Why more units are better than fewer

Once you’re sold on the idea of buying an apartment building, the next question is: “What to buy?”

One of the important principles to keep in mind is that it’s usually better to buy more units than fewer for a given amount of money.

To see why, let’s compare two different deals on the same street:

Duplex (two units)

  • Each unit rents for $2,000 / month
  • Total rent of $4,000 per month
  • Expenses (not including mortgage) of $1,000 / month
  • Net operating income of $3,000 / month
  • Price of $500,000
  • Mortgage for 80% of price, or $400,000, at 4%
  • Monthly mortgage payments of $1,910
  • Free cash flow of $3,000 – $1,910 = $1,090

Fourplex (four units)

  • Each rents for $1,000 / month
  • Total rent of $4,000 per month
  • Expenses (not including mortgage) of $1,000 / month
  • Net operating income of $3,000 / month
  • Price of $500,000
  • Mortgage for 80% of price, or $400,000, at 4%
  • Monthly mortgage payments of $1,910
  • Free cash flow of $3,000 – $1,910 = $1,090

Both of these deals look similar on paper. They’re both 7.2% caps at 10.4x gross rents. They’re both returning $1,090 x 12 = $13,080 per year in free cash, which is 13% per year on your $100,000 down payment.

So, why is the fourplex a better deal than the duplex, everything else being equal? Well, imagine you have a vacancy in one unit. For the duplex, this means that, until the vacancy if filled, your income is $2,000 / month. This means that you can cover your expenses of $1,000 per month but you’re going to have to come out of pocket to cover $910 of the mortgage. That’s no fun.

Now consider the fourplex. Until you fill the vacancy, your income is $3,000 / month. You are still able to cover the $1,000 in expenses. You can also cover the mortgage of $1,910 and still have $90 left over. Obviously, that’s not great. But you didn’t have to part with any of your own money. And that’s why, all things being equal, the fourplex beats the duplex – the income stream is less dependent upon any single tenant.

A caveat. In real life, all things are not equal!! Sometimes fourplexes are bid up and pricing for duplexes is just better.

And sometimes, you’re not a perfectly rational, economic buyer. By this I mean, sometimes you actually care about how the property feels to live in, because you’re going to be living there. It’s hard to resist the lure of making your first purchase a single family home. There’s no shame in making the first one a duplex instead of a fourplex. You’re still doing way, way better than if you bought the single family.

OK, I want to buy a building. What do I do first?

Call me. J/k. Sort of.

The first thing you need to do is take stock of your current position. Here is what you need to get started:

  • A decent credit score. FHA will loan down to a 580 score, but ideally you’d be north of 700.
  • A stable work history. The ideal loan applicant would have worked in the same job for 2+ years with stable or rising income which is reflected in his/her tax returns.
  • A bit of cash. Depending on where you want to buy, you’ll want at least $25,000 in the bank for a minimum of two months. FHA will allow you to get the money from someone as a gift, but you’ll be better off it’s been sitting in your account for two months before you even begin the loan process.

If you’re missing one or more of the above, don’t worry. Cash can cover up a lot of sins. If you can get together enough cash to put down 20-30% of the purchase price, you’re almost definitely going to be able to get a deal done, even with bad credit or a non-traditional employment history (though the terms of the loan won’t be optimal). If you do have all of the above, or if you have a bunch of cash, you’re ready to get started.

The next thing you need to do is determine what sort of property you’re looking for. For a first time buyer who fits the loan criteria, I strongly recommend an FHA mortgage, which means you’ll be limited to 2-4 units. My advice is to be open minded, but to favor 3-4 units over two. (If you already own property, or are going to be putting down 20-30%, go with more units, since you’re not getting the benefit of a high-leverage FHA loan anyway.)

Next, you want to determine where to look. All other things being equal, I recommend areas where the rents are increasing. Buying a building for a fair price with a fixed, 30 year mortgage in an area with increasing rents will turn your good investment into a home run without you having to do much. To find increasing rents, look for gentrifying areas (in LA, try Echo Park, Highland Park, etc.).

Finally, you want to find an experienced agent… hence my semi-joke above. I am sometimes guilty on this blog of making buying buildings seem easy. But you have to remember that buying a building with a mortgage is basically equivalent to doing a leveraged buy-out on a small business. Leverage (debt) magnifies outcomes. This means that, if you do a good deal, you do very well. But if you do a bad deal, you can do very badly. You wouldn’t do a leveraged buy-out without getting advice from someone who knows what they’re doing. Don’t make that mistake with an apartment building!

So find an agent you trust. Tell him/her what your resources are, what kind of building you’re looking for, and where. And listen very carefully to what he/she tells you. You’re probably 60-90 days away from buying your first cashflowing asset.

Why I write this blog

You might be wondering: Why does this guy spend so much time writing about apartment buildings?

I think the financial crisis of the past few years has changed something fundamental about the relationship between young people and real estate, and I want to try to both explain that change, and help shape it and move it forward.

