Multi Family 101

Thinking of upgrading rental properties, perhaps moving from single-family homes to multi-family buildings? Have no fear. While managing these complexes, whether they have six apartments or 60, can sometimes feel more like running a business than managing a real estate investment, many of the tax, landlord and general real estate investing rules that apply to single-family housing also apply to multi-family investments.
Purchasing: Obviously, the overall cost of a multi-family building or apartment complex is much higher than a single unit. Small buildings with say, six units can range anywhere from several hundred thousand on up into the millions of dollars depending on the market, so you’ll probably need to have more cash available up front than if you’re buying a single-family home. The cost “per door” varies widely from market to market but is typically lower in larger properties, a result of various economies of scale.
An ideal building has a good mix of two-and three-bedroom apartments, the larger of which provides an opportunity to rent to families. Complexes with all one-bedroom or studio units tend to stay empty longer since they significantly narrow the pool of tenants they can attract. Of course, this all depends on the location of the property. A building near a college campus, for instance, might very well find plenty of tenants looking for one-bedroom apartments. In most scenarios, though, buildings with a good mix of unit sizes will outperform those packed with studios or one-bedrooms.
Location matters, so if you can, choose a property near the bus lines, local shopping centers, recreation facilities and other local attractions. Well located buildings command better sale prices and higher rents because they will be more desired and sought out by landlords and tenants alike.
Financing: Generally, a residential loan is all that is needed for buildings with one to four units, while a commercial loan is necessary for buildings with five or more units. Typical financing for one to four units will require 20 percent cash down, and loan fees vary, but usually average around 3.5 percent of the purchase price. In order to add larger properties to your portfolio you need to apply for a commercial loan, which has different underwriting and approval processes. For smaller residential loans, the banks generally look at the investment potential of the real estate and then fall back on the borrower’s personal financial and credit history. That’s not strictly the case with commercial loans where lenders are much more interested in profit and loss histories for the project itself. That can make convincing your bank to give you the money based on forward-looking projections more difficult. If possible, you should provide at least a three-year (five is optimum) historical report of income and expense data with your application package.
You may also run into trouble finding a bank that wants a commercial loan for less than $500,000. That means you’ll either have to think bigger and spend more upfront or shop around until you find a bank willing to finance smaller deals. Overall, lenders tend to look at all cash flow considerations including the amount of money you have in reserve to cover unforeseen expenses. They’ll also look at other costs you’ll incur besides the mortgage; these will include taxes, regular maintenance management fees and vacancy rates. Remember, banks need to see an ability to make repayments on a monthly basis in order to approve a loan. Many banks will have a set income to debt ratio, called debt service coverage ratio or DSCR that you will be required to maintain. A DSCR of 1.0 means for ever dollar of income there is a dollar of debt repayment. Expect most lending institutions to require a DSCR of at least 1.25 — one dollar and twenty five cents net income for each dollar of debt repayment — before they consider a loan viable.
Cash Flow: One big advantage of a multi-unit complex is that you will get payments from multiple tenants each month, making both vacancy rate hiccups and deadbeat tenants easier to absorb. If a single-family home is empty, vacancy is instantly 100 percent and cash flow plummets to zero. In a building with six units, if one or two of the apartments are empty there is still income flowing to help pay the bills. Compare that with a single-family house where just a few months without rent can quickly put a landlord in a cash flow crunch.
Because valuations of multi-family properties are tied more to cash flow and net income than single-family units, they tend to be less prone to wild speculative swings in value during both rising and falling markets. These values are often stated in the form of a “cap rate”, which is the ratio between the net income and capital cost. For example, a building purchased for $1 million that generates $100,000 in net operating income has a cap rate of 10 percent. When valuing properties, it is useful to think of the cap rate the same way you would look at a rate of return for any other investment. The higher the cap rate, the higher the rate of return on the investment, but also the higher the perceived risk. Cap rates vary depending on the location, size and history of the property. A fully tenanted apartment complex in a rapidly developing area will command a lower cap rate than an older building in a questionable part of town which is perceived to be a higher risk proposition.
Maintenance: This might be the first tangible difference many investors feel after the purchase process is completed. Even if purchasing and financing your first complex was easy, chances are you’ll soon feel pressure from the extra tenants you’ve taken on. Managing your first multi-unit project can feel like a full-time job. Real estate professionals will advise you to be prepared for the worst, and you should plan accordingly. Instead of that one perfect family you rented a house to with little fanfare, you’ll have several tenants with their leaky pipes, noisy neighbors and lost rent checks to deal with at any given time. Also, keep in mind that the same commonsense rental rules apply to apartments as homes. That means the more units you have, the more you will have to repaint, clean and inspect before a new tenant moves in.
However, if you currently manage several single-family units in different locations, buying a single larger complex could provide an advantage for you. Instead of six families living in six separate homes, your tenants will now share a single roof, lawn, and parking lot, leaving you only one area to maintain instead of six.
It may be advantageous to hire a property maintenance company to supervise, maintain and field calls for you. This will cut into your profit, but if you are a serious investor who wants to spend your time vetting new projects, it may well be to your advantage hiring someone else to take care of broken toilets and overgrown lawns on a day to day basis.
The Right Bet
Investing in apartment complexes should be considered a longer-term and possibly deeper commitment than owning and renting out single-family homes. It takes longer to sell a building or large complex than a home and it may take some time to get the hang of managing such a large property. However, if it’s done right, owning a multifamily complex can provide a constant source of income for years to come with considerable upside along the way. Any investment is a balance of risk, work and reward, but if you’re ready to take on a bigger challenge and move to the next level of investing, then a multifamily project might be the right bet.

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