How To Choose A Multifamily Rental Property

Multifamily

Multifamily rental properties are a great way to build your experience, cash flow, tolerance, and overall rental property portfolio without spending a ton of personal money.  If you do it correctly, they are self-sufficient from a money standpoint and will allow your business to grow, with just one initial investment.

Multifamily: Residential vs Commercial

We must define what a multifamily property is. A residential multifamily is a property that has between 2 and 4 units. A commercial rental property has 5 or more units. Typically, people do not call properties with 5 or more units a multifamily, but you may see it. For now, we will stick to how to choose a residential multifamily property, because they are much easier to finance for the beginner investor.

When examining a residential multifamily, there are three main items that you should take the most heed of: monthly positive cash flow, price, and location. If you are like me, your overarching goal is to make money. Price is where just about everyone starts and stops. If Property A is listed at $120k and needs $10k worth of work, but if Property B is listed at $140k and is perfectly turnkey, how do you choose? This assumes they gross about the same per month.

Depends

What you choose depends on your situation, and everyone’s situation is different, but I can provide some example scenarios. If it is your first property and you have absolutely no money, there is only one choice, Property B. This is because you will not have the cash to do the repairs. Cash flow is king and you would not have any if you chose Property A because of its deferred maintenance costs. Yes, this is not the best choice in the long haul from an investment perspective, but it is your only choice.

If this is your second property, you may still have to choose Property B. It is all about return on investment. You must determine if the $10k is better spent on fixing the property or putting the money towards the next property. Sometimes it is better to spend a little more, if it means buying another property faster. Let me give you an example.

Bigger Pockets

Check out Bigger Pockets for definitions on the different property classes

Be Smart

My father is the type of person who does not want to pay someone else to do a job that he can do and this is a commendable trait. This personality will lose him money. Plain and simple. If he can perform a $100 an hour job and he chooses to mow the grass, which is a less than $100 an hour job, he has lost money. It pays him to pay someone to mow the grass, if he can work elsewhere making that $100 an hour.

This is the mentality you must have if you want to expand and expand quickly. This is not to say not to do some of the work yourself when getting started. The concept of leverage is one that you will have to master if your goal is to have more than a few properties. Planning your next step is often more important for scalability goals.

Leverage

Investopedia has a great article on the concept of leverage. It has to do with more than just real estate and rental properties, but it is worth the read. I cannot tell you how many people I have met at real estate investors meetings that buy a few properties and stop, because they do not know how to leverage properly or cannot get themselves organized. Enough of this tangent, let’s get back to how to choose a property.

http://www.investopedia.com/terms/l/leverage.asp

Deferred Maintenance: What is it?

Deferred maintenance is the cost of fixing any repairs that have been neglected from the previous owners. Determining the amount of deferred maintenance needed, and the fix-up price that the maintenance entails are arduous tasks if you are just getting started. If you are not well versed at this, you will need to learn how. There are some great YouTube videos out there, but if you want more depth, consider seeking out courses on insurance adjusting or property appraisal. Both will be helpful.

Educate Yourself

Insurance adjusting looks at the cost of replacing specific items and there are several certifications and licenses that you can study, even if you never plan to get the license. Second, learning how professionals appraise properties will help you judge the worth of a property more accurately.
These two are surefire ways that you will know you are correct in your pricing models.

Personally, my father is a licensed insurance adjuster and sold items such decks, roofs, windows, siding, etc. for over a decade, so I have someone who I can bounce ideas and prices off of and be confident of its accuracy. This is a luxury that most do not have. If you have any questions on this, post a comment or send me an email and I will do my best to help.

What should I look for?

Some items that you should look at when buying the property are items that have the higher cost to fix/replace or the items that can cause future issues, such as the foundation, outside grading, roof/gutters/downspouts, any current or prior water leaks, termites, and mold. Personally, I also try to look only at brick buildings (less maintenance than siding) and dislike flat, rubber roofs.

Foundation issues are not something you want to deal with, they are expensive. If it has a basement, look at the walls to see if it has any cracks and if there is any separation between them or sliding. Horizontal cracks are usually the worst, whereas vertical cracks on the corners of the building aren’t unusual and you should not be as worried about compared to the horizontal ones.