Before the crash, here’s how most people felt about real estate:

  • I want a big house on a big piece of property
  • I will work very hard at my job in order to afford to take out a big mortgage to afford this big house
  • While I own it, this big house will increase in value every year
  • Some day, I will sell my big house, take my profits and buy an even bigger one

Here’s what happened as a result: A lot of people ended up buried under huge mortgages, unable to sell, unable to re-finance, and facing years (maybe decades) of hard work in order to pay off loans on properties that will never be worth what they bought them for (at least, in real terms).

Sensible young people looking at this situation could come to two conclusions, both reasonable:

  1. I will never own property. It’s not worth the risk. There is value in the flexibility that renting provides. I will therefore rent. Or…
  2. I will own property, but it will be income property. I will slowly build an asset base, taking advantage of the low price of real estate, the availability of cheap debt, and the major subsidies that both the national and state tax codes provide to owners. Over time, as I save more money, I will buy more income property. And, eventually, one day, maybe 10-20 years from now, I will wake up to the fact that I have secured my family’s financial future.

I write this blog for the people who have reached conclusion two. If you are one of these people, or think you might be, get in touch.

I will help you learn for yourself how this whole thing works. And then, when you’re ready, I will help you buy your first income property. (Bonus: The whole thing is free, because, as a broker, I get paid by the sellers of property, not the buyers.)

Silver Lake Income Properties In High Demand

We’ve just completed a review of the data for sales of 2-4 unit income properties in Silver Lake over the past six months. For more on the methodology, please see below. Meanwhile, here are the headline numbers:

  • Median estimated gross rent multiple: 12.7x annual rents
  • Median estimated CAP rate: 5.5%
  • Median sale price as % of list price: 98%
  • Median days on market: 51
  • Median price per sq ft: $318
  • Median price per unit: $226,500

More color on the data:

What does it mean that properties are selling at 98% of list?
Buyers need to know that the days of low-balling sellers in Silver Lake are pretty much over. To get a property, they need to come in with a strong offer at around the list price.

What does a 12.7x gross rent multiple mean?
This means that properties are selling at around 12.7x the total annual rent that they generate. Here’s some more info on gross rent multiples.

What does a 5.5% cap mean?
An estimated median cap rate of 5.5% means that, if you bought these properties using all cash (instead of a mortgage), you would be earning 5.5% on your money in year one. Here’s some more info on cap rates.

What does it mean that the days on market number is 51?
Days on market includes the time from when the property was first listed until the date of closing. It generally takes 30-45 days to go through the escrow process. This means that properties are getting accepted offers within roughly one to two weeks of being on the market. So buyers need to be confident enough about what they’re doing to move aggressively on properties they like.

Why are buyers paying prices that equate to 5.5% cap rates?

  1. Interest rates are around 4%, so borrowing money to buy these properties actually boosts your annual return into the 8-10% range.
  2. With money market rates around 0.5%, even a 5.5% return looks pretty good.
  3. Buyers are betting that rents will continue to increase over time, thereby increasing the returns.

Fine print: 

We looked at properties listed as sold by the MLS between 9/1/11 and 2/28/12 in the area defined as Silver Lake by the LA Times Neighborhood Mapping Project. There were 20 properties in the initial sample. We removed four properties which, for various reasons, would not have qualified for a mortgage, meaning that only a professional flipper could buy them. For the remaining properties, we estimated the rents for units which were delivered vacant at time of sale. We also estimated the cap rates based on an expense margin of 30% of rents.

Based on information from the Association of REALTORS®/Multiple Listing as of 2/28/12 and /or other sources.  Display of MLS data is deemed reliable but is not guaranteed accurate by the MLS.   The Broker/Agent providing the information contained herein may or may not have been the Listing and/or Selling Agent.

Oh, and yes, we know we left out leap day. Sue us!

The data: Silver Lake Income Property Survey February 2012 – final

Imagine Your Building Burned to the Ground

When I look at a new building to buy, I almost always start by imagining it burned to the ground. Am I some kind of psycho?

No, I’m not (at, least, not that I know of). I imagine my building in ruins because it helps me focus on the most important aspect of any property: the land.

Particularly in cities, over the long term, land always increases in value. Why? Because the population grows every year but the amount of land doesn’t. So the demand for land increases but the supply is constant. I got a C+ in my college economics class, but even I know that increasing demand plus limited supply equals increasing prices.

You can always repair or replace a structure that is falling apart. But there is nothing you can do about a small or badly positioned parcel. And, on the other hand, it’s really hard to screw up a deal where the land is good – someone will always want to buy it from you.

So, when you’re looking at a property, imagine the building burned all the way to the ground. Think: Would I want to own this piece of land? What does the topography and the local zoning allow me to build on this land? Is the neighborhood in which this land is situated getting better or worse?

The best apartment deal isn’t necessarily the one with the absolute highest cap rate. Often, it’s the one with the reasonable cap rate plus the upside associated with an absolutely killer piece of land.