The problems with small multi-families (at least in DFW)

[John Chapman]

I keep getting asked why I've come to dislike small multi-families (2-4 units) in my area, and I wanted to make a list to see if maybe I'm missing something. I’m not saying small multi’s don’t make sense in other areas, and I’ll readily admit that a lot of my criticisms are derived from my own, personal values/priorities that may be different from others. Also, I should say that I do hae a fourplex and it performs fine. Here are my criticisms in no particular order.

(1)·They are valued on the sales comp approach. It doesn't matter if I do an awesome job of going in, fixing it up, and raising the rents or cutting expenses (thus increasing NOI), the value does not change much. If my bozo neighbors next door decide to sell theirs for a cheap price (maybe due to deferred maintenance or whatever), that's the market price that is used for appraisal purposes and financing. You can probably push the value up a little on your building due to improvements, but you can't ever fully escape the sales comp. approach.

(2)·They are harder to finance and refinance than SFRs. There are not as many of them so it can be hard to find comps for them to appraise. This also makes them harder to sell. SFRs are generally very easy to refinance due there generally being more available comps.

(3) I think it's harder to find value-add plays. Having directly marketed to both types, you generally get big discounts when there's a lack of symmetry in information. You are more likely to find this in the SFR market than the small multi-family market. That is, sellers of small multi-families tend to be more savvy than sellers of SFRs.

(4)·Value plays are essentially done the same way as small SFRs. You basically have to find a dilapidated building, go in and fix it up, and then it will now be worth the retail value what other buildings are selling for. (Again, it's the sales comp. approach) It's not like a commercial apartment building where you can buy, improve the building, and then cash flows improve such that your NOI (and thus value) goes up. Put another way, with a small multifamily, your ability to add value seems limited to buying at a significant enough discount to the retail market. With larger commercials, it seems like it's tied more to your ability to increase NOI, which gives you more creativity and flexibility to improve value. (I'm not sure this is really a point so much as continued gripe of the stupidity of the sales comp approach.)

(5)·You do not get the benefits of economies of scale. Having researched apartments quite a bit lately, your really don’t start to get economies of scale until you can have onsite (or at least full time) management and maintenance. With small multis, you still have to use contractors (which are more expensive than employees) and off-site, fee-based management (typically around 10%).

(6)·The pool of potential buyers is more limited, which leads to less liquidity. With SFRs, I can sell to an owner-occupied or investors. With small multis, it’s generally just investors, who tend to be more savvy.

(7)·I think people drastically underestimate the management headaches of small multis. As soon as people are sharing walls, there is eventually going to be drama. You don’t have this as much with SFRs

(8)·For the fourplexes in my area, the tenants tend to be of a lower socio-economic status and thus cannot absorb rent increases as well as my SFR renters. @Ben Leybovich wrote a great blog on the problem of stagnant wages and rents that I found to be very insightful.

(9) A corollary to the above point is that, particularly for fourplexes, many times the landlord has to pay water. Water rates have gone up quite a bit in my area, and I expect they will continue to do so. (Fortunately, with my fourplex, the water is tenant paid.) Stagnant rents and increased expenses are not a good combination, in my opinion.

(10)·Living next door to your tenants is horrible idea. I see people talking about buying a small multi and then living in one of the units. These are almost universally people with no landlording experience and I think they underestimate the stresses/annoyances of living next door to their tenants.

(11)·I don't see generally much if any discount on them on the MLS compared to SFRs. I can buy a $100,000 house that rents for $1000/month or a $200,000 duplex that rents for $200,000. (the numbers are little better for fourplexes but not enough to justify the management headache) The maintenance costs and square footage are about the same (and duplexes around here are not even two story such that you would have a smaller roofing cost). If I'm inclined to pay retail, as some investors are, why wouldn't I buy the house (with less management headache and broader selling pool) than the duplex?

I can probably come up with more if I think about it, but this was just off the top of my head. Let me know your thoughts.