Residential Multifamily Basics

I am currently looking for 50 unit and up properties for a 1031 investor…but I’m also researching plexes and small apartments for a California investor that wants to move his equity to an environment that is more favorable.  There are huge REIT funds now that focus on single family residences and plexes…and they are doing quite well.  The fact that they are active in Portland says volumes.  With PDX being the #1 city in the US for year over year appreciation three months in a row we can expect that to continue.

Residential Multifamily (RM) Definition:  Typically Residential Multifamily is regarded as 2-4 units, or “doors”, with 5 units and up being considered Commercial Multifamily.  Lending requirements differ greatly…so the differences are important.  Many multifamily investors start by purchasing a duplex, triplex or quad; living in one unit and renting out the balance.  I know of one very successful investor that started out with a tri-plex and now has 5,000 multifamily units to his portfolio.  Perhaps even more amazing…he sold the triplex years ago…but has yet to pay taxes on the profit due to judicious use of the Section 1031 IRS Rules.

Residential Multifamily Pluses and Minuses: One advantage of a plex investment strategy is that lower down-payments are permitted by banks…sometimes as low as 3%.  RM loans close much more quickly with fewer requirements than CM loans.  RM loans focus exclusively on the lender’s evaluation of the owner’s credit worthiness…with CR weight is also given to the quality of the investment.  It’s easier to keep a watch on your renters when they’re next door, too.  Prices per door tend to be lower than single family homes.

Their pluses are also a source of their weakness:  living next to your renters means they always know when you’re home.  From the renter’s perspective you are always available to discuss their maintenance problems and “wish list” of improvements they would like you to make (without compensation.) You are more likely to become “friends” rather than business associates.  It’s harder for most to enforce rent timeliness on friends.  Paying a Property Manager 8-10% of your gross rental income makes it very hard to have positive cash flow on small investments.

Plexes tend to produce low Cash Flow, a reason they were previously eschewed by some investors.  Cash Flow is simply the monthly amount remaining from:  (All Income) – (All Expenses, including taxes, insurance and debt service).  With fewer units to amortize expenses over, plexes had a hard time competing with the functional efficiency of commercial complexes.  As a result, the plex investor focuses primarily on returns gained over time from appreciation.  Those gains are that are reaped at resale or refinancing of the property.  Contrast this with the investor of larger investments that expects to make a higher downpayment (20 to 40%) and receive monthly distributions from profitable operations.  (In addition to appreciation.)

Valuing Residential Multifamily Assets: The local submarket  for single family residences (SFR) is the strongest fundamental in determining values of plexes.  Without adding in other factors, most potential renters will not pay more for the inconvenience of living close to neighbors than they would pay for of a SFR which would likely have more privacy. RM purchasers use the Gross Rent Multiplier (GRM) to compare properties.    GRM = Purchase Price ÷ Annualized Gross Rent. GIM, or Gross Income Multiplier is also used interchangeably.  It’s intended to reflect that rent is not the sole source of income; late payment fees, NSF charges, garage rent and other revenue sources need to be considered.  A triplex that rents for $600 per door and produces $400/year in other income that is for sale for $279,000 is available at a 12.7 GRM.  Proof:  $279,000 ÷ $22,000 = 12.7.

GRM Limitations: As it is based solely on the Gross Income, there is no accounting for vacancies, concessions or expenses.  What if their property has occupancy problems due to poor maintenance?  What if the landlord is giving a lease concession of two months free rent, thereby reducing revenues by 10/12’s or 16.7%?  What if expenses are managed poorly?  In each of these examples the value of the asset is lessened, yet the GRM would remain the same.  Use GRM only as a rule of thumb when investing in plexes to see if a more thorough investigation is warranted.  All competent investment advisors will offer a proforma including expected profits based on actual income and expense.

1% Rule: This archaic valuation factor was derived from the notion a property’s value would  equal 100 times a month’s rent.  Rent rates have not increased at the same rate as home values.  A $250,000 house would rent for $2,500/month under this scenario.  If someone cites the 1% rule they are telling you: “I don’t know what in the heck I’m talking about.”

 

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