Investing Architect

Category: Long Term Rental Properties

Branching out to solve the Biggest Challenge: Small multifamily properties
In an article I wrote at the beginning of the year, I summarized the biggest challenge of 2014 for long term real estate investors in a single word: Supply. Now that the second quarter of the year is almost coming to a close, that prediction has become reality. And as we go into the summer months, supply historically shrinks even further as demand rises. In the meantime, your financial goals are still there, calling for acquisitions to be made to build income streams that lead to financial freedom. On one side of the coin, you don’t want to acquire assets that don’t make sense from an investment standpoint simply for the sake of acquiring them. But on the other, you don’t have the luxury of simply taking a year or two off in an environment where prices and (eventually) interest rates are expected to rise further. So how should you navigate under these circumstances?

Market “gravity”

In life and investing alike, there are issues that are rightfully up for debate and then there’s “gravity” – a law that applies equally across the board regardless of our beliefs about it. In long term real estate investing, a gravity-type law says that you take what the market gives you and build your strategy around it. Many a fortune have been squandered by investors on a mission to disprove that simple law. While in midair, many such investors actually think they have outsmarted the law – on the way to the eventual pavement.

However, one major distinction is that, unlike physics gravity, which is constant and applies to all equally, the real estate investing market is an ever changing landscape. Today’s market “gives” investors a much different set of circumstances than say it’s 2008 counterpart. So while the law always applies, there’s a variable dimension to it and you must be able to adapt your investing strategies to reach your goals. That’s not to say that you switch strategies as the wind blows – the principles must remain the same. But you shift your investing approach while abiding by those principles.

Principles to assets

Investing principles come first and assets follow. I know it sounds like a Captain Obvious proclamation but you would be surprised to know that the majority of long term investors get that important order completely backwards. Without first devising an overarching strategy and distilling from it investing principles to live by, they make an arbitrary decision on the type of real estate assets they will pursue. They buy “cheap single families and rent them out” or “small apartment complexes at $X per door” or “small condos with a max price of $X”. And all the while there’s no rhyme or reason to it. And most crucially, there’s zero consideration of the fact that the market “gravity” may have changed the landscape to extinguish the opportunities in the asset type they’ve arbitrarily chosen.

The alternative approach: Start with the end in mind (goals), devise a plan to achieve them (Blueprint), come up with clear criteria the asset must fulfill (principles) then look at the market and the asset types it offers that are the best suited vehicles to get you across that finish line.

Asset principles of the Blueprint Strategy

Our Blueprint strategy’s approach to determine investing principles for the type of asset to acquire is very simple. Our investors reach their goals when they own the right size portfolio of real estate leased to great tenants. Great tenants lead to low vacancies, low turnover and profit maximization. In our experience, great tenants look for properties located in good school districts in great, safe neighborhoods with easy access to employment centers through highways and great amenities and low hassle. Constant repairs in a property represent a great hassle to a great tenant (and the corresponding investor which has to foot the bill to boot) and they’re a direct result of the age of the property. It’s better to purchase an older property in a great location than a new one in a bad location but it’s so much better to purchase a newer property in a great location. Real estate investors should be concerned with two types of returns: returns on investment and returns of investment. The way to protect your invested capital and make it grow through appreciation over time is to purchase a property that can be sold for top dollar should the investor decide to exit. No one pays top dollar for average, run of the mill properties so investors should be looking for a property that will have appeal to the eventual buyer to whom they will sell the property eventually. And last but not least, the property has to have a good price to rent ratio as to provide an adequate return on investment.

So, to sum up, long term investors following the Blueprint strategy look for newer, quality properties in top locations with good price/rent ratios to provide an adequate return on investment.

Asset types

Notice how in the above summary, there’s no mention of specific property types. No “single family homes”, “small multi-family”, “condos” etc. That’s an omission of crucial significance because different markets “give” investors different asset types that can accomplish the goal. For example, in North Carolina, new (or new-ish) attached townhomes offer everything the asset principles above call for at a more favorable price/rent ratio than single families. In Texas, single families substantially outperform townhomes. In some cities, there are newer small multi-family opportunities in great locations while in Houston they’re virtually non-existent – they’re either older properties in good locations or newer ones in bad locations.

That’s the reason most of my case study articles that discuss investing in the Houston market involve single family homes. It is not because, that’s the type of asset we favor but because in this particular market, that’s the best asset type the market gives us to help investors accomplish their goals.

