5-20 Unit "Sweet Spot" Properties

[Ben Morand]

Hello BP community!

So I currently have yet to purchase my first property, and I wanted to hear some opinions on my preferential strategy. After researching quite a bit, I have come across the niche in which investors seek out 5-20 unit commercial properties for a variety of reasons. First, this market is less concentrated than others. From what I've heard, the vast majority of investors are scared to enter the commercial industry because they feel overwhelmed by its "complexity". On top of this, I've heard that most experienced commercial investors are not looking for such small properties, and would prefer to invest in large multifamily (80-100+ units) to increase their return. This leaves the smaller, 5-20 unit commercial space with less concentration and more opportunity for deals (especially in particular markets around the country).

Beyond this, I also am attracted to the fact that commercial value is based upon NOI and cap rate, rather than on comps, so the value is more in control of the investor and less based on the surrounding properties. From what I've heard, this allows investors to add value without as much rehab to the property (through raising rents, adding in additional revenue-building assets, decreasing expenses, etc.).

However, I do know that is is harder to find quality property management for these sizes of properties, and it is also harder to sell them (due to less demand). Also, commercial loans are also a bit more complicated (at least to me) than residential loans, so I would need to learn much more about how these work before ultimately cracking down on the strategy.

I am curious as to what are your guys' thoughts are on skipping the residential realm and hopping directly into small, multifamily commercial properties? Also if anyone has any advice, tips, or resources, I'd love to hear them if you'd be willing to share.

Thanks everyone!

[Erik W.]

@Ben Morand, hi.

First, I'll start with some of the information you've laid out.  Then, I'll give you my thoughts on why I think you should do these kinds of deals.

1) "I've heard that most experienced commercial investors are not looking for such small properties, and would prefer to invest in large multifamily (80-100+ units) to increase their return."  Based on my research as well, this is correct in my market.

2) "This leaves the smaller, 5-20 unit commercial space with less concentration and more opportunity for deals".  Maybe.  But keep in mind that even though institutional investors aren't looking for these, people like you are.  Do you think there are more institutional investors or private investors in your area?  You also lose economics of scale in management and maintenance.  

3) "I also am attracted to the fact that commercial value is based upon NOI and cap rate". Partially true. CAP Rate is the measure for commercial properties, but you cannot do a whole lot to a 5-10 unit building that will dramatically impact the value other than simply raising rents. Switching from fluorescence light bulbs to LEDs in 200 units saves thousands of dollars over a year. In 5 units...maybe $30-$40 a month. Also, a 100 unit complex can probably afford full-time or part-time staff. With less than 20 units you will be self-managing or hiring a property manager who manages other units that you don't own and will probably pay the standard 10% of monthly rent fees plus maintenance mark ups. Also, my experience with banks/lenders/inventors says you don't really start looking at CAP rates until you hit 50+ units. Yes, 5+ units mean you will be getting a commercial LOAN, but until your deal becomes self-sustaining it doesn't measure according to CAP rates.

Remember what the function of a CAP rate is: to provide a way to do apples to apples comparison on rate of investment return between different asset classes. But how does a self-managed 10 unit compare to a diversified stock market portfolio? It can't really. Thus, you need a building that can support staff so that even if you, the investor, sells or drops off the face of the earth, there's a team in place for the new owner(s) and business continues as usual. Internal rate of return is a more sophisticated measure of apples to apples comparison, and if your investment doesn't qualify for that level of scrutiny, it likely doesn't qualify for CAP rate analysis. Sure, you can run a CAP rate with single family houses and duplexes if you want to--the formula is the same regardless--but keep in mind most people won't do it that way.

Now all that said, I think 5-20 units is a good spot for a new investor to get started.  Just keep in mind that you won't be flying high like the big boy syndicators for a bit.  Starting smaller but still with multi-units is a great way to learn the ropes and give you some equity towards your next deal, without putting yourself at risks of multi-millions of $$$.  You can learn about tenant management and make contacts with contractors, local Govt officials, lenders/money partners, etc, which can all help you in future deals.

I hope this helps. Good luck!