Multifamily VS Single Family
We invest in apartments and single family homes. Our preference is for having more doors under fewer roofs. As a result we focus effort towards multifamily/apartment deals. We still buy single family homes; however, we do so based on strategic investing objectives and the value we expect. We may hold some of these homes, but most of the time we’re looking to flip houses. When it comes to investing in apartments our goal is to create cash flow and increase value by improving the operations. Doing this well, builds wealth faster because of two advantages multifamily have over single family home investing:
- Economies of Scale
- How Value is Calculated
In this article I’ll demonstrate these points by using two multifamily deals from our past experience. One was a six unit multifamily property – our first commercial deal. The other is a 30 unit apartment complex in a different state with several other investor partners.
Economies of Scale
What does it mean to have “economies of scale”. The Merriam Webster dictionary defines it as: a reduction in the cost of producing something brought about especially in increased size or production facilities. When related to multifamily real estate investing it means that as the number of rental units increase, your cost of doing business becomes a lower percentage of income; therefore, increasing value and return on investment. This is the main advantage multifamily has over single family homes.
Our first commercial deal was a six unit multifamily deal. It was purchased as an REO from a lender that had foreclosed on the borrower. It was purchased many years back shortly after the recession of 2008/2009. It had one vacant unit (16.6% vacancy rate) at time of closing. The vacancy was not a problem as we felt confident we could get it leased. The real vacancy issues happened soon after closing.
Less than 2 weeks after closing, one of the tenants sharing an apartment with his mother and depending on her social security payments, notified us he would have to move. His mom passed away and the social security payments would stop. He had no job and planned to move to Las Vegas.
The second issue started shortly after when a second tenant was struggling and not paying on time. We eventually had to serve him eviction documents, but he luckily moved out before any court appearances were required. We had 3 units vacant (50% vacancy rate). This was at a time when finding good tenants meant spending a lot of time showing units and processing applications to filter out many unqualified tenants. In hindsight it was a good experience because as we adapted and adjusted our qualification criteria, we were able to refine our skills at finding lower risk, qualified tenants. We were building our operational experiences towards becoming good future landlords.
Santa Fe Sixplex
Our First Commercial Property
Get To The Point:
Despite having a 50% vacancy rate, we still had 3 tenants paying rents on-time. These 3 tenants were paying off our mortgage and operational expenses. Our cash flow was definitely affected, but we were still able to operate because of these 3 tenants. There was no need to take money out of our pockets. We continued to show the vacant units and eventually leased them all. Once we were all leased up, and providing superior service to our tenants, our relationships with them became stronger. Some of these tenants referred family and friends to rent from us and still do to this day – 10 years later. Over time we were able to increase rents and boost the value of the property.
In comparison to a single family home, once a tenant vacates, there’s no income to help offset operational expenses or turn-over costs. Any repairs and expenses are paid by you. This is what is meant by economies of scale. There are more customers paying into the business that help the business withstand fluctuations in the operations; the market; the economy or all of the above. This is the main advantage multifamily has over single family homes.
How Value is Calculated
The other advantage multifamily has over single family homes is the way value is calculated. For the residential market – which includes single family homes, the comparable sales method is used. This means the price of recently sold properties in the surrounding area that are similar to your property will determine the value based on the opinion of an appraisers study of these comparable sold properties. Regardless of how much cash flow or improvements you’ve done to your property, the determination of value will always be related to what others in the surrounding area have sold for. This means if your neighbors don’t keep up their homes or values decrease in your neighborhood, there’s an adverse effect to your property’s value.
In commercial real estate the value is determined by the Capitalization Rate (cap rate) that shows the potential return based on the operations. A cap rate value is determined using the net operating income (NOI) and dividing that by the price. Different cap rates are determined for different classes of commercial property based on age and location, but the NOI is a determining factor. This gives more control to your ability to influence the value by improving the operations. If you’re doing a better job at running your business than your neighbor (by either increasing income or decreasing expenses), than the value of your property will be higher giving you more control.
Our first out of state deal involved a 30 unit apartment complex in Texas with the help of 4 other investors. At the time of purchase we projected that we would be able to increase rents to the market rate and conservatively forecasted future rents out 5 years. We expertly negotiated the price and did thoughtful due diligence. Because of our ability to run the operations well, we achieved our forecasted rents within 2 years. This increased the value tremendously, as it was generating more income while keeping our expenses stable.
This caused our NOI to increase affecting the value or cap rate. After we had lenders review our financials they determined the value to have almost doubled, giving us the ability to refinance our existing loan and return 100% of our investor’s capital.
Our return on investment was infinite, as we had recouped all our dollars invested back and still owned the property. Putting a larger loan on the property would affect the cash flows, so we did a cost benefit analysis. We determined in the short-run how much cash flows would diminish. However, analyzing rents showed we had room to increase rents and eventually get back to our cash flow dollars prior to refinance. Our investors were happy to get back their capital and still have an ownership stake giving them cash flow.
These two examples show the advantages apartments/multifamily have over single family homes – economies of scale and how value is calculated. Economies of scale with a larger scale properties help to overcome operational issues and market conditions due to more tenants paying for the business. This gives the owners greater flexibility to operate when incomes or expenses fluctuate. How apartments are valued (using the cap rate method) gives the owners the power to increase its value if they are able to increase the NOI. This value creation is regardless of how surrounding properties operate or look. We continue to buy single family homes for strategic investment reasons but time isn’t limitless. Every project requires time and if the choice is to use our time for multifamily vs. single family, the desired choice for our company is multifamily/apartment real estate.
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