Summary: When new investors are just getting started investing in real estate, they often get stuck figuring out what type of real estate they should buy. Even within residential real estate, the property types range from single-family residences to properties with hundreds of units. In this post, we discuss the benefits of investing in 2 to 4-unit multifamily properties for new investors.
[Disclaimer: We are not accountants, lawyers, or financial advisors, so please consult your own team of professionals about the topics covered in this article.]
We often hear from those new to real estate asking: What type of real estate should I buy?
In this post, we’ll compare and contrast the different types of rental properties. We’ll also give you the reasons why we think 2-4 unit multifamily (MF) properties are a good place to start for new investors.
The Power of Focus
But first, a word about focus (click here for a deeper dive on the power of focus)
We believe that focusing on one type of residential property at the beginning will make it easier for you to take the first steps toward purchasing your first property because:
- You will be able to increase your knowledge about that type of property more quickly. This is a result of constantly comparing and contrasting similar properties.
- This approach will also make it easier to compare rates of return and pick the best investment.
- It will make it easier for your real estate agent to find you deals.
Now, back to comparing and contrasting the different types of residential properties. We’ve broken them down into four types: single-family homes (SFH), 2-4 unit multifamily properties (MFs), 5-15 unit MFs and >15 unit MFs. We’ve outlined the pros and cons of each and also illustrated this in the table below.
While we think 2-4 unit multifamily properties are a great place to start for a new investor. Use this information to decide what works best for you!
Single Family Home (SFH)
SFHs are the most common type of listing in the multiple listing service (MLS). These are the homes that people generally buy to live in as their primary residence. There are numerous benefits to having SFHs in your portfolio. However, as you are building your portfolio, we think there are numerous downsides to starting out with this type of property.
The main issue is that it’s harder to find properties that meet your cashflow requirements. This stems from the fact that the sales price of these properties isn’t driven by the rental income. It is driven up by the “emotional buyer”. Who is willing to pay more because he/she really wants to live there.
Another potential issue is the higher average per unit maintenance costs. Which is due to the fact that you have more of everything. Compare a four-unit MF property, which consists of four apartments under one roof to four SFHs. Which will have four roofs to replace. With the SFH, you will likely have more maintenance items compared to MF properties.
One last issue with SFHs is the potential for lower rental income over time due to vacancies. When we have a vacancy in one of our fourplexes, we are still getting rents from the other three units to help cover the mortgage and other expenses. In SFH, a vacancy means that you are paying out of pocket to cover the expenses while it sits empty.
2-4 Unit Multifamily Property
We believe 2-4 unit MF properties are the easiest to get into when you are just starting out. They also have the most benefits with the fewest downsides.
Some of the benefits include:
- It can be relatively cheap to buy a duplex, triplex, or fourplex compared to a larger property.
- You’ll have relatively low-interest rates (though not as low as SFH’s) because you can use a residential loan, which usually has better terms than a commercial loan (click here to read about residential vs. commercial loans).
- There is less competitive pressure from real estate investment firms. These are companies that use institutional funds (i.e., pension funds, 401k funds) to buy apartment complexes.
- Other benefits include the ability to spread the risk of vacancies and maintenance costs over 2-4 units rather than a single unit with an SFH.
The downside to the 2-4 multifamily category is that most cities have fairly low inventory compared to SFHs. You may have higher utility costs because some of the utilities supplying a MF property aren’t split between the units. For example, you usually have one sewer line going to a MF property rather than each individual unit having its own sewer line. However, it’s often possible to bill back utility costs to renters each month, making this type of investment even more attractive.
5-15 Unit Multifamily Property
When you get above four units, you no longer qualify for residential loans. At this point, you have to switch to commercial loans. Commercial loans tend to have higher interest rates and/or shorter loan periods (also known as amortization). As a result, you have a higher monthly mortgage payment.
Also the more units you have, the greater the competition from real estate investment firms. These firms tend to avoid smaller MF properties and SFHs. The reason is that it’s less efficient for them to buy them due to the transaction cost and time.
However, the market for larger complexes has started to dry up in the last few years. As a result, it seems that these investment firms are getting into 5-15 and even 2-4 MF properties. So even these properties aren’t immune to the competition from these firms.
>15 Unit Multifamily Property
The split at 15 units is somewhat arbitrary. However, above 15 units, you have higher capital requirements and intense competition from investment firms. You also have to think about not just individual tenants but about creating a community. This might entail creating and managing common spaces like laundry rooms, playgrounds, barbecue areas, etc.
Also, if you’re just starting out, your inexperience can cost you. Not only do you have more money at risk, but the cost of an error could also be magnified greatly. Experience is also essential for qualifying for larger loans as lenders want to lend to experienced operators.
Commercial loans for larger properties are more expensive up to about $1 million. Larger loans (> $1 million) can actually be more affordable with lower interest rates and longer amortization periods. However, these larger loans have downsides like pre-payment penalties. You can read about our experience getting one of these larger loans HERE.
On the other hand, if you’re able to operate the property well, the benefits can be significant because of the sheer scale of the property. For example, a $50 per unit increase in rent for a 50 unit property represents an extra $2500/month in revenue or $30,000 per year.
We believe there are many benefits to investing in a 2-4 unit property when you are just starting out on your journey. They are the easiest to get into. However, no matter which type of property you decide to pursue when first embarking on your journey, remember the power of focus. The key is to not get stuck figuring out what type of real estate you should buy. Dive in and make your first purchase!
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