Solving the Biggest Challenge

Let’s come full circle to the initial premise of the article: Rising prices and increased competition for single family homes in the Houston market have reduced the supply of opportunities for long term investors. But if your Blueprint still calls for further acquisitions in a climate of reduced options, what are we to do? We need to look for additional options elsewhere – in markets that have most of the same strengths that perhaps “give” investors access to property types that just aren’t available here at this moment. That’s what we’ve been diligently working on since the second half of last year and I’m excited to say that what we’ve found abides by the asset principles above and gives us some additional benefits to boot.

I plan to present a specific case study with hard numbers in a subsequent article but I’d like to end today’s post with a summary of strengths that this new opportunity offers:
1. New construction, luxury small multi-family (duplexes) zoned to great schools
2. A growing Texas market with a population growth rate 9 times the national average
3. Quality property management company in place providing a true turnkey investment
4. Maximization of asset value per conventional loan
5. Low property taxes, hazard insurance, HOA dues
6. Attractive price/rent ratio and low days on market/vacancy rate
7. Luxury low maintenance finishes (brick exterior, granite counters, 11-12ft ceilings, oil rubbed bronze fixtures, no carpet anywhere)
8. Builder warranties (1 year wall to wall, 2 year HVAC/electrical/plumbing, 10 year structural)
Next time, I will present the hard numbers and show you how you can weave these small multi-family properties in your Blueprint strategy and utilize some of the strengths above to propel you towards your goals. Until then, take good care of yourselves for me.
May 16, 2014
The principal reason you won’t become wealthy investing in real estate

The majority of my writing here covers real estate investment strategies and mindsets you can use to become wealthy with long term real estate investing. In various case studies, I have shown you how to create a six figure income and how to retire in seven years etc. by making smart real estate investments tied by the common thread of a solid Blueprint strategy.

And that’s all well and good. We all can benefit from a little more “big picture” insight to help us design and take charge of our own financial future. But when you get down to the dirty details, the execution of such plans usually ends up being a lot messier than those projections. It’s one thing to look at and intellectually understand the mathematical implications of a strategy that assumes flawless execution. It’s another to actually execute. Think about all the things you have to contend with when making an important financial decision. We all want to avoid risk where possible (risk aversion) which leads to uncertainty (indecision) about whether this is the right move (wanting the best deal possible) which leads to procrastination and paralysis by analysis (inaction).

Sometimes knowledge of the path that leads the opposite way can illuminate the path that leads to what we want to become.

In the context of building wealth through a disciplined approach over long periods of time this is not only true – it’s eyeopening.

You see there’s this massive myth in the realm of real estate investing that has been propagated by multiple books and has been accepted as truth by most. It claims that in real estate investing you live and die by your rate of return. You might have heard it put a different way in “you make your money when you buy the property” or “if your incoming rent is not at least X% of the purchase price, don’t buy the property”. They’re all different shades of the same idea:

Myth: Your ultimate success or failure in becoming wealthy investing in real estate is a direct result of your rate of return. Therefore, you should have a set return number in mind and use it as an acid test. Anything yielding a lower return is a nay, anything higher a yay.

Sounds sensible enough, right?

Let’s add on another layer of context to this discussion. In a free capitalist society the only constant you can count on is change. Case and point: The real estate market over the last 9-12 months has been experiencing rapid change from a sleepy sideways market to a “write your full price offer before you leave the property or you don’t stand a chance” Seller’s market. Obviously this has caused prices to rise and inventories to shrink substantially in most markets which leads to downward pressure on rates of return investors are able to obtain. Last week, I had a conference call with a client that had purchased several properties in 2007-09 and was mortified by the unrecognizable landscape.

With that in mind, you can see how “the number” you have in your mind for an acceptable return can change based upon your previous experiences (a new investor with no past frame of reference would view today’s market very differently than an investor that acquired property at the most distressed point of the 08 recession) and therefore influence your action (or inaction) going forward.

But none of that matters.

