/C/T), please take those 8 points to heart.  

I strongly urge anyone seeking to throw their hat into the world of real estate investing (particularly buy-and-hold) to make their money in the real world and THEN buy rentals.  In my experience, rentals don't make you money - they cost you money.  They build wealth, but you can't spend wealth.