What should be my next step?

Question

Hello all,

I have been a long time reader and thank all you guys for the feedback.

I am here to get feedback of some experienced investors to see if they can help me take the next step in my REI career.

I started investing in RE a couple of years after the market crashed and have been doing rental properties. As of today, I have 25+ rental units and REI is what I do full time. The properties that I have are a mix of SFHs to 4 units. I am very fortunate to be in the situation where I don't need the income from my rental properties for daily expenses. I primarily use the rental income to reinvest in RE or other income generating assets.

I am planning to purchase couple of more SFHs in next few weeks, so the rental units number will go up.

Majority of the units that I own are high cash flow units, but lately I have been focusing on Cash Flow plus Value SFHs.

I have a full time employee who helps me with management of the properties and a part time maintenance person.

Every now and then I wonder if I am on the right track with my portfolio mix. I wonder if I should do some flips or keep focusing on rental properties. Even within rental properties I wonder if I should focus on SFHs or multi units or commercial properties.

So I am hoping someone can provide me some feedback as to what should I focus on.

If you would like any other information, please feel free to ask.

Thanks!

Sam M. · Answer

Mark C. - This is a very valid point. I was partner in a 50 condo deal and we noticed during our due diligence that this was one of the major drawbacks in multi-units.

I also prefer the quality of tenants that come with SFHs.

Bob Hines - I appreciate your input. It's very helpful.

Every now and then I wonder if I should change my strategy, but I agree with you that I should probably stick with adding SFHs or at worst upto 4 units in my portfolio vs buying apartment buildings. SFHs is what I feel comfortable with and should focus on that.

The reason why I prefer rentals over flips is because my mindset is geared towards keep building income generating assets. I personally don't like the idea of spending time and effort fixing a house and then not have the asset in my portfolio. That's just my thought process.

Bob Hines · Answer

Sam, it sounds to me like you are doing quite well with what you're doing so I would suggest sticking with what you know.  It seems to me that people get into trouble when they start to stretch into areas that aren't their expertise.

Flipping can be a natural match to rentals if you're familiar with the costs of rehab and have a fairly good idea what would go into getting a place ready for resale.  That means you know what buyers want in terms of finishes, locations and values.  That also means that you can manage a construction crew.  I have a friend that is similar to you size wise-she has 27 units-and has done at least 30 flips (that I know of, probably more) and she's stopped doing flips recently as she is burned out working with the construction workers and the headaches that that entails.  Flipping isn't all glamor.

I have looked into multi-families several times also and have decided to stick with 1-4's.  When you get to the MFs, many times they are sold by Cap Rate because only investors are buying them.  I'm also finding that I can get much higher returns on my small units vs MF.  Since MF values are linked to Cap Rates, which are linked to interest rates, you have an additional moving part in the equation.  Using an 8% Cap Rate on May 1, 2013; Douglas's $1.5 million example above lost about $90k of value in the last 6 weeks since interest rates have gone up more than 50 basis points in that time period and therefore Cap Rates should have moved up by 50 basis points too.  His $4 mil example would have lost $235k in the last 6 weeks while your SFH's are valued differently and might have lost a little bit of value but probably didn't lose any.  Your 2's & 4's would have lost some value but their values are not as strongly linked to cap/interest rates as MFs are.  (losses would have been bigger $$ with cap rates lower than 8% btw) With interest rates so low, there will be a long-term headwind to MF values (and to a lesser extent 2s & 4s) as interest rates will go up eventually.

Like you, I am also investing in high cash flow properties and have thought many times about buying a single, more expensive 2 or 4 family in a better part of town that won't cash flow as well but would retain/increase in value better, have "better" tenants and be very easy to sell if I ever had to quickly.  I haven't done it yet as I'm still focusing on the cash flow, and I'm just now getting into the cash flow sweet spot, but I keep thinking about it for when "I get there".  It might be something for you to think about to see if it's right for you.