The idea that your wealth building efforts will succeed or fail based upon your ability to secure a certain rate of return is just untrue. Here’s an example that dispels that myth: Suppose you have two real estate investors A and B. Investor A puts together a portfolio of 9 high quality properties yielding 15% annual returns and Investor B purchases similar quality properties (9) that only yield 10% returns. Both investors employ a Blueprint strategy to aggressively pay off their properties over the next decade and end up with the same income at retirement. All else being equal, Investor A will get to retirement much faster due to the higher return on his investments but in the end both investors end up with a similar net worth and income. In other words, both end up wealthy. So the 30% difference in returns impacted the speed of success but not the ultimate result.

Of course, all else is rarely equal in real life.

Take the same example above and add the layer of context of a changing market I described above. During the acquisition phase their plans, the market shifts and now 15% return properties dwindle in numbers and Investor A only acquires 5 out of the 9 properties he was planning to acquire. Meanwhile, Investor B completes all nine purchases since his 10% rate of return is more readily available. Who do you suppose fares better in the end? Investor B portfolio crushes Investor A’s and his coveted 15% because he acquired and paid off a larger asset value becoming significantly wealthier in the process.

It’s not the rate of return that determines your success or failure on the road to becoming wealthy. It’s action. If you’re disciplined and have a solid plan, you will pay off and own whatever you acquire. But it’s the acquisition that sets everything in motion. Without it, you lack the target to hit and with it the structure you need to be able to execute.

Remember this: Far more wealth is lost by inaction than ever was lost by accepting a lower return. Don’t let an arbitrary number in your head back you into the corner of inaction. That’s the principal reason one fails at becoming wealthy.

February 28, 2014
The biggest challenge of 2014 for long term real estate investors

Sometime around the summer of 2013, the investing landscape in Houston began to change at a rapid pace. Demand soared, inventories shrunk to record levels and the Houston real estate market lit up like a wildfire.

Bank owned foreclosures, the perennial sweethearts of investors everywhere that had accounted for one in four sales just a year ago, now barely contributed six or seven percent. The few properties that banks were bringing to market were either inaccessible to investors (in favor of owner-occupants) or priced at market prices despite the need for repairs.

Meanwhile, builders started ramping up construction to complete subdivisions that had been developing at a snail pace and break ground on new communities. But as one builder told me, “after five years of increasing construction costs and stagnant prices the market was finally allowing them to raise prices”. And raise prices they did. Same subdivision, same property that had been selling in the high $140s, first went to the mid $150s then mid $160s in six months’ time. Fortunately, rents kept on rising right alongside prices so it made sense up to a point. Then prices rose out of reach.

Finally, the owners of existing homes with plans to sell started setting their pricing sights ever higher boosted by anecdotal evidence of neighbors’ homes selling in a matter of days at full price and multiple bids.

As a result of this combination of higher demand and tighter supply, we ended up with record numbers in sales, prices and inventory for 2013:

So what does this mean for investors in 2014?

After that synthesis of the second half of 2013, the knee-jerk conclusion that some investors might draw is that the “train has left the station” and the prudent course of action would be to sit tight and wait for prices to come back down to the good old 2010-2012 levels. While I understand the impulse to draw that conclusion, I think it’s misguided on several levels.

First, the idea that if we just wait it out, prices will come down in short order is based on the assumption that we are currently in a bubble that will burst soon. That couldn’t be further from the truth and here’s why. From 2008 till the end of 2012, home prices in the Houston area were pretty much flat. They didn’t go down much (like California, Nevada, Florida and the like) but they didn’t go up either. That was during the 2008 recession. In 2013, prices went up 10% for a single year after five sideways years. If that constitutes a bubble, I’m Irish. In a real estate recovery, what do you suppose prices should do? Not only are prices not going to come down shortly, but they are likely to go up some more. In fact, Forbes (among others) predicts that prices in the Houston-Sugar Land-Baytown metroplex will grow about 24% over the next 3-4 years. So waiting on the sidelines will not help but rather hurt your efforts as an investor.

Second, if you are an all cash investor that does not utilize financing, the price you pay for a piece of property is the single determining factor in how that property will perform as an investment. But for the overwhelming majority of long term real estate investors, that’s not the case. They will put down a large down payment (20-25%) but will finance the rest. For that overwhelming majority, prices tell only part of the story. The terms of their financing tell the rest.

Here’s what I mean: Suppose there is a property that you can purchase for $150k today (and finance $120k of it at 5.25%) or you could wait a year and buy the same property for $127,200 (and finance 101,750 of it at 6.75%). Do you know that for cash flow purposes, the cost of both properties is exactly the same? And here’s the kicker – the scenario where interest rates rise 1.5% over the next 12 months is a lot more plausible than the possibility of prices dropping by 15% in the same timeframe!

