Critique my strategy (newbie)

[Alan Verde]

My goal is to diversity into multifamily real estate. I already have one investment SFH, but it would be my first time getting into MFH. I still consider myself a newbie, but I've been reading a lot. Here's what I am thinking about. Could use any constructive advice from this wonderful community!

1. Find Class A-ish multifamily property, ideally with existing tenants. Lower margin, but lower risk since it's my first time.

2. Buy it with cash using either my savings or potentially get a PAL temporarily if I need more cash (or both). Ideally, use the all cash purchase to negotiate a better sale price.

3. Depending on the property and my budget, do some minor upgrades (ex. common area, landscaping) to increase property value.

4. Do a cash-out refi using DSCR after 6 months. I'd weight the interest payments if using a PAL vs just straight cash from my account. I suppose the risk is the variable interest rate for the PAL during those 6 months.

5. Try to raise rents after 1 year to improve cash flow.

6. Repeat with a new property.

What am I missing? Thanks in advance!

[Evan Polaski]

@Alan Verde

In theory all of this checks out, depending on your return requirements.  But, a couple notes:

For many people, a Class A property means new(ish) construction with all expected amenities available (clearly a 2-4 unit will have different amenities than a 200 unit).  As such, there is often nothing really to do to common areas or landscaping, let alone upgrade kitchens and baths, to improve value.  Maybe you mean Class A area, but Class B property, which in theory would offer these opportunities.

As noted a 4 unit is more likely going to be valued based on other 4 unit sales in the area, rather than your rents.  That being said, having nicer finishes will impact value if you did find one that you were able to upgrade over time, just like a remodeled single family sells for more than an outdated single family, and those upgrades often allow higher rent, so you still get some return in value for improvements.  But, if you are truly looking at a, say, 3 yr old property in already great condition, then raising rents, if possible, will generally not impact your value.

Buying cash, as noted, can be a risk, but it depends on your personal situation.  If you have $600k of cash sitting around, and you buy a property for $300k cash, while it may not be what many people do, I could consider that fairly low risk.  If you only have $300k to your name, and you put it all into the purchase of the property, then you certainly have a lot more risk.  Most people need loans to buy properties, which is one reason "everyone uses loans".  But, if you look at the asset in a silo, many "Class A" 4 families in good markets are selling for very high prices.  Typically, where taking a mortgage at purchase hurts your returns: i.e. if your unlevered yield is 5% and you borrow at 7%, you are paying 7% to earn 5%.  That does not help your returns, it hurts them.  But, there are often other factors, beyond the short term financial returns, at play that cause people to take on negative leverage.

And most importantly: raise rents to improve cash flow.  While this is possible, the real factor is how much can you raise rents and how quickly.  THis is often where renovations come into play and buying older properties.  As noted above, for most people, a "class A" property is already modern.  As such, while rents can be increased over time, in most markets, those increases are 5% (at most) per year.  But some properties and markets are seeing rent declines.  So, just assuming you can raise rents can make for some big mistakes.  This is where both macro-economic effects and local economies have a big impact.  At the end of the day, you have almost no real control of rent levels.  You can buy in areas that have put historic tail winds behind you, but if a new property with 300 units opens up down the street and they decide to slash rents and provide concessions to fill their apartments, you will be stuck having to do the same.