1031 into Larger Multifamily or Multiple 4-Plexes?

Question

I own a 4-plex in Los Angeles and have built up ~$1 million of equity
 in the property (bought in 2011, at the lows). I'm considering selling 
the property and exchanging into more units (still in L.A.) but I'm 
trying to decide between two strategies and would be curious to get 
others' thoughts.

Option
A - Buy 4 fourplexes. With $1mm equity, I can theoretically cut four
$250k checks and, with 70% LTV, purchase four $900,000 fourplexes. These
would be smaller units or in slightly less optimal submarkets of LA
(e.g. North Hollywood vs Burbank), but would leave me with 16 units and
$3.6 million of property value.

** I recognize it might be
tough to find 4 properties that are actually worth investing in at
today's prices, but let's assume we can find them (or be patient enough
for opportunities to materialize).

Option B - Buy one larger multifamily (e.g. 12 units) for $3 million (with ~$1 million down payment).

My questions are:

1) Is one option clearly better than the other?

2)
For Option A, which assumes standard conforming Fannie/Freddie loans,
would it be difficult to quality for 4 residential mortgages within a
12-month time frame? I have generally strong W2 income, but I feel I'll
hit up against DTI ratios if I don't have tax returns showing the income
from the new properties (which I won't have until ~12 months after
closing each property).

3) Is it even possible to get 70% LTV these days on conforming 4-plex deals?

4) Brokers
that I'm speaking with (Marcus & Millichap, Colliers) are saying
that 4-plexes generally appreciate more per year than larger
multifamily. Is this true in your experience?

5) Are there any
other concerns / pitfalls I should watch out for as I enter this
process aside from the 1031 timing considerations?

Lauren Speidel · Answer

@Ara Abrahamian @Jaysen Medhurst Yes, you can sell one property and buy multiple replacements. The number of properties doesn't matter but you must identify your replacement properties within 45 calendar days after closing on your relinquished and then you have another 135 calendar days to close on something you've identified. You also must reinvest all of your equity and debt value into the new properties.

Dave Foster · Answer

@Ara Abrahamian, that's a great point by @Joseph Cacciapaglia.  Here's another twist that could help mitigate.  All the IRS requires to defer all tax from a reinvestment stand point is to purchase at least as much as your net sale and use all of the proceeds in your next purchase or purchases.

So a possibility comes to mind (depending on valuation) where you break those purchases down into two or three tranches.  Use your proceeds to purchase one 4 plex for cash or as little leverage as possible. and one with maximum leverage.  As long as this satisfies your reinvestment targets then your 1031 is complete.  Once that is done then you could refinance the cash property at will whenever you found the next good buying opportunity and get your next units using refi proceeds.  No more time angst from the 1031.

Dave Foster · Answer

@Ara Abrahamian,  You can sell one and purchase more than one replacement property.  But you've got to be very careful.  There are some very strict parameters for how you identify your replacements and how they're valued  that could invalidate your entire exchange.

You mentioned purchasing 4 replacement properties.  That puts you into a whole different set of identifying parameters for your replacement properties.  When you want to purchase more than 3 replacements then the total value of all of the properties named can't be more than 200% of the value of what you sold (unless you purchase 85% of the value of your potential list).  So if you're thinking to purchase 4 properties for 3.6 mil then your sale can't be more than 1.8 mil.  And if you've named any back ups on that list to give yourself some wiggle room then those amounts have to be counted towards the 200% as well.

You don't say what your sale will be so you may be OK. But these are the kinds of regulatory concerns that have to inform your strategic thinking.

@Jaysen Medhurst and your professionals are spot on with their observations about appreciation of 4 units and less.  I'd add to that by observing that if you look at what every syndicator in America is trying to buy (medium to large apt complexes) this is maybe not the best sector to find good deals in.  I'm seeing investors now having more success and NOI going smaller rather than bigger because of the insane competition for larger multi.  Financing is also much easier actually on these smaller units.

Another option that you didn't mention was using one portfolio loan (laddered or at once) to purchase the four unit buildings.  I don't know if there's savings with that approach over conventional but that's definitely worth pursuing.

Joseph Cacciapaglia · Answer

1. I don't think one is clearly better. You can get great returns from 4-plexes and larger properties, and both have pros and cons.

2. You shouldn't have difficulty with multiple mortgages. At least in my market, lenders are willing to credit the income of the property based on a rent schedule appraisal. They don't require that it be on your past tax returns. Of course, you should run this scenario past a few local lenders and see what they say.

3. The last several 4-plexes I sold were financed at 75% LTV. That money is definitely out there. I don't know specifically for CA though, these were all in San Antonio, TX.

4. It does seem to be the case that 4-plexes naturally appreciate faster. However, if you're doing some value add, it's easier to force appreciation on larger properties.