Water is your enemy

How the water runs off the building can be a huge issue in the future. Make sure that water doesn’t try to flow towards your building if it were to ever rain, but rather make sure the grading around the building makes the water flow away. Gutters and downspouts make a huge difference with this. Questions to ask yourself are, are the gutters large enough and are they clogged? Visit the potential property when it is raining hard if possible.

Water leaks can also be expensive. Look for signs of water leaks on the drywall or on the floor. They are usually easy to spot. There are also handheld tools that can detect moisture in drywall that you can buy, but they are somewhat cost prohibitive.

 

Home Inspection

Extensive termite and mold are two items that I do not want to deal with. Many people will put up with them, I will not and if you are a beginner, I suggest you avoid both. Of course, a home inspection will check for all of these items in depth, but you do not want to pay for a home inspection more than you have to. The more you know about what to look for, the less you will have to pay someone else. Plus, you should not want to risk your money without having some knowledge about what you are investing in.

What do you want to pay for this property? A Short Look

The second item you should look at is price. There are several metrics you can calculate to determine whether or not the price is a good deal or not. These are each just quick calculations that you can figure to quickly bypass lower quality investments. Many investors like to use capitalization rate or cap rate for short.

Cap rate

For example, let’s say for shits and giggles, that after expenses, a property that is valued at $120k nets $10k a year. 10,000 divided by 120,000, times 100 is 8.33%. That is not a great cap rate in my book and I am not a huge fan of this calculation. The cap rate does not tell the whole story. By using the cap rate in conjunction with other calculations, you can paint a better picture of the property’s value or lack thereof. Never use just one calculation.

1% and 2% Rule

A calculation that I use, and this may not work in your area, is to try to get as close as possible, or over, to the 2% rule. What is this? If a property is selling at $100k, it should hopefully gross 2% of that in rent per month, so $2,000. It would be difficult to get 2% in my market, but I get close. Some markets must use the 1% rule. Again, markets are not all the same, but in my area, this works well.

Lastly, I try to see if the property can pay for itself, from a gross rent number, in five years or less. For example, if a property is listed for $120k and the current gross rents are $20000, then the property is overpriced. There is one very big caveat with this calculation. What if the rents could be increased to make $25,000 per year? Or even $30,000? Then this property could be a good deal. Overall, these three are close to being the same calculation with minor differences, but they allow you to skim properties quickly and find the best deals.

Location, Location, Location (which is incredibly cliché, I know, deal with it…)

Most investors consider there to be four types of properties based on location: Class A, Class B, Class C, and the warzone. Class A are the luxury apartment buildings in the nice neighborhood that you would let your college age daughter live by herself, if you had one. Class B are in the neighborhoods that are in the okay areas, nothing terrible, but not fantastic. This is where I try to be when I buy mine. Class C are in low income areas with a fair amount of crime. If you buy in this kind of area, make sure you have a property manager who will manage here.

Lastly, the warzone. This is the type of place you do not want to be in in the daytime, let alone the nighttime. You will see needles on the ground and get the eye if you drive through it. You know this type of neighborhood, do not buy here unless you like constant migraines.

Rents

Rents are a good place to start and Rentometer.com can give you a rough idea of rents in the area. They are not always accurate, so look at it with a grain of salt, but they get close sometimes. Your best bet is to call other properties in the area, as if you are looking to rent their apartment.

Speaking of cash flow, expenses make or break profitability. When searching for a property, if possible find one with tenant paid utilities. This is not always possible, but in the winter time, your profitability will stay more constant than it would if the owner pays utilities.

rentometer.com

Valuation Methods

My market is Cincinnati, OH. It is just about the national average on most items, such as cost of living index, but it is 54% rental and 46% own. There are all kinds of valuation methods, that you may or may not prefer, but they all will help in some fashion. If you want to see more, Investopedia has a good page on differing valuation methods.

Know that residential multifamily buildings are not valued the same as commercial buildings. Commercial properties are usually valued by how much income they produce, whereas, residential somewhat use a combination of income and comparable multifamily properties in the area. Your realtor should be able to come up with comps of the property you are considering purchasing.