Third, it’s very important to understand what happens to an investment’s returns in an environment of rising prices. There are two dynamics at play – On one hand, paying more for the same stream of income puts downward pressure on cashflow returns. If before you could get 12-16% cash on cash returns, now you’d be looking at 9-10%. But, on the other hand, suppose you acquire a property for $150k in January 2014 investing $35k out of pocket in the process. If by the end of the year prices rise a modest 5%, your return on investment from that appreciation for the year is over 20%! How? Well, when you purchase the property with 20% down, you invest only 20% of the amount out-of-pocket but reap 100% of the price appreciation. Therefore, that $7,500 increase in asset value (5% of 150k) represents a return of over 20% on your invested cash of $35k in addition to the cashflow return you realized. So, the same factor that compressed your cashflow returns is the same factor that caused your appreciation returns. To be fair, cashflow returns are different in the sense that they are reaped every year whereas appreciation returns require the sale of the asset to be reaped. But the goal of a long term real estate investor is maximum cashflow at retirement facilitated by capital growth until that point. In that context, this new environment of slightly lower cashflow returns and higher appreciation returns accomplishes the same goal via a different path.

The Biggest Challenge

That brings us to the crucial point of this article – the biggest challenge of 2014 for long term real estate investors. One Word: Supply. From where I stand, the ability to find and acquire assets to assemble your portfolio will continue to be the principal challenge for long term real estate investors this year. Over the last six months or so, my principal focus has been to find solutions for this challenge. And I am happy to report that I will be sharing some of those solutions with you in the coming posts. So stay tuned – it will be worth it.

Note:

After an avalanche of a fourth quarter and a major life event (we had a healthy baby boy in December), I have been absent around these parts for quite some time. I really appreciate that many readers have reached out and missed the regular writing. I can’t begin to tell you how much I miss it myself. Although mildly sleep deprived (sleep is overrated, anyway), I’m back on the saddle and I look forward to the discussions on the blog. Thanks for sticking around –

Investing Architect

February 3, 2014
How to find and screen tenants for your investment property
When you are trying to reach your retirement goals using a long term real estate investing strategy, there is a multitude of factors can make the crucial difference between success and failure. To mention a few, the quality of the location and school district, the price to rent ratios in your portfolio and the terms of your financing are all factors that lead to underwhelming results when compromised.

But if I had to pick one factor that all successful long term real estate investors must get right, one ingredient that is necessary for your portfolio to achieve its full income potential, I’d have to go with the ability to find and keep great tenants. Without great tenants, your dream retirement unravels into a hassle laden, vicious circle of vacancies, evictions and problem calls that typically keep skeptical inventors from investing in real estate in the first place.

With that in mind, I’m convinced that one of the greatest services we provide for our clients on a daily basis is the procurement of great long term tenants. So today, I wanted to share with you some pointers on how to find and screen potential tenants to find the hidden gems that will pay rent on time for a long time and take care of your property like it’s their own.

Before I begin, I want to point out something of outmost importance. The investment properties you buy generally attract (and essentially pick) the type of tenant you will eventually have. If you buy a property in a bad location, with high crime rates and low quality schools your applicant pool will consist of tenants that would want to live in that property. There’s no magic wand that would allow you to find great tenants for a low quality property. So, what follows assumes that the property itself is an investment grade property in a good location that would attract a well qualified tenant.

Now that we got that out of the way, let’s say you just closed on a great investment property and are anxious to find a great tenant (as 100% of investors are). How do you go about finding and screening applicants in a methodical and proven way?

