Investing in multi-family real estate
There’s no question—with regards to real estate investing—that single-family homes will represent the lion’s share of your focus. Learning to acquire, renovate, sell—even establish a recurring rental property income—is a fantastic way to learn the basics of the real estate investing trade.
At some point, however, you’ll want to explore adding multifamily investing to your portfolio. The reason is simple: Investing in multifamily properties lets you boost your income while reducing vacancy rates.
Tips for investing in multi-family real estate
Investing in multi-family real estate will prove to be a unique experience when compared to building a portfolio of single-family properties. Review the tips below to gain a better sense of how to invest in multifamily real estate, and what to keep in mind while you get started:
Find your 50%
The best way to scan through potential deals is to crunch the numbers and determine (approximately) how much a specific multi-family property can make you as an owner. You do this by calculating the difference between expected income (rent payments, storage fees, parking fees) and expenses (repairs, maintenance, etc.)
When you do not have access to some information, such as a clear neighborhood comp, you can use the 50% rule. Simply take the expected income and HALVE it, this then becomes your estimated expense number. The difference between your estimated monthly income and estimated monthly expense is your net operating income (NOI).
Calculate your cash flow
The estimated mortgage payments are brought into the equation in this next step, by calculating your estimated monthly cash flow. To find out how much money you’ll actually be putting into your wallet on an ongoing basis, you want to subtract the monthly mortgage payment from the NOI of your prospective multifamily property. This calculation will provide you with your cash flow estimate, helping you determine whether or not the investment will be worthwhile.
Figure out your cap rate
A third critical calculation to memorize is the capitalization rate, or cap rate for short, which indicates how quickly you will get a return on your investment. It’s important to remember two things: one, the cap rate for a “safe” investment, such as a certificate of deposit (CD), is usually in the low 1% to 2% range. Two, this cap rate you’re about to calculate doesn’t take into account factors such as increases in property value, boosts in monthly NOI, or the many tax breaks afforded to owners of multifamily properties.
To calculate cap rate, all you do is take your monthly NOI (multiply it by 12 to get the annual number), and divide that number by the property’s current market value. The key thing to understand about cap rate is that higher is not always better. A higher cap rate generally denotes higher risk and higher return. While a lower cap rate, conversely, indicates a lower risk and lower return.
A good rule-of-thumb is to shoot for a cap rate in the 5% to 10% range. Anything lower and the investment may not have enough yield, anything higher and you want to be sure you understand all the risks associated with the investment.
What to look for when investing in multi-family properties
Casual window shopping for real estate is nice to do on a Sunday afternoon, but multifamily investing requires much more than browsing your local open house. For investors, it requires a reasonable amount of due diligence that will not only encompass locating a property below market value, but also commencing efforts to analyze and assess its financial sensibility.
Along with the actual hustle of finding so-called property, it takes a combination of things to ensure a quality real estate deal. In most cases, the search will begin by locating a potential property and then comparing purchase prices, short-and-long term costs, and rental estimates. While this will generally forecast a ballpark figure of what investors can expect, it’s up to them to continue their due diligence and refine those numbers to ensure success. Because investing in multifamily properties requires a little more attention than other real estate deals, an investor’s first concern should always be on the numbers. These financial figures will not only expose the true value of an investment property, but reveal its bottom line. In addition to the numbers, there is a selection of underlying factors that can, and will, influence multifamily investing.
For those looking to invest in a multifamily investment deal, the search begins with the following checklist:
It’s been said many times before, but location is of the utmost importance for real estate investors, and even more so when investing in multi-family properties. With more tenants, each and every unit will need to appeal to renters; location is generally the most desired criteria. When investing in multifamily properties, investors should pay attention to high-growth, high-yield areas where properties are in high demand, well-maintained neighborhoods.
Total number of units
The next step is to evaluate the property as a whole. Investors should take into consideration the amount of units on the property, including the number of rooms in each unit. Beginner investors should begin their real estate search focused on three types of multifamily properties: the duplex (two units), triplex (three units), and four-plex (four units). These types of properties not only offer the most upside with the least amount of risk for beginner investors, but they are generally more affordable.
The next step is determining the income a property can accrue. Sites like Rentometer.com or Craigslist are helpful sources for verifying rental prices and income, but investors should practice due diligence, taking everything into consideration.
For those looking to remain conservative, the 50% rule is a general recommendation: 50% of a real estate investment’s income should be spent on expenses—not the mortgage. While too mild of a strategy for some, it’s a good rule of thumb for beginner investors.
Every situation will differ when financing real estate, especially multi-family properties. For example, the investor may choose to live in one of the units while renting out the other, which would allow them to qualify for owner-occupied financing. This means the income from the second unit will be factored into the lender’s qualifying ratio. Investors need to also consider their credit score when contemplating financing options, as this important number will greatly influence the qualifying process. In general, lenders will look at three components: credit, debt-to-income ratio and down payment.
There is one more question when evaluating potential multi-family properties is: Who’s selling the place? Because the purchase price can vary greatly depending on the seller and their motivation, it’s imperative for investors to gain an understanding of who they’re dealing with. A bank-owned property is dealt with much differently than a for-sale-by-owner property, which means there’s potential for cost savings.
Single family vs. multi-family investing
Investing in single-family vs. multi-family properties continues to be one of the great debates in the world of real estate investing. While each offers several compelling advantages, each side represents a very different exit strategy for investors, including management style and income earned. Because these properties are viewed differently by investors, insurers and lenders, comprehending the ins and outs of multifamily and single-family properties is critical for success.
