For many aspiring real estate investors, the most logical first step to building their real estate empire is to purchase a single-family house, fix it up, rent it out, rinse, and repeat. But in this blog article, I’m going to show you why in the battle of single-family versus multifamily, jumping right into multifamily investing will not only grow your wealth more quickly but is also easier and less risky.
What is multifamily?
Multifamily is the industry term for any property that is two units or more, so duplexes, triplexes, fourplexes, and beyond are all considered multifamily properties. Once you go to five units and beyond it is considered commercial multifamily.
Vacancies Hurt Less
If a tenant moves out of a single-family rental you now have 0% occupancy. If the unit needs a lot of repairs before you can rent it out again, then you could be without income for a month or more.
If a tenant moves out of a duplex, you at least have one other unit producing income to help cover the mortgage and expenses. As you scale up to more and more units, you’re able to still cash flow during tenant turnovers. Higher occupancy equals less risk.
Lower Per Unit Cost
Buying multifamily investment properties is like buying in bulk at Costco, the more units you buy at once, the cheaper it is per unit. When buying multifamily properties you’ll generally pay a fraction of the cost of a single-family home in the same market. In general, the price-to-rent ratio for each unit is more favorable for multifamily properties.
Economies of Scale
Economies of scale refer to the cost-saving businesses realize due to efficient production at scale. With multifamily investments, all of the units are in one location, which makes it exponentially more efficient, cheaper to maintain, and easier to manage. Instead of contractors driving to houses spread all over town, they can get to all of the units in one place. Replacing the roof for a 10-unit multifamily is cheaper than replacing the roof on 10 houses spread across town. Economies of scale benefit the investment across the board.
More Cash Flow
Everyone’s favorite benefit of the economies of scale multifamily provides is the greater potential for cash flow. The math is simple, the more units you have and the less they cost on an individual basis means it’s much easier for the property to produce excess cash the owners can distribute to themselves. The more cash flow you produce, the sooner you’ll be able to reinvest and continue growing your portfolio. It’s much easier to cash flow multifamily compared to single-family.
Cheaper and More Professional Property Management
Single-family homes are less efficient to manage, so property managers charge more to manage them. Property managers typically charge 8% – 10% of gross rental income to manage a single-family home, whereas commercial multifamily management fees range from 4% – 8%.
On top of that, the best management companies don’t even offer their services to single-family rentals, and once the property is large enough for onsite staff, the management gets even better.
Ability to Force Appreciation
With a single-family investment, your property value is derived based on comparable home sales within the last six months. You could renovate the home as much as you want, but you essentially have a ceiling on how much value you can add.
Once you go five units or more and have a commercial multifamily investment, your property is valued based on how much income it produces, not what comparable properties recently sold for. Commercial multifamily is valued by taking the net operating income for the past 12 months and dividing it by the capitalization rate (cap rate) for that market. The net operating income is simply what’s left over after subtracting all of the expenses for the year, except for mortgage payments. The cap rate for any market can be obtained from commercial real estate brokers or from data sites like CoStar.
So if the net operating income is $180,000 and the market cap rate is 5%, then the value of that property is $3,600,000 ($180,000/.05).
Now let’s look at an example of how powerful the forced appreciation is. Let’s assume you purchased a 10-unit commercial multifamily property with a net operating income of $180,000 for $3.6M. Over the course of a year, you renovate each unit as they turnover and average $200 more in rent for each renovated unit. That’s $24,000 a year in added income or about $22,080 after accounting for the additional management expense. At a 5% cap rate, that’s a $441,600 increase in value. If we assume you spent $10,000 per unit in renovations, that’s a 342% net return on investment.
More Options To Add Value
What’s great about the valuation formula detailed above is that it applies to all the income a commercial multifamily property can produce. This gives you more options to add value. Value-add strategies like offering storage units for additional fees, premium parking fees, month-to-month premiums, pet fees, conference room rentals, laundry facility income, and more can have a huge impact on the value of the asset.
Using the example above, if you installed storage units and 5 of the 10 tenants rented them out for $50/month, that’s $3,000/year in added income, which increases the value of the asset by approximately $60,000 at a 5% cap rate.
Better Financing Options
With single-family rentals, lenders qualify you based on your debt-to-income ratio (DTI). Once your DTI no longer qualifies for traditional financing it gets more difficult to get investment property loans and the terms are not as favorable.
With multifamily rentals in the 2-4 unit range, you can use the projected rental income towards your DTI ratio to help qualify for loans.
Once the property is 5 units or more and considered commercial multifamily, the banks no longer look at your personal finances, and instead, offer loan products based on the net income of the property and their minimum debt-service-coverage ratio (DSCR). To do this, they divide the annual net income by the annual debt service. This ratio must meet the bank’s or lender’s minimum DSCR criteria, which is typically 1.18 or 1.20. So, if the property’s annual net income was $202,080 and the annual debt service was $160,000, then the DSCR would be 1.26 and most lenders would offer a loan.
Buying a 10-unit multifamily is not only cheaper than buying 10 houses, but it’s also easier. All the units are under one mortgage, one insurance plan, one tax payment, etc. Buying 10 homes usually means 10 different transactions. This requires more effort in looking for good deals, more negotiating, and in general, a lot more time compared to purchasing one multifamily property.
Multifamily investing is not only more cost-effective, but it’s also surprisingly easier to buy and manage. The economies of scale, ability to force appreciation in any market, and reduced risk are why the most successful real estate investors always tend to graduate to multifamily.
Of course, even though multifamily costs less on a per-unit basis, the total price tag for a multifamily apartment can be beyond most investors’ budgets. Don’t let that discourage you from pursuing multifamily. Instead, learn how you can partner with others to combine your capital to acquire larger multifamily properties. Beyond most apartment complexes are dozens, or even hundreds, of investors. Splitting an investment not only allows you to participate in more lucrative investments but also allows you to split the workload of buying and managing.
If you want to learn more about how to participate in multifamily investments, be sure to follow me on Instagram (@shawn_dimartile), and click the “Invest with Me” button on my website to get email updates whenever I’m looking for investment partners.
Curious if 2023 is a good time to start buying multifamily? Read my blog article on whether 2023 is a good time to buy real estate.