First let’s tackle the “finding part”. At the outset you have to let the market know that you have this great property available for occupancy. Painfully obvious, I know. But you’d be surprised how many investors fail at this stage in a futile quest to save a few hundred bucks. In order accomplish this, your property needs to be listed/advertised/posted where potential tenants look for rental properties. That means your property must be listed on:
1. The MLS – A large percentage of the great tenant pool are relocations into the city where your property is located. These tenants are usually well qualified, have high paying stable jobs and they HAVE to move. So all the ingredients are there in a neatly wrapped package. Now the wide majority of these clients have agents who represent them that were assigned to them by the relocation company. Their agents aren’t going to drive by neighborhoods at random and see your red “For Rent” sign you bought at Lowe’s. If your property isn’t on the MLS, you essentially don’t exist for a large section of the very tenants you are hoping to attract.
2. Every Real Estate Portal – Your listing needs to be on every real estate portal that accepts lease listings: Zillow, Trulia, Hotpads etc. Do all these work all the time? Not really. But you are trying to cast a wide net and see what brings in the haul. The good news is that most MLS these days automatically syndicate to these portals. Or in the event the one in your city doesn’t, there are websites you can use to upload the property once and propagate it to all portals (i.e Postlets)
3. Craigslist – Finally, the godsend for landlords everywhere. After the MLS, Craigslist is the second largest source of tenants we have found. Your listing must be on Craigslist and it must be there as often as they will allow you to be there.
But the fact that your property is listed in these places, is as important as how it’s listed. In order for your property to stand out, you must have well lit, high quality pictures taken. If you don’t have a high quality camera and flash, hire a professional photographer. It will be the best Benjamin you ever spent. Pictures are crucial.

Last but not least, the ad for your rental property needs to resemble the ad for a job. Just like the employer paints a picture of the ideal candidate they would like to hire, so should you describe the exact tenant you are looking for in specific detail. Don’t be afraid to alienate the candidates that don’t meet your criteria (provided your criteria are reasonable and most importantly, legal). You’re not trying to generate interest for interest’s sake. You’re trying to generate targeted prospects that have a high probability of getting approved.

That brings us to the second part of the discussion: The screening process. Suppose that your marketing efforts have paid off and now you have lease applications from prospective tenants. What are the factors that will determine the eligibility of the tenant or lack thereof? In order of importance:
1. Rental History
2. Sufficiency of Income
3. Employment History
4. Background check
5. Credit Check
6. Pets
7. References
The prior rental history of the applicant is a great indicator of how they are likely to perform during your lease term. So in most cases, serious problems in the applicant’s rental history lead to the rejection of the application. What you are looking for here is at least a two year history of leasing properties with no issues. Any prior evictions, collections from previous landlords, lease breaches etc tend to indicate problems that are likely to repeat themselves so we avoid them every time. Other aspects of the applicants’ rental history that matter are the typical length of their prior leases and the rent amount they’re “used to paying”. If the history reveals a tenant that moves every 3-6 months, that might not be the best fit if you’re looking for a long term tenant. And finally, you want to avoid the effects of rent increase shock. A tenant that has been paying about the same amount of rent over a period of time is less likely to be shocked than a tenant that’s used to paying half the rent you’re asking.

Sufficiency of income is paramount to avoid future defaults, evictions and vacancies. In fact, one of the principal reasons that lead to evictions is the investors’ own carelessness in placing a tenant in a property they can’t afford. This may sound like overkill but what you need to do to determine sufficiency of income is to run a down and dirty budget for your tenant. How much of their gross pay do they take home? How much “disposable income” is left over after they pay your rent, utilities, food, gas, and monthly payments? If the answer is “not much” you’re one car problem away from not getting your rent paid. Why would you do that to yourself on purpose? So, to insure there’s enough income there to support the lease, we require tenants to make 3.5 times the monthly rent in gross income. Essentially, we want the lease payment to be no more than 28.5% of their gross pay. Last but not least, their income has to be reliable (salaried or base, not variable commissions) and documentable through pay stubs or tax documents.

Employment history addresses the probability that the income we’re relying on is likely to continue during the lease term. Typically, we look for at least 2 years in the same line of work (they can be at different companies as long as its the same job and level of income). Of course there are exceptions – for instance a recently graduated college student with a solid job offer letter for a reputable company.

The background check is another go/no go criterion. It must be clean of any issues that show character flaws (theft, violence, fraud, drug related issues and other serious criminal offenses). We look at small misdemeanors on a case by case basis. If its an issue that happened 20 years ago and the tenant has no issues since, that’s looked at differently than something that happened last week.

The credit check is a tricky one because investors tend to simplify the matter down to a credit score. I don’t agree with that approach. More important than the score is the story. Some credit reports tell the story of an applicant that’s always late on all payments. Others, tell you about a rough patch the tenant may have been through a while back due to a job loss or medical issues but also speak of solid payment history since then. The funny thing is, both candidates may have the same exact credit score. And I’d lease to the second (provided all the aforementioned criteria is in order) but not the first.