5. I know you said "aside from the 1031 timing", but I want to talk about that really quickly. I had a client in a similar situation last year. They were selling a single property in CA and were trying to buy several properties here in SA. They eventually decided that it was too difficult to identify several properties, and went with just a single property. I don't know what the 4-plex market is like where you are, but here most don't stay on the market for more than a few days. Getting 4 under contract in your 1031 window can be difficult, and sometimes forces investors to make poor buying decisions.

One benefit of the 4-plex option is that you gain more flexibility with your future sales, because it's no longer an all or nothing experience.

Jaysen Medhurst · Answer

@Ara Abrahamian, understanding that I don't know your market specifics, I think larger is usually the way to go. You'll see much better efficiencies of scale and you can force appreciation, which you can't do with residential.

I'm not sure if you can do a 1031 from one property into 4 and still defer all of the taxes. Maybe @Dave Foster can clarify.

Not surprising that quads are appreciating faster as they're tied to the residential market. Cap Rates on commercial property can only go so low I guess.

With a larger deal, and a commercial loan, DTI won't be as much of an issue. Commercial lenders care about the deal and your experience. If the deal has a comfortable DSCR and the underwriting makes sense, you should be golden.

I definitely think it's worth finding the new property first, then put up your current building for sale to avoid the deadline jitters.

It's also worth looking into agency debt for a larger MFR. There are hoops, of course, but it's non-recourse and great terms.

Ara Abrahamian · Answer

Thanks, Joseph, agreed. I think it boils down to supply / demand for housing but, nevertheless, I'm sure there is a lower limit on what return investors will accept. I think 2.9% is below that threshold. I'll go back and revisit my numbers.

Joseph Cacciapaglia · Answer

@Ara Abrahamian I agree with your assessment of future cap rates. It's hard to imagine 2.9% being attractive to investors. We're significantly higher than that in San Antonio today, and we still have a lot of push back from buyers. I think as long rang investing becomes more accepted, you won't see the huge premium in CA that you're seeing today. As it is there are tons of CA investors moving there cash here. I don't think there will ever be true parity, but I think there will be some merge.

Ara Abrahamian · Answer

@Joseph Cacciapaglia, thanks for the clarification. I always approached properties from a cap rate perspective (even 4-plexes), but I can see how others might not.

@Jaysen Medhurst, thanks as well. For the agency debt, it might be worth considering if I do 1 large property. Wouldn't work for the smaller ones due to the minimum size requirements.

Regarding the analysis, I'd be happy to share the Excel file, but don't see a way to do that here. It all comes down to the assumptions, but I was assuming 5% annual appreciation on the 4-units and 4% appreciation on the larger multifamily. This was essentially the biggest driver of the delta. Property value grows from $3.6M to $5.9M ($3.9M equity value) in the former scenario and from $3.0M to $4.4M ($3.0M equity value) in the latter. This difference is partly offset by more cumulative cash flow in the larger multifamily due to slightly higher cap rates there ($500k of cash flow over 10 years vs $175k with the 4 quadplexes).

But again, the assumptions make or break it. Under the forecast I built, the 4-plexes at $5.9M in year 10 imply a cap rate of 2.9%. I think it's unlikely that cap rates stay that compressed for that long.

Jaysen Medhurst · Answer

@Ara Abrahamian, forced appreciation is about increasing NOI. This doesn't necessarily come from rehab, though it could be related. You increase NOI by either increasing income (nicer units should command higher rents) or lowering expenses, usually through operational efficiencies. This works with 5+ unit properties because commercial buildings are valued based on how profitable they are.

Agency debt in the this context is offered directly by Fannie and Freddie. You need a minimum loan balance of $1MM. There are a whole list of other qualifications, but it's worth pursuing where possible for the reasons I listed above. Don't confuse this with what Fannie/Freddie does in the residential market. I.e. purchase mortgages from originators and the package them in to other investment vehicles (mortgage-backed securities).

A portfolio loan could be an option on multiple properties, but the lender would probably want them to all close at the same time. A discussion worth having with them.

I'd be curious to see the math on how you got to $500k more value over 10 years

Joseph Cacciapaglia · Answer

@Ara Abrahamian The reason it is easier to force appreciation in 5+ unit properties, is because they are usually priced based on cap rates not comparable sales. If you have two identical 4-plexes sitting next two each other with different rental rates, they are typically going to sell for about the same amount. This is because the marginal buyer in most markets is the owner occupant, and they aren't necessarily cap rate driven. On the other hand if you have two 5+ unit properties sitting next to each other with different rental rates, they are going to be priced accordingly. This is why it's possible to force appreciation simply through better management. You don't actually have to change the property, if you can raise the rents as is.

1031 into Larger Multifamily or Multiple 4-Plexes?

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