Multifamily vs Single Family

If you are just starting out, I highly recommend residential multifamily buildings over single family homes or commercial rental properties. Losing one tenant does not mean all your income comes screeching to a halt. It means that hopefully you can still pay for the mortgage loan and all required upkeep, even with some vacancy.

Whether you want to be the next real estate mogul or just have a few, you should scale as if you want to be. This way, when you get to where you are able, you do not have a lot of work to do on scalability. Come up with processes and systems that automate time consuming issues because this can keep you profitable. Speaking of profitability…

The Scary Part: The Math, dun, dun dun…

A residential multifamily rental property should make money!  You should calculate that return on investment in depth before you invest and if you spend too long on getting the best deal possible, you may lose money over a good deal done quickly.  It is a balancing act that you must optimize and the only way you can optimize it is to calculate it.   A residential multifamily rental property should make money!  You should calculate that return on investment in depth before you invest and if you spend too long on getting the best deal possible, you may lose money over a good deal done quickly.

It is a balancing act that you must optimize and the only way you can optimize it is to calculate it.  Some of the calculations you can do are the following: cap rate, gross rent multiplier (GRM), cash-on-cash returns, return on investment (ROI), internal rate of return (IRR), modified internal rate of return (MIRR), and/or the 1%/2% rule.  There are hundreds of calculators that others have built on the internet.  Search for them.

One that I use personally, is this one that calculates the internal rate of return or IRR.  There are some drawbacks from using IRR, like if you have different returns for each investment, but it works in my business model currently.  You must decide what works for you.  You don't have to be Einstein.

Calculate (<-- Terrible section heading)

Each real estate guru will inform you of their slightly different opinions on the same calculations. Be sensible, you are intelligent. Everything in moderation. A plethora of investment gurus will tell you to use other people’s money, and that is a great idea if you can do it. For the real estate and rental property investor beginner, that’s tough to do when you have other commitments and do not have the confidence an experienced investor has.

The one simple calculation that you should do is to determine how much net income you will make after expenses. On my second property, my total mortgage payment is just under $700 per month. Currently, it grosses $1,900 per month in rent. Before other expenses, that is $1,200 per month in profit. The rents are going to be increased to at least $2,150 soon. If you use the 50% rule, which is one that states expenses will be 50% of the gross rent or $950 per month, then after everything, my profit will at least be $250 every month.

Worst Case Scenario

Be conservative in your calculations, calculate the worst possible scenarios.  If you still make good money, then it is probably a good first investment.  This is not to discount the return on investment calculation, but not everyone makes money their first time out.  Aim high, but be realistic.  There are a great many people who lose money.  Be conservative in your calculations, calculate the worst possible scenarios.

If you still make good money, then it is probably a good first investment.  This is not to discount the return on investment calculation, but not everyone makes money their first time out.  Aim high, but be realistic.  There are a great many people who lose money.   Cash-on-cash return or cash flow return on investment, is a big one in my book.  It can make you and break you at the same time.

Personal Case Study

I bought my second property and put $28,750 down on it. I expect to make anywhere from $5k-$10k profit this year on it. My cash on cash at $5k is 5000/28750 or 17.4%, not bad. But at $10k, double it, 34.8%. That would be awesome. The reason that this can break you is that if you are too focused on lessening your down payment, you may over leverage yourself. Leverage amplifies both profits and losses. To pull a quote from Paula Pant at AffordAnything.com, “There are experienced investors. And there are over-leveraged investors. But there are not experienced, over-leveraged investors.”

Why Not?

Why not leverage yourself as much as possible, but have a large, liquid emergency fund somewhere? Set aside an emergency fund for each property you buy. Do not dip into it for anything else. Without it, you could be one major expense away from losing your business. Again, you must decide how much risk you are willing to take on.

Choosing the correct properties will make or break your wallet, your dreams, and your business.

 

Good luck and if you have any questions, leave a comment or email me at Feedback@PlusFourZeros.com. Thanks for reading!

By Trey Stevens

Learn what I did wrong or right from My Journey in real estate and rental properties OR check out other articles on my Blog.

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