Got cash? Larger buildings are better than smaller ones

Right now, if you have the cash to put down a big downpayment, you’re almost certainly better off buying a larger complex versus a smaller one if the prices are the same.*

Why? Like almost everything else in real estate, it comes down to interest rates, affect the market in two discrete ways  right now:

1. Low rates on savings causing money to flow into the apartment market generally.

This one doesn’t need a lot of explanation. If you’re earning 0.25% on your cash right now, even a 5% cap apartment deal looks pretty damn tasty.

2. FHA funny-money on 3-4 unit buildings.

Right now, the federal government, through the FHA, is propping up the residential housing market with incredibly cheap debt offered up to very high ratios of loan to value (up to 96.5%, incredibly). The government defines “residential” properties as including apartment buildings with 2-4 units. This is why using FHA loans on smaller buildings is such an amazing deal right now (assuming you avoid these problems and your broker isn’t dumb).

All of that cheap debt is pushing prices up for smaller buildings. Prices in NE LA have gone from around 10x rents last year to 12-13x this year. You can still find good deals to do with FHA loans, but it’s much harder than it was.

But what if you have a bunch of cash and you’re not planning to use FHA (either because you don’t plan to live in the building, you already own something else, or you don’t qualify)? You’re going to have to put down 25% like the big boys do, because the loans on larger properties don’t receive the same kind of subsidies from the government.

This is where the problem comes in: if you try to put down 25% on a 2-4 unit income property, you will be competing with a bunch of buyers who are only putting down 3.5%. Guess who’s willing to pay more?

Meanwhile, larger deals are trading at a discount to smaller ones. You can buy good, 5+ unit buildings for 10.5-11.5x gross rents. And, on a price per unit basis, you’re almost certainly going to get a better deal. For example: There are two deals in Echo Park a block away from each other listed at $1.5MM, one a triplex (at $500k / unit) and the other an 11 unit building (at $136k / unit). Which one would you rather own?

So, what’s a buyer with a lot of cash to do?

If you have the cash to put 25% down, I strongly, strongly recommend going for more units at any given price point. (Just please remember to use a broker who knows what he’s doing, so you can avoid the kind of mistakes I made on my first big deal.)

*Note that this analysis doesn’t necessarily apply to very high-priced areas in West LA and Beverly Hills, where sellers won’t look at FHA offers but where rich people are throwing huge amounts of cash at smaller properties anyway.