Mark C. · Answer

Not entirely a correct analysis.  Both are now cash flowing, but the politics of partnerships, the hastles of dealing with tenants who dont actually appreciate what you're prividing, their propensity for litigious claims, city inspections and code issues etc. etc. etc.  Funny how most people paint this rosy picture of MF.  
I also have several fellow investors that are also in hit or miss MF and some have even been given back to the banks.  It has definately been a learning experience.  
It has just been my observation that when I rehab a home and I get a tenant that is moving up from apartments  they are so appreciative and bend over backwards to help take care of the property and payments on time with text message confirmations.  
I guess what I'm saying is I'm not comfortable with some people in that industry. Just my opinion.

Douglas Quaid · Answer

So you not only overpaid for what you bought, you most likely bought properties in undesirable areas, made zero profit, and you are saying SF beats MF because of those experiences?

If you would have wisely invested in actual cash flowing properties you'd be singing a different tune.

Mark C. · Answer

If I had the money FOR ALL CASH and I was sole principal for MF.  I might do it.  But something to remember.   Your income from a MF would likely be the same amount as what you would pay a  full time property management firm.  5%.  Most people are not gonna have the ability to just jump straight into a 300 unit deal and earn some big $$.   YOu would have to stay above 80 units if you want to maintain a full time property manager and maintenance guy.
 The competition is fierce, you're always out there having to offer concessions to compete with the guy down the street.   The people you're dealing with, will pick up and move in a heartbeat sometimes without even a notice just to get $40 bucks less in rent.  Now add on top of that the lawsuits if they hurt themselves.   They love to sue.  We had one lady try to sue us because she says the bedbugs ate a hole thru her leg.  We had another lady slip and hurt her back on some stairs.  We had another family on the 3rd floor not watching their little one he either climbed over the railing, or thru it or sibling dropped him over the railing and he fell 3 stories.  Luckily he landed in some shrubs.  No injury but, no witnesses though so they are sueing us because the bars on the railings should have be 4" instead of 5".  The medical industry helps aid all this too.  Claimants will drive all over town racking up medical bills to file a suit against you.   
And then theres the financing of a property, a whole other story.   The hoops and requirements that Fannie/Freddie/HUD can make you jump thru to get long term financing it increases exponentially over SF.  Sorry but I could go on and on.  
SO yes, I like the control and stability of SF.

Douglas Quaid · Answer

Your ROE is always less than your ROI if value has been created and the property is worth more.

Over time appreciation, forced appreciation and capital paydown will always be more than rental increases, therefore your ROE will decrease over time, even though your net worth is going up.

For example, you own a free and clear 14 unit apartment building that can sell on the open market for 1.5 million dollars. It grosses 120 000, and nets 60 000.

The equity of that building is 1.5 million, the return on that equity is 60000/1500000 about 3-4%.

Why not sell that property, and move it into a property that has 10% return on investment? That 1.5 million can be moved into a 4 million property. You will net more cash every year PLUS your capital paydown and appreciation is much more on a 4 million property than a 1.5 million property. Your net worth is still 1.5 million! But it grows faster because 1% appreciation on 4 million is >>>> 1% on 1.5 million.

What I am saying Sam, is to sell off properties with lowest current return on equities, and moving that equity over to larger properties with more income. Your net worth stays the same, you are just moving it over to a property with more total income. However you create wealth even faster, because the capital paydown and appreciation on larger properties is much more on an aggregate (total) level than with smaller properties.

Sam M. · Answer

Mark C. - Thank you for sharing your experience. I am sorry to hear that it hasn't gone so well for you upto this point, but I sincerely hope that things will start turning around for you.

Would you do MF if you were the sole or majority partner? Or would you prefer owning SFHs over MF?

