For many people, the idea of owning rental property is a dream...one they think about for years before finally pulling the trigger.
Then you finally do it. YES!
First rental property in the books!
A nice little single family home that produces a little cash flow.
Then maybe the next year, you get another...then another.
And you start realizing that it’s pretty cool to be able to say you own real estate.
YOU are taking care of your future...not leaving your survival up to the government or an employer’s pension management abilities. It feels good. Empowered!
But...you start realizing that the cash flow is marginal at best.
You start looking around and notice facebook groups that seem to focus on multi-family real estate. Hmm - more doors under one roof. On a per unit basis, they’re actually less expensive.
So you start looking into it and realize that there’s a significantly higher amount of cash flow when you start adding multiple units under one roof.
But...you’re not really sure how to make that transition from single family home investing to multi-family investing.
You seek knowledge and information from various sources - podcasts, youtube videos, articles.
It can feel pretty overwhelming and confusing. Then add the prospect of moving into 5+ units - which is now considered commercial real estate...and you really start worrying about whether you can make the transition. It’s an entirely different game when you move into apartments.
In this article, I will help you evaluate your options for transitioning from single family home investing to multi-family investing, so that you can get into action and truly start scaling your portfolio.
For starters, let’s begin by describing the most common scenarios for single family home investors, some of which may apply to you, some of which will not.
When many people start investing, they buy a house where they live...they advertise it for rent, take all the calls, do all the showings, prepare the lease, collect rent, deal with evictions (when needed), do the unit turnover...I mean, it kind of sounds like you thought you were buying an investment, when really what you did was buy yourself a second job.
It’s still better than what 99% of people do to build wealth...which is nothing. But that kind of investing can exhaust you to death. Then you’re going to buy another one? Oy.
But that’s what is most common.
I was lucky as a new investor - I lived in an area that had really become too expensive to own for cash flow, forcing me to seek other options and I learned about investing remotely.
So, can I do all that management myself?
It required me to develop a new skill of leading a team remotely...and using third party property management.
It’s funny, because I remember being a new investor and being sold on the idea of “passive income”.
Close on the property and just sit on the beach, sipping margaritas, collecting all that “mailbox money”.
Ah-hem. The reality couldn’t be further from that (particularly if you’re doing the business the way I described above). But even with investing remotely, using third party management...you can never just check out.
Nobody will ever care about your assets, your cash flow or your retirement plans more than you do.
What does that mean? It means you need to keep your eye on the prize. Even though you’re not managing your property yourself (thank goodness), you absolutely must pay attention to what is happening with your assets. In a previous AAOA article, I talked about managing your property manager. It’s not like it’s a LOT of work...but it still does require you to stay engaged in knowing what is happening, reviewing monthly reports, asking questions, etc.
The one thing I will tell you is that if you ever want to scale significantly from single family to multi-family, you must make the transition from self management to third party management. Just like you probably leveraged the bank’s money to buy your property, you must start to leverage your time in order to create space to (1) learn and (2) buy more assets.
There is a learning curve in transitioning from single family to multi-family.
How much of a learning curve?
It depends on what type of multi-family real estate you want to transition into. There are two categories of multi-family. One is small multi-family (2-4 units) and the other is apartments (5+ units).
It also depends on where you live and whether it’s a cash flow market. If you’re like many investors, where you live has prices that make it impossible to buy for cash flow...which means your learning curve will include learning how to be a project manager instead of a do-er. You’ll have to learn to invest remotely (which is a lot easier than it sounds, once you wrap your mind around what is involved - the majority of our students have stated that investing remotely was actually easier than investing locally - and we agree).
Okay, putting that one piece aside, let’s begin by discussing the difference between small multi-family and apartments. Both are multi-family…but they are very different.
Small multi-family is going to be very similar to what you already know. Why is that? Properties that are 1-4 units are considered “residential” for the purpose of financing. When lending money, most banks will look first at the borrower and second at the property, which means they want to make sure you make enough money to pay for all of the expenses of the property plus the mortgage payment if all of your rents don’t come in.
