Buying a multifamily property can be an important next step for a real estate investor who had previously purchased single-family homes to rent to tenants. Doing so can allow you to produce more income and build net worth faster, if you’re up for the challenge.
“You’re ready to buy a multifamily property when you’re excited about the idea,” says Brian Davis, a real estate investor and co-founder at SparkRental.com. “I’ve known people to buy a multifamily property as their first investment property, and I’ve known investors to buy dozens, even hundreds, of single-family properties because that’s what they liked.”
The key to determining whether the increased responsibility, liability and capital reserves required to buy a multifamily property suits you is performing careful due diligence, so heed the following tips from real estate experts:
Consider living in one of the units for favorable terms. If you buy a building with four units or less and live in one, you can qualify for owner-occupied financing with little money down, while investors usually have to put at least 20 percent down, says Mark Ferguson, a real estate agent, investor, author and creator of InvestFourMore.com.
It may also allow investors to purchase another investment sooner because their debt-to-income ratio would be lower to show banks they are better qualified, Ferguson said.
Choose the right professionals to help. Buying a multi-unit building can be overwhelming, so choose an experienced broker who can help you through the entire due diligence process.
“At a minimum, your experienced team should include a broker, attorney, and lender,” said Lee Kiser, managing broker of Kiser Group in Chicago
“These professionals can guide you through local practices and customs, and help you determine the most important items to review during due diligence,” Kiser says, which include physical aspects of the building and the financial and cash flow of it. Instead of hiring a general inspector, enlist consultations of local tradespeople to give you opinions for each major system or component of the building.
Ask for detailed paperwork. Request income and expense statements for the current and previous years, current rent rolls, service contracts and all existing reports, Kiser says.
“Make sure the historical information matches your expectation of the current operations – and if it doesn’t, find out why,” he says.
“Get very, very familiar with the vacancy rate in that neighborhood,” Davis adds, and talk to the tenants directly to get honest feedback about the building’s condition and potential problems.
Also, verify proof of rental payments and copies of leases, says Janine Acquafredda, associate broker of House n Key Realty in Brooklyn, New York. Have security deposits transferred to you and meet all of the current occupants.
Value the prospect carefully. A multifamily property is not valued by its price per square foot, but rather its income and return on investment generated. Look at the income and expenses of the building and see how much is left over, which is called net operating income. This number is divided by the typical rate of return for a market area (called a capitalization rate) to determine fair market value, Davis says.
A cash-on-cash return is determined by dividing the income after expenses by the cash you’ve put into the property, Kiser says.
Keep adequate cash reserves. Unexpected events will occur when owning a bigger rental property. For instance, do not assume the property will be fully rented all the time or that tenants will pay consistently, says Corey Vandenberg, a mortgage banker in Lafayette, Indiana.
“Sometimes it’s good to see if 50 percent rented would pay the bills,” he says.
You’ll also want to make sure that you know what it will take in your jurisdiction to evict a tenant, says Ralph DiBugnara, vice president of Residential Home Funding in Parsippany, New Jersey.
A good rule of thumb is to take 10 percent off of the top of expected rents to prepare for unexpected market declines, vacancies and other factors, says Adam Bray-Ali, a Los Angeles real estate agent and investor.
Know what you’re getting into. “Do you want to be a landlord for reasons other than money?” Bray-Ali says. “Your due diligence should include an attitude check to determine if you want to deal with the management.”
“Headaches are largely based on the quality of the neighborhood and the age of the property,” Davis says.
You can determine those factors by seeing how it is classified – either as A, B, C or D class property (A being the best condition) – and buy one according to your wherewithal and budget.
“Having owned many D class properties, I can tell you firsthand this is entirely true,” Davis says. “In my worst properties, it’s a constant struggle to collect rent, to repair damage caused by tenants, to keep the properties rented, and so on. In my best property, I have none of those headaches. All of my renters there have always paid on time like clockwork and treated the property with kid gloves.”
There is often less inventory of multifamily properties than single family homes, so “you may have to sacrifice on location or property condition to find one in your price range,” says Allison Bethel, real estate investor analyst for FitSmallBusiness.com.
Bethel says investors often fail to confirm property is legally zoned for its use and number of units.
It’s also a good idea to have a property lawyer set up your leases and an LLC to own the property, Vanderberg says.
Consider professional management. First-time apartment building buyers should think of paying a property manager to handle day-to-day issues for tenants and repairs, which normally costs a fee of 3 to 10 percent of rents, Kiser says.
“Each market has its own idiosyncrasies for landlord-tenant relations, advertising, leases, disclosures and many more items,” he says. “It is usually a good idea to learn this from a professional third-party manager working for you than to learn by making the mistakes yourself.”