MFH: Four versus More?

Question

Hi everyone,

I've been absorbing everything on BP recently and have a question regarding starting out in multi family that I wasn't able to find in my searches.

I have access to a reasonable amount of capital for investment in buy & hold rental property, and was looking to start with effectively a turnkey multi family. I'm in CA and am primarily looking in the Midwest and Southeast, which explains the interest in ready-to-go properties as I'd be using a PM anyways.

Now, because I'm looking out of state, FHA's benefits for live-in 2-4 units wouldn't be in play; as such I'm curious how to think of the differences would be in finding say a 3-4 unit property vs. something larger (but not massive) like 5-10 units. From my understanding, the biggest factors are a change in loan and pricing structure (commercial vs residential?). How substantial of a difference is this in the lower range of multi units over 4? What else is there to consider?

Thanks everyone!

Andrew Johnson · Answer

@Ben Yelian I'll be overly general and say that you can roll with a 30-year fixed on your <4 unit properties but 5+ will mean 5-7 year fixed rate (with a balloon) and a 20-25 year amortization table.  They can get a little better or a little worse but that's a good "middle of the road".  You'll also pay a little more when it comes to your interest rate.  And you might have to shop around at the small/regional/local banks that will carry the note.

But with 5+ you can "force appreciation" but just raising rents.  So if you're looking at flyover country that doesn't see "dirt value" go up like it does here in San Diego or Los Angeles, it could be advantageous for you over the long term.  And at 5+ you're seldom going to be bidding against an owner-occupant.  You don't get any financing advantages for living in the property so you're only up against other investors with capital that will be analyzing deals in a similar manner.

What I do think you'll find is that some operating costs don't scale linearly with small multifamily.  You won't pay twice as much for landscaping for a 10-unit vs. 5-unit.  You'll have less roof and/or exterior per unit with a 10-unit vs. a 5-unit.  It's only one exterior to deal with for pest control, etc.  So I wouldn't "avoid" a 5-unit but there are some advantages when you go a little larger.

Anyway, one thing that's really easy to consider when looking at properties is which utilities are individually metered.  Paying a dumpster fee is one thing, paying water bills for 10 units of people that know they don't have to pay the water bill...well...it leads to a lot of long showers.  And when you're advertising rent I don't think it's that easy to get a dollar-for-dollar increase when "water is included" since people look at price first.

Andrew Johnson · Answer

@Ben Yelian In your shoes, I'd start where I want to end up.  If you think it's commercial property then go for it.  Since you're looking in the midwest and south you'll incur costs to visit the property.  It's easier to "distribute" those costs over 7 units than 3, it's just less impactful.  I know everyone here likes to talk about 1031ing their way to bigger properties.  However, it does cost ~10% to do that when you take into account closing costs, realtor fees, getting it "sale ready", etc.  I wouldn't want to eat 10% of the sale price to move from a 3-unit to a 6-unit in 3-5 years if I could just get the 6-unit now.  But that's me.  That said, I do know that down the road my interest rate could increase when it's time to refinance when the balloon hits.  I don't know if we'll be at 5% then, 6%, 8%?  Who knows.  And I know that my properties can "take a hit" when it  comes to interest rates and still bumble along.  The most practical thing to do is model out what happens if rates do rise with a commercial property.  It might be a big deal, it might not.

Jeremy Taggart · Answer

@Ben Yelian 3-4 is still considered residential. More favorable loan structure, 30 year fixed with a decent rate and lower closing costs than commercial.  Usually more competition from other investors for this very reason. Downfall of these is you are limited to other comps as to what the ARV is. Good thing is these are very plentiful and you can get some great cash flow with them still. Also more of a user friendly starter investment since you can start smaller and lock up nice financing. Commercial loans you start seeing balloon payments and higher closing costs/interest rates. The nice thing about these is you can add some serious value in a short period of time by turning around a property since the ARV is based off the income the building brings in. You can also usually get better cash flow with more units and can utilize economies of scale.

Jay Helms · Answer

One of the biggest differences @Ben Yelian when going from conventional to commercial is the ability to have a non-recourse loan. Typically the property has to be stabilized or historically stabilized to qualify for non-recourse but that is one of the biggest differences. I see you're looking in the Southeast and I cover the panhandle of FL up into parts of AL. Let's link up.

Ben Y. · Answer

@Andrew Johnson Thanks for the detailed write-up, that confirms a lot of what I was thinking regarding the cost scaling you mentioned. You bring up a lot of good points regarding forcing the appreciation, and there's the same elements of the small size ~5-7 units maybe not being bad, but still in an awkward spot. I guess it'll come down to whether I should look for something a little easier but more competitive to start with in a triplex/fourplex or dive right in with a larger unit and its costlier financing. Seems compelling why most people lean towards the former when doing their first (few) deals.

Jeremy Taggart · Answer

@Ben Yelian yeah might make the most sense to just do 3-4 to get your feet wet and build a trustworthy out of state team then scale or 1031 to something bigger like 10-50 afterwards. That seems to be the sweet spot for non institutional investors.

Ben Y. · Answer

@Jeremy Taggart Thanks for your answer! If that's the case, particularly if closing costs and interest rates are less favorable, it seems like the smaller non-residential units I was talking about might be in an awkward position of being more expensive at the outset, but not of a sufficient size where there are significantly larger economies of scale to reap. All of this especially so since I'm hesitant to look at big rehab efforts on out-of-state properties.

MFH: Four versus More?

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