Straight talk on investing in small multi family properties

“I know you are against investing in two to four unit properties – but that’s the direction I’m leaning in at the moment” – Theresa said somewhat tentatively.

The overwhelming majority of case studies or portfolio scenarios I’ve written about involve the acquisition of a portfolio of quality single family homes in great school districts. Therefore, it is not at all surprising that some of you might assume I discourage the purchase of other categories of investment real estate.

But the truth is I’m not against investing in any type of investment real estate. Nor do I have a bias to favor single family properties over all else.

So then, why am I advising clients to focus on single family homes when investing in the Houston market?

Our process to identify target acquisitions is deeply rooted in the principles of our Blueprint real estate investing strategy . In a nutshell, we look for quality, recently built properties zoned to great school districts that would attract long term quality tenants and offer solid returns.

To understand why small multi-family properties don’t fit that general standard, one must understand the concept of “highest and best use”. Imagine for a second that you are a real estate developer and you need to make some decisions on what to build on a vacant plot of land. If the land is a corner lot at a busy intersection with lots of traffic near the Galleria, you probably don’t want to build a home on it. There’s a higher and better use for that land than residential property. You might build a commercial shopping center or a single tenant building to house a Starbucks or a bank branch. Instead, if the land is a single lot on a residential subdivision, the highest and best use for it would probably be a residence of some sort.

Since the 1980, the Greater Houston area has experienced the full effects of urban sprawl. By and large, Houston residents don’t mind 30, 45 or 60 minute commutes if that means they could live in a great home with lots of space, 2-3 car garage and a yard. This has been a boon for real estate developers who found themselves with lots of cheap land and good demand for suburban properties.

But they were faced with an important question. If you had 1000 acres of land in Katy to develop residential housing, what was the highest and  best use for that land? Should they build a community of duplex properties? Fourplexes? Or single family homes? Really, it was a demand question for the future homeowners that would occupy the properties. If you had a choice Future Buyer, where would you rather live: Duplex, fourplex or a single family home?

For over three decades, the result has been a resounding leaning towards single family homes. In fact, since the 1980’s, there has been very little new development of small multi family properties in the Greater Houston area. The ones that have been developed have quickly turned into outdoors apartment complexes with the wide majority of occupants being renters as owners have transitioned into single family homes.

So the first problem real estate investors face when looking for small multi family properties in the Houston market is a lack of recently built properties zoned to great school districts. What multi family properties exist in these areas are usually built in the 1980’s and bring with them the typical maintenance, repair and capital expenditure problems of older properties.

To illustrate the second problem investors face with small multi family properties, let me tell you about an actual case study. A long term  client of ours purchased a four unit property from a bank that had repossessed it. This property needed work but had a lot of positives going for it. The unit mix was great: Two of the units were 2/2 and the other two were 2/1. These were large apartments (over 900sf each) and the building was across the street from three good  schools (elementary, middle and high). The price was affordable too – $700 a month for the 2/2 units and $675 for the 2/1 units. Finally, the price to rent ratio was a favorable 5.6 (monthly rent was 1.5% of price) so the positive cashflow on paper promised a great return.

The second problem real estate investors face with small multi family properties in Houston is that proforma numbers don’t match real life numbers.

In order to qualify for a $700/mo apartment, a tenant’s gross monthly income has to be 3-3.5 times rent. So we were renting to tenants that made $24,000-28,000 a year in income before taxes. As a result, there isn’t a whole lot of disposable income there to save and absorb any major expenses (see: unexpected car repairs). To use a common term, our tenants were living paycheck to paycheck. I say this not in a denigrating way whatsoever as we all have been there and know what it’s like. I’m  just stating the facts about the situation they face month in and month out. So, when those unexpected expenses showed up (as they usually do) the rent was late or unpaid. That inevitably leads to a much higher eviction rates and turnover of tenants.

The second wake up call came during showings. Prospective tenants weren’t as much interested in the unit itself as they were in the incentives I didn’t know we had to offer. Free rent, no deposit, deposit split into payments are all foreign concepts to those who invest in quality single family properties. Concepts that add much risk to the equation and reduce those paper returns substantially. More importantly, tenants in these properties do not usually commit to long term leases (or in some cases, violate existing leases)  because they know there’s always someone offering a juicy incentive around the corner.

Furthermore, when you own a small multi family property you are most likely competing against larger apartment complexes for the same pool of tenants. In most cases, these properties have a competitive advantage over your duplex or fourplex. They can offer tenants amenities that you cannot (i.e. pool, on site management, gated community etc). They have more units so they can offer better incentives. So in the contest for the best apartment tenants they get first pick. And you get what’s left. Many of the applicants you will get have been turned down at the big apartment complex around the corner because they have a broken lease/background check issues/unapproved pets/insufficient income etc. So you are having to lower your tenant standards and keep a blind eye towards these issues if you want a full building. Which brings us to the third problem with owning small multi family properties in Houston – they fail to attract the high quality tenants that our strategy calls for.

Last, tenants that lease apartments have very different expectations of the responsibilities of the Landlord than tenants that lease homes. They expect the Landlord to fix every little thing that ever goes wrong with the property. Therefore, you must have an property management company actively manage the property for you. And when you read “actively” you should imply plenty of repair calls on a regular basis.

So  you see, it’s not that I’m against any category of investment real estate. Our strategy lays out very clear acquisition criteria and we take what the market gives us and what the investor’s capital will allow. In Houston, there is no supply of small multi family properties that are recently built which would attract quality long term tenants and produce solid returns. In Houston, at the moment the market is giving us single family properties that fit all criteria and are within reach of the capital our clients possess. Once the capital base of our clients grows to critical mass, the market may give us commercial property with great business tenants. And we will surely make that transition when it’s available.

Other markets may be very different in this respect and small multi families might be optimal there.  In that case, I’ll be the first to say, go ahead and invest. But before you pull the trigger please make sure that the property is in a good location and not just in a good enough location. Moreover, make sure that your numbers reflect reality. If you’re using the same assumptions for single and multi family properties, your numbers are wrong. Plan for higher vacancy rates, management fees, lost rent through incentives etc. Finally, make sure that ou have a clear understanding of how much attention a multi family property requires. If you think you can be an armchair investor with a small multi family property, you will find yourself off that armchair shortly after closing.

Matthew Rutledge via Compfight