Should a newbie start with an apartment bldg or with tri/quad?

Question

Hi

Exploring apartment investments as my first venture into real estate, other than having owned two single family residences which I then rented out, one of which had a separate basement apartment that I rented out and managed.  Am I nuts to try to get into an apartment bldg at this point--thinking 8-10 units--or should I start smaller with quadplexes? Looking for advice, experiences.  Once my home sells I'll have roughly $135,000 to invest and want to use it wisely and get the best rate of return using leverage, which I thought an apt building would be a good fit.

Separately, in my research I requested and received an offering memorandum on a prospective property so that I could run my financial analysis.  When it arrived it did not include an asking price, is that normal?  i feel like they should start with one up front.

Thanks

Michael

Jeff Kehl · Answer

@Michael Newman there is not that much difference between a 4 unit and a 10 unit except that you will make bigger mistakes on a 10 unit than you will on a 4 unit monetarily. If it's your first multi, expect you will make mistakes and do lots of work to try to minimize them.

Also, the financing on a 4 unit is much better than a 10 unit due to arbitrary rules about what is residential. You can buy 10 4 unit buildings using government sponsored 30 year fixed rate loans at 4 % or 4 10 units at 20 year variable rate loans at 5%.

Having said that, if it were me, I would not let that influence me much. The bigger question is which one can you get a better deal on? If a 4 unit offers a 12.7% return and the 10 unit offers 10.5% isn't the answer obvious?

People will tell you to only invest in commercial stuff because of the 'economies of scale'. In my opinion that is bs if you're willing to do the work to fold in the smaller properties. I own a 20 unit, a 22 unit, and a 12 unit but my last few purchases were a quad and a few houses because they offered higher returns. I have looked at quite a few 50-200 unit properties recently and I would love to jump to that but the returns don't match what I can get grinding the smaller properties.

Tom Mole · Answer

I like the way @Chris Tracy thinks. There is no particular reason that a small apartment should have greater returns than a larger one, all other things being equal. The smaller unit counts have slightly better returns because they are priced lower. Sure the returns may be lower on the the 200 unit, but that is an indication of how they are more desirable.

Several things factor into a higher price per unit on larger communities. For example, in most towns there are fewer larger complexes than smaller ones, so the competition is greater and the price follows.

One of the big problems with smaller unit counts is the way that vacancy weighs in. One extra vacancy in a 10 unit has 20x the impact on the bottom line as it would in a 200 unit. This can work both ways of course. Sellers like to brag that their small buildings are more profitable because they are 100% leased, which may even be true at the time they say it.

However, when market vacancy for the area is 10%, they should have at least one unit in 10 vacant at any given time on average. Sometimes landlords slant the table in their favor by offering concessions to renters to get them in and keep them. These make the property appear more desirable but the expenses go straight to the bottom line. To compensate sellers very often don't mention these expenses in calculating the Net Operating Income (NOI), instead they offer proforma numbers that conveniently leave out such costs and thus make the income seem higher. Be very careful with proforma numbers. In fact be downright paranoid about anything that comes in the marketing packet.

Another factor to consider with larger unit counts is that they are rarely owned by Mom and Pop owner-operators. They are owned by sophisticated investors or syndication entities. These folks know their way around a spreadsheet. You may not be on a level playing field, but that doesn't mean you're out of the game.

Consider partnering with someone who has done a few deals. Make sure that you know what goes into evaluating commercial properties. It ain't the same as residential. Above all, if you you're not sure about something, ASK! As @Jeff Kehl pointed out, the leverage in larger complexes that can make you a lot of money, can work against you as well.

I would not focus too much on what might go wrong. That is loser thinking. I would instead consider what could go sideways, figure some options for mitigating that, then I would focus on what could go right! Done well you could be out of the Rat Race in one or two big deals.

Cheers!!

Chris Tracy · Answer

@Michael Newman-

"Am I nuts to try to get into an apartment bldg at this point--thinking 8-10 units--or should I start smaller with quadplexes?"  No sir... not at all!  Why not go even bigger?  Even if your returns are slightly less... you will have more of your life back because you don't have to manage a bigger deal- you just oversee the property management company.  I think running around managing multiple smaller properties is nuts.  It's like @Jeff Kehl said... If you can handle the grind.

"Separately, in my research I requested and received an offering memorandum on a prospective property so that I could run my financial analysis.  When it arrived it did not include an asking price, is that normal?  i feel like they should start with one up front."  You will see that occasionally because the broker is trying to get top dollar for the seller and create a mysterious bidding war.  Ask the broker- "What do you think this property will trade at?"... That will give you something to go off of.

Michael Newman · Answer

Thanks for all the great replies. Thinking now about economies of scale arguing in favor of a larger deal, and working with a partner with a bit more experience. Don't think I will have financing for a first deal large enough for a 50-100 unit, but perhaps 25 to start.

Definitely have a lot of due diligence to do and will run some numbers.

Again, thanks to all.

Chris Tracy · Answer

@Michael Newman-  The challenge with using a property management company for smaller deals is having enough cash flow to justify using them.  That's why I was suggesting considering bigger deals because with something that is at least 50 units, you can then use an on-site manager and it makes financial sense.  Plus there will be other miscellaneous expenses such as taking trips to check on the property, doing tax returns, etc and with smaller deals the cash flow becomes thin.

But if it works for you... It's all good!

Michael Newman · Answer

@jeff

@Jeff Kehl Thanks. Appreciate the comment on rate of return. Truly key.

@Chris Tracy thanks for verbiage on how to reapproach the broker. The whole thing seems a bit off to me. Like haggling over an Afghan rug.

One of the reasons I gravitated toward a larger multi was to consolidate issues that arise into one place with one manager. Guess I am assuming that one 10 unit building would have fewer issues than three quads since you have fewer moving parts--one roof vice three, one plumbing system vice three etc...

I'll likely be using a management company sine I don't expect to be local to the properties.

Should a newbie start with an apartment bldg or with tri/quad?

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