4 unit to 5 unit conversion for refinancing - good or bad idea?

Question

I am looking to get some cash out of an existing 4 unit rental but the residential value for a refi is too low for any significant amount of money. What about adding a 5th unit (very easy to do since we prepped for this when we did the original 4 units) and getting a commercial appraisal for a larger refi? The units have very good cash flow which I can't use when calculating value for the 4 units but would add to the value if it were commercial. Is this a good idea? The main goal is to get cash for another property purchase so things like higher interest rate, shorter loan terms etc... are not as big an issue as they might be otherwise.

Bonnie Griffin Kaake · Answer

Frankie, unfortunately, too many tax professionals are not up-to-date on the benefits available to investors in commercial properties and residential rentals. It is far easier for them to do straight-line depreciation at a time when not enough students are graduating with accounting degrees or going on to get their CPA designation. It is not to your advantage as an investor. You need a good cost segregation estimate and someone you trust to give you on-going tax expert tax advice that knows more about investment properties.

Frankie Lotrec · Answer

@Stephanie P. Thanks so much for all those good points to consider. HELOC may very well be what we end up doing.

Kerry Baird · Answer

@Stephanie P. brings up some great points. Four units and under is still in the residential side of financing, insurance and so forth. Also will be easier to sell as a 4 unit. Five and up are in the commercial space, which will limit your options for selling, as well as for financing/insurance.

Jeffrey K. · Answer

Hey, Ultimately this is going to be dictated by your market and the logistics of the conversion. However, it is unlikely that this will be beneficial.1st, I would double check that this conversion is feasible. Zoning districts often draw a hard line between 2-4 unit areas and 5+ unit areas. The flexibility to do either is relatively rare from my experience, but ultimately this is specific to your municipality. You may also want to check the difference in the tax mill levies between the 2 asset classes. Next, you will want to do a little leg work to verify that this will increase the appraised value of your property. 1-4 unit properties are evaluated using a residential appraisal and the resulting value is dictated by a comparable sales approach. I.e. what have similar properties sold for near your property. Alternatively, 5+ unit properties are appraised with a commercial narrative appraisal and the value is determined by the cash flow on the property. It would be prudent to determine your NOI and the gross rent multiplier of the area to ensure that change will actually result in a significantly increased valuation. Finally, loan products on 5+ unit properties tend to be lower leverage. So, even if you increase the value, you may actually get less money out. Again, there could be a situation where the conversion would work in your favor, but there are some hurdles to address 1st. Hope this helps

Frankie Lotrec · Answer

@Julio Gonzalezpardon the typos

Frankie Lotrec · Answer

@Julio Gonzaleztge purpose of the 5th unit is not so much for the cash flow as much as it is to turn to comercual financing in order to access equity based on cash flow ( 5 units father than 4) instead of comps. As a quad we don't have enough equity rn. Adding the unit would be about 20k it's already roughed in Finally, I asked my CPA about cost segregation he said we do that but not a full one si c'è it's costly and not worth it for just 4 units. tx so much

Julio Gonzalez · Answer

@Frankie Lotrec I think it depends on a multitude of factors. How much money are you needing out of this property and how soon? How much equity do you have in the property? How much would it cost to add the 5th unit? Does that offset the amount you are needing to pull out? How much extra rent could you get by adding the additional unit? How soon could you have the unit finished and leased? With the cost of financing right now, a cost segregation study could definitely be a great option for you, especially considering its a multi-unit property. I'd recommend getting quotes from multiple cost segregation companies to compare the potential tax benefits and cost.

Uriel Resendiz · Answer

If you want cash for another property using your current equity, I would suggest a HELOC instead.

Frankie Lotrec · Answer

@Bonnie Griffin Kaake Bonnie thanks for your input, I would like to know more about the study. I emailed you as well. Tx

Bonnie Griffin Kaake · Answer

@Frankie Lotrec You have not said how much you paid for the 4-unit. Nevertheless, if you haven't done a cost segregation study on the property, you may have some cash-flow that you simply have not tapped yet. We can usually give you about 6% to 8% of your purchase price in after-tax cash flow that you can leverage into another property. The same goes for another property that you might own and lease out. Leverage is the name of the game. Let me know if you have questions.