Apartment buildings (5+ units) are considered “commercial” for the purpose of financing. When lending money, banks will look first at the property and how it performs. They will want to see that regardless of your existence, the property pays for itself and then some. For example, there is something called Debt Service Coverage Ratio (DSCR). If a bank has a minimum DSCR of 1.25, they’ll want to see that the Net Operating Income (income minus operating expenses) is at least 1.25 times the debt service (principal and interest payment). That is their primary concern. The borrower is secondary – and make no mistake…they’re still looking at you, but they’re not qualifying the property based on how much YOU make. It’s based on how much money the property makes.
Another significant difference between the two types of multi-family properties is in how they are valued. Residential properties (2-4 units) are valued the same way single family homes are – based on comparable sales. Lenders will be looking at the income of the property but that doesn’t impact the value. On the opposite end of the spectrum, with apartments, the value of the property is based on the Net Operating Income of the property divided by the market cap rate. That means that the more net income the property is producing, the more it will be worth to a buyer.
So, what do these differences mean for you?
Well, nothing really.
But it’s important to know the game you’re preparing to play. If your personality is more conservative in nature, I’d venture to say that starting in residential multi-family real estate (2-4 units) will provide a nice stepping stone to allow you to get to know multi-family, using the experience you’ve already gained through your single family home investing…but with the benefit of having more units and more cash flow. Not much else is different.
Sometimes it’s really more of a mental hurdle.
Some investors who are just not wired to be overly analytical or conservative will likely feel more comfortable moving immediately into apartment investing. After all, there’s only a one unit difference between a residential 4-plex and a commercial 5-unit.
However, it’s a completely different game.
One that can reward you greatly when you can successfully identify, analyze and identify opportunities for raising the income. And at the same time, can punish you horrendously when you make a mistake related to the Net Operating Income. Because whether you’re driving the NOI up or down, you’re changing the value.
So you really have to get educated about it before jumping in...whereas stepping into small multi’s, you can pretty much just decide and go. The analysis is the same.
So, the first thing you have to decide is, which direction you’re going to go.
The next thing you have to decide is, which market (or markets) you’re going to invest in.
Next, you start reaching out to realtors and/or brokers to describe what you’re looking for.
The more succinct you can be with this conversation, the more likely you are to receive properties that match your strategy.
For example, do you like the idea of buying something that is already performing and cash flowing? Or do you prefer to increase the value and do a “forced appreciation” play by rehabbing (for 2-4 units) or increasing NOI (for 5+ units)?
For small multi-family, the forced appreciation strategy is the BRRR strategy - you may have heard of it before - Buy, Renovate, Rent, Refinance (and of course, repeat). For apartments, the strategy can involve a lot more pieces - the ultimate thing you’re doing is increasing the Net Operating Income. Sometimes increasing the NOI involves some rehabbing, but not always. Sometimes it just involves recognizing that the previous owner missed all sorts of opportunities to maximize the NOI (such as keeping up with market rents, offering value add services to tenants that bring extra money to the bottom line, or having an effective management team in place that manages the income AND expenses properly).
Be crystal clear in your mind before getting on the phone. Also practice (out loud) explaining what you’re looking for multiple times before getting on the phone. You’ll come across as more confident and seasoned if you’re not stumbling over your words (super common when you’re doing a new thing).
TIP: If you’re really worried about it, pick some random market that you have no intention of investing in and make those calls to get live practice. If you totally screw up and say you’re looking for “tutuflip” properties instead of “two to four unit” properties (you laugh...and you also know it’s possible!! LOL), it doesn’t matter because you never planned to invest there anyway!
Hey...sometimes you have to do your own hacks to get through a difficult part...but with some practice, you’ll sound like a seasoned pro.
Also remember, you are ALREADY investing. So be confident in stating you’re an experienced investor, just looking to expand into a new area. Speak boldly and clearly...and above all, talk like the CEO you’re on the journey of becoming.
Now, get out there and start making stuff happen. YOU are the one that will take care of you and yours, not the government, not your employer...and you can do this! And you are worth it!
- Jen and Stacy