For those considering taking the plunge and investing in multifamily properties or single-family properties, it’s important to understand which investment vehicles do what. Deciding among single-family or multi-family properties is largely about personal preference and goals, and the following will explain the major differences between the two investments, including the various advantages and disadvantages of each strategy. If you are looking for an answer for the single-family vs. multi-family debate, I encourage you to keep reading.
Multi-family investing benefits
A multifamily property, sometimes referred to as a multi-dwelling unit (MDU), is a type of residential housing with two or more units under one roof or several buildings within one complex. They are generally comprised of many configurations, with the most common examples being duplexes, townhouses, and some types of condos. Each unit tends to have its own living space, a separate kitchen and bathroom. Although the definition differs from situation to situation, a multifamily property will generally consist of owning a combination of the property and the land on one recorded deed. In some cases, it can be owned by one or more parties.
While they are the least common type of residential buildings, investing in multifamily properties are an immensely favorable strategy among investors thanks to their additional source of monthly income, along with slow but steady appreciation. As an investor, the advantages of owning a multi-family property include:
Bigger cash flow: If a single-family property generates a single monthly income, why not invest in a multi-family property producing multiple forms of monthly income? While the allure of investing in multifamily properties is easy to see, these investments represent an innovative opportunity to generate additional income from one investment. In addition, investors may decide to live in one unit, and rent out the others for income. When it comes to passive income retirement investing, a multifamily property can be used in multiple ways.
More control over value: The more income a property receives, the higher the value is. Because multifamily properties are comprised of more units, which means earning multiple streams of income, these types of investments are generally valued higher than single-family homes, which are dependent on comparable sales as rentals.
Larger pool of tenants: One of the underlying benefits of investing in multi-family properties is less risk. How you ask? Because, unlike single-family units, where income is lost when the home is vacant, multifamily properties have numerous units and alleviate the total economic loss for investors.
Scalability: Multi-family investments epitomize scalability. Rather than purchasing individual properties and slowly growing your business one transaction at a time, these investments represent the opportunity to acquire multiple properties within one building. They are perfect for those looking to grow their real estate investment portfolio and take their business to the next level, with the option for investors to venture into the arena of mixed-use and apartment investing down the road.
In its simplest form, new investors should conceptualize multifamily real estate as a hybrid between a single-family home and a condo where both the structure and the land is owned and on file in one recorded deed. Along with the ability to generate more income than a single-family property, these investments are ideal for those looking to not only grow their business, but offset risks when generating monthly income.
Single-family investing benefits
A single-family property, otherwise referred to as a single-family home (SFH), is defined as a free-standing residential dwelling built on a single lot with no shared walls. Unlike a multi-family home, these properties contain only one unit which is neither attached or built in unison with any other type of structure. In addition, a single-family home will generally include a front and backyard, as well as a garage.
Traditionally used for owner occupancy, single-family homes can also be used as an investment vehicle to generate monthly income. With record-low mortgage rates and fast-rising rental rates, these investment properties offer an assortment of advantages compared to multifamily real estate, especially for beginner investors. The following examines the benefits of investing in single-family properties:
More affordable: One of the more obvious advantages of investing in a single-family property is cost. The price for these real estate investments is generally much lower than multi-family properties, including additional expenses such a down payment and maintenance. Rather than 25% to 30% down, which would be the case for a multi-family home, investors simply need to ante up 10% to 15% for the down payment. In addition, most rental agreements will require the tenant to pay for the majority of utilities, as well as take responsibility for the landscaping, which makes long-term maintenance costs much cheaper. Also, insurance rates will be more affordable for single-family homes than multi-family properties.
Higher appreciation: For one reason or another, single-family investments tend to appreciate more than other types of properties. It could be a variety of factors, but it mostly pertains to how lenders value each type of investment. Unlike multi-family properties, which are valued on the rents coming in and the condition of property, single-family homes are valued on supply and demand of owner-occupied buyers. If well-maintained and situated in a thriving neighborhood, buyers will always be in demand for single-family properties.
Easier to finance: Although financing guidelines and rules vary from bank to lender, financing a single-family property is typically much easier than its multi-family counterpart. Lower interest rates and higher loan-to-value (LTV) ratios are one of the main benefits of financing single-family homes. And because these properties are typically much more affordable than multi-family homes, many investors will forgo financing options and purchase the property with cash. It’s important to note that financing a property for the intentions of rental income (non-owner occupied) will subject borrowers to different mortgage rates than an owner-occupied loan. Investors can expect to pay 0.25% to 0.50% more than owner-occupied mortgage rates.
Easier to manage: Managing one unit over four has its appeal. The one aspect many investors fail to consider when investing in real estate is the cost of managing it, which can vary depending on the amount of units. With only one tenant, single-family rentals are much easier to manage. Investors can choose from becoming the landlord and managing the property themselves and hiring a professional management company to oversee the investment.
Investing in multi-family properties requires a considerable amount of time and effort to get started. Done right, multi-family properties can be an excellence source for passive income retirement investing. However, it’s important to understand the ins and outs of multi-family investments first, including how to find and obtain these properties. The great part about using math to inform your multifamily investment property decisions is that it takes the emotion out of the process. Instead of being influenced by extraneous factors, such as personal relationships, by crunching the numbers on a possible multi-family property, you’ll quickly get insight into whether this project has enough ROI potential for you, or is something that should be avoided at all costs. And knowing which deals to walk away from can often be as important as knowing which deals to pull the trigger on.