Mark C. · Answer

As I am in MF deals as a passive partner and sometimes a principal I have to admit I have a bad taste in my mouth with respect to MF.
I started in 2 value plays which took 3 years to get refinanced and have barely seen squat in quarterly distributions.   The first one I think we over paid for and had to vote out our lead partner and put in a major property management firm, but its 95% occupancy at 95%.  
The second we just refinanced and was able to pull a little bit out at closing.  Its also sitting around >93% economic.  IT took over 3 years on both. Also invested in a package of 3; a yield play but with the down turn and location of these properties we will be lucky get 50% back with no distributions.   Altogether 200k invested and I keep kicking myself in the backside when I think about how many SF properties I could of had.  I learned real quick 2 things. Partnership(loss of control) is bad and the headaches of MF.  I would take 100 SF and maintain the control I have, better tenants and better cash flow as they are paid off than MF.  I am sure some have had a better experience but not me.   Like you my wife and I both work so we roll everything back into the SF in hopes of paying them off one by one with that snowballing, picking a few along the way before retirement.  All I can hope for now is someday a big payday if we can ever sell these properties and use that cash to buy more SF or pay some off.

Sam M. · Answer

Just want to make sure that I am not missing anything here. Is the added value of equity $15,000 or $19,000 ($50,000 minus $30,000 minus $1,000)?

Douglas Quaid - I will be very honest, my investment strategy is very simple. At the end of the day, I focus on keeping a balance between growing my net worth and getting the best ROI for my $ invested.

I understand in your example my ROE will be very low, because of the additional value I have created, but in my books that's a positive thing, because I have put $6,000 into a house, but my net worth has increases by $19,000. That's roughly 4 times the net worth return PLUS I have positive cash flow on that property as well.

Am I understanding this correct, that in order to the added equity, I will need to purchase SFHs and do 1031 exchange into larger properties?

I guess I am not sure if I follow the value of ROE.

For example, if I have two following opportunities.

Opportunity # 1

Purchase Price - $90,000
Repair - $10,000
After repair value - $100,000
Rent - $2,000
Purchased with all cash
To make the example simple, let's say the net cash flow is $1,000. My ROI will be 12% ($12,000 / $100,000). My ROE will be same as my ROI. Return on Net Worth = 100% ($100,000 / $100,000)

Opportunity # 2

Purchase Price - $90,000
Repair - $10,000
After repair value - $150,000
Rent - $2,000
Purchased with all cash
My ROI will be 12% ($12,000 / $100,000); however, my ROE will drop to 8% ($12,000 / $150,000). Return on Net Worth = 150% ($150,000 / $100,000)

Of the two opportunities above, I will choose the 2nd opportunity, because my net worth has increased by $50,000 and my ROI is same in both cases.

Douglas Quaid · Answer

For me, multi units = leverage. Leveraging time and finances.

ROI is still ROI so if ROI's are high for SFH (at dirt cheap prices) I would continue to do those but systemize it so I don't have to deal with 25 different roofs. Blackstone (the largest asset manager in the world) set up a real estate fund and they bought up tens of thousands of SFH. I don't think the CEO Larry Fink takes any calls from tenants at night.

Here's how I look at it. Say you bought a property for dirt cheap and you make 15% return on your investment. But what is your return on equity? What is the value of that "dirt cheap" property after you've added value to it?

That increase in equity value must be added to your capital investment to determine your return on equity. You'll see that it drops vs return on investment. If you take the capital that you put in, plus the added equity, you can use that to buy a bigger property that ROI's the SAME as the ROE from the previous property. Get my drift?

It's a purely purely financial concept applied to real estate.

Example:

You put up 5000$ to buy a 30 000$ property. You put in another 1000$ to fix it up and rent it at say 1300/month. What is it now worth at 1300/month? Say it is now worth 50 000$ to an investor, your return on investment is still Net income / 6000$, but your return on equity is net income / 6000$ + added value of equity (in this case another 15 000$).

Another example:

I bought a multi unit building that I converted into condos. I sold half that property and pulled out all my invested capital, I decided to keep the rest. Essentially my ROI is infinite.

But what is my ROE of the remaining condo units? After all the rents - expenses / equity still left in building I was averaging about 5% ROE. Why don't I sell the rest of the condos, take out all the capital, and buy a larger building that aggregates just 10% compared to the 5% I'm currently getting.

Bigger properties = larger aggregate income.
Larger aggregate net income >>>> higher ROI's.

I was in Chicago last year, loved that city, loved the downtown loop area.