1031 into Larger Multifamily or Multiple 4-Plexes?

Question

I own a 4-plex in Los Angeles and have built up ~$1 million of equity
in the property (bought in 2011, at the lows). I'm considering selling
the property and exchanging into more units (still in L.A.) but I'm
trying to decide between two strategies and would be curious to get
others' thoughts.

Option
A - Buy 4 fourplexes. With $1mm equity, I can theoretically cut four
$250k checks and, with 70% LTV, purchase four $900,000 fourplexes. These
would be smaller units or in slightly less optimal submarkets of LA
(e.g. North Hollywood vs Burbank), but would leave me with 16 units and
$3.6 million of property value.

** I recognize it might be
tough to find 4 properties that are actually worth investing in at
today's prices, but let's assume we can find them (or be patient enough
for opportunities to materialize).

Option B - Buy one larger multifamily (e.g. 12 units) for $3 million (with ~$1 million down payment).

My questions are:

1) Is one option clearly better than the other?

2)
For Option A, which assumes standard conforming Fannie/Freddie loans,
would it be difficult to quality for 4 residential mortgages within a
12-month time frame? I have generally strong W2 income, but I feel I'll
hit up against DTI ratios if I don't have tax returns showing the income
from the new properties (which I won't have until ~12 months after
closing each property).

3) Is it even possible to get 70% LTV these days on conforming 4-plex deals?

4) Brokers
that I'm speaking with (Marcus & Millichap, Colliers) are saying
that 4-plexes generally appreciate more per year than larger
multifamily. Is this true in your experience?

5) Are there any
other concerns / pitfalls I should watch out for as I enter this
process aside from the 1031 timing considerations?

Account Closed · Answer

I agree with both Ara and Jeffrey.  I was faced with this choice 18 years ago after rehabbing my first duplex and having some profits to deploy.  I decided to go into multifamily -- as many units with one roof, one foundation, one LLC, one tax return.  I bought a 6-unit, then a twelve, then 24, alway value-add, always fixing it up.  I'm now approaching 500 units, and don't think I'd be at this scale sticking with 4-plexes.  It would simply be too much management, too many LLCs, too many tax returns, too many roofs, foundations, etc.  That's my perspective.  Keep it simple.  It's the units that generate rental income, not the property.  So go for more units, fewer properties.  Hope that helps!

Ara Abrahamian · Answer

@John Warren, @Jeffrey Isenberg, and Account Closed - thanks for all the feedback.

John, I'll look into the commercial Fannie Mae deals you mentioned. I wasn't aware of the larger loan programs they offer.

Jeffrey, thanks for the feedback. Can you clarify what you meant by "market rent programs that offer 70-75% LTV"? Is this a specific type of loan? A different way to underwrite conventional <= 4-unit properties?

Mark, I appreciate your feedback as well. You make a strong point about the economies of scale with the larger buildings. This had always been my intention - to get into larger properties with 1 roof, 1 driving route, 1 sprinkler system, etc, but I recently started considering the multiple 4-units to (A) increase property value (through leverage) and (B) create a path to "average-out" to a decent blended cap rate across multiple properties.

The multiple 4-unit strategy would allow me to purchase 2 properties with ~30% LTV within the 1031 window to satisfy the requirements, then do a cash-out refi (almost immediately) and redeploy the rest of the capital into 2 additional properties when cap rates improved. Although I'd buy 2 properties at 4% cap, the other 2 would hopefully be at a 5.5-6% cap, leading to a better average cap rate than deploying all $1 million from this sale into a 4% property today. Is this something you would take into consideration at all? Do you think there are acceptable deals to be had at the 8-15 unit range ($2.5-$3.0mm) in today's market or is it better to consider this "averaging" strategy?

Account Closed · Answer

Hi Ara, if you're finding better opportunities in the 4-unit range than the 8-15 units, then, yes, pursue the better opportunities regardless of size.  You can always level up to multifamily later (possibly selling your 4-units in pairs to get into larger bldgs.  I just did this with a pair of 5-units in Koreatown that I'm trading into a 30-unit in Westlake).

...And a benefit of 4-units is that you can find emotional buyers, who will buy at lower cap rates if you fix them up nicely.

But a great thing about LA is the sheer volume of inventory there is.  You should be able to find 8-15 unit opportunities at 5+ cap rates, that compete with 4-unit prices.  You may need to explore up-and-coming areas that are more marginal now / earlier in their transition.

Your strategy of exchanging into a low leverage, then refinancing to pull out tax cash, works, too.

I hope that answer isn't too confusing!

Ara Abrahamian · Answer

@Mark Hentemann, thanks for the reply. I think the key takeaway is to keep an open mind and make a decision based on what’s available in the market. I appreciate you offering your perspective and recent case studies.

Ara Abrahamian · Answer

To clarify, the above question about values is in regard to the LA market, specifically the San Fernando Valley. Thanks.

Jeffrey Isenberg · Answer

@Ara Abrahamian In answer to your question as to which strategy is better, it depends on your long-term investment goals.  As you know in the 2-4 unit space financing is typically conventional.  However there are market rents programs out there with 70%-75% loan to value that will not consider your personal income.  With that said, valuations will predominantly be based on comparable sales at price per square ft.

In the 5+ unit commercial space, property valuations are determined solely based on income (calculated on GRM).   Under this scenario, if you can force the appreciation through value-add, this will typically exceed the upside associated with acquiring several additional 4 unit properties.

John Warren · Answer

@Ara Abrahamian I would personally look to place your capital into a larger deal that qualifies for fannie mae loans right away. Right now, the interest rates on these loans are in the low to mid 3's. That is incredible, plus these are non recourse loans and you can probably get interest only to help you boost your cash flow.

Finding four 4 plexes would be incredibly challenging just about anywhere in the US in today's market if you are on a timeline. I am sure the market is different there than here in the Chicago suburbs, but there are barely four 4 plexes on the market at all right now in my sub market. The ones that are on the market are being sold because they have appreciated. It is not easy to find a value add opportunity in this space at all.

1031 into Larger Multifamily or Multiple 4-Plexes?

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