Pets are another issue that requires a lot of care. If you just purchased a quality property in a great location you might be tempted to categorically disallow pets to prevent damage to your property. The problem is, a large percentage of the “great tenant” pool have pets so by excluding them you’d be missing out on some great candidates. Besides, pets require a lot of care and dedication so in a way, the fact that your tenant may have a pet is a sign of maturity and stability. But on the other hand, some pets can cause a lot of damage to properties. So, it’s important to get this right. Usually, we go with a case by case approach on this. We place weight limits (40lbs) and total number of pets limits (2) as well as exclude breeds considered dangerous to eliminate liability. We also charge non refundable pet deposits for each pet to mitigate the risk.

Finally, you want to make sure that the information on the lease application is true and correct and has not been “enhanced” by the tenant to fit what you’re looking for. You do this by checking references. Check county records to make sure the listed landlord truly owns the property they leased and isn’t a friendly uncle. Then, call all previous landlords listed and ask open questions (not yes/no questions). After you’ve verified the information as correct ask them if they’d lease to the tenant again if given the chance. Repeat the process with their managers at work.

There’s no possible way to avoid all defaults and problems as they’re part of life (even qualified tenants can be laid off) but if you follow the advice I’ve just given you to find and screen great tenants for your investment property, you’ll reduce their occurrence to a minimum.

Juhan Sonin via Compfight
May 31, 2013
In the path of growth: Exxon’s mammoth campus under construction in North Houston

During the acquisition phase of your Blueprint real estate investing strategy, the temptation is to focus exclusively on well established neighborhoods. But as a neighborhood becomes more and more established, home prices rise and returns drop. So how can you get better returns without sacrificing quality?

You buy properties in the path of growth.

That well established neighborhood of today was at one point not so well established. Needless to say, investors that purchased properties in the neighborhood during that period paid considerably less money for them that you’d have to pay today. It makes perfect sense: At that time, the investment was riskier since no one could know for sure how the neighborhood would turn out. Therefore it was only right that the return should be higher as well.

So, how can we determine which locations and neighborhoods are going to be the popular neighborhoods of 10-15 years from now? More importantly, how can we avoid the misstep that the location we thought had promise doesn’t turn into a dog instead? To get the answers to those questions, let’s take a look a current case study.

Exxon Mobil’s mammoth campus

. There are over 20 structures being constructed on a 386 acre site west of I-45 just south of the Woodlands in what the Houston Chronicle is calling a “mini downtown”. The completion of the project is expected in the middle of 2015. When completed, the complex will house 10,000 employees, 2000 of which will be transferred from Fairfax, VA and the rest will be repurposed Houston employees. The company has already sold its Downtown tower and has put their Energy corridor facility on the market.

That’s great, but what’s that have to do with residential real estate? How does a commercial project of this magnitude impact future growth?

It’s Economics 101. Employment drives demand which in turn drives growth. At the moment, there are about 3000 construction workers dedicated to the project. When the project is complete, 2000 Exxon employees will be transferred from out of state and 8000 Houston employees will probably need to move closer to the area. But that’s not all. Because there are two kinds of employment: Basic and supplemental employment. Two thousand new Exxon jobs are basic jobs which in turn create a multiple of supplemental employment. Here’s how it works: When new jobs are created those families add to the local demand for housing and services. The need homes to live in, grocery stores to shop in, restaurants to frequent etc etc. So, builders will build more (and hire more construction workers), additional commercial shopping centers will be developed and businesses will lease more space. So, the added employment will create added demand which leads to local growth and higher home prices and rents over time.

I’d say the area around this massive project will look very different 10 years from now, wouldn’t you? We can’t know for sure as no one can tell what the future holds but we can be assured that big changes are coming. And we can get on the “train” before it leaves the station and prices get out of reach. We can do that a couple of different ways. We can purchase recently built resale and bank owned homes within a few miles of the project. Or we can build new and take advantage of the warranties and low hassle of a new home. The opportunities are still there even though they’re thinning out as builders and sellers alike try to take advantage of the very thing we’re talking about.

If you’d like to discuss how you can take advantage of buying investment properties in the path of growth as described above, you can call my cell at 713-922-2702 or contact me.

Steve Snodgrass via Compfight

April 25, 2013
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

March 29, 2013