How to Choose a Multifamily Building by Kyle Malnati – Madison & Company Properties, Denver
Show Notes (below)…
Q: Why would someone pick a multifamily building and why would it be more attractive?
– Multifamily properties allow investors economy of scale and efficiencies by having multiple rentals “under one roof!” The natural progression is to buy a single family property as a rental on first rental purchase. This presents a potential problem… demands on time when owning several rentals across a given metro-area.
Q: How does an investor get started when they want to find a multifamily property in 2014?
1. look on the MLS (just like residential)
2. look at LoopNet which is a “commercial information exchange” (not MLS)
3. hire a REALTOR that specializes in multifamily investments as many transactions occur “off-market”
Q: How is financing different? – MAJOR differences are:
1. amount of down payment required (typically 25%-40% but can be higher)
2. fixed period of the loan’s interest rate (usually max is 10-years) where as residential loans are fixed for 30-years. Most multifamily purchases are financed with ARMs
3. investors that own 1-4 unit properties are now limited on how many rentals they can get loans on
4. 5+ unit buildings are considered “commercial loans”
5. Best suggestion would be to start SMALL – buy a 1-4 unit building to get experience – start with a building that you can feel comfortable managing on your own – build upon that experience
Q: Buyer pre-qualification process on multi-family?
1. borrower is still the main qualifier on a commercial “recourse” loan
2. DCR: debt coverage ratio – income needs to be a percentage above the loan payments to satisfy the lender’s requirements
— EXAMPLE: $10,000 annual mortgage payments you would need a $12,500 cash flow to have a 1.25 DCR
Q: Do lenders adjust the vacancy rate during underwriting?
1. market vacancy factor – there are several different sources that are used to generate the market vacancy
2. generally 3%-15% for most purchases that I have seen.
3. vacancy is a way for lenders and investors to “stress test” a property even if it hasn’t experienced any vacancy throughout the last year.
Q: How does Debt-Coverage-Ratio impact down payment?
1. DCR controls the down payment requirement.
2. Lender continues to move the down payment amount higher until they satisfy their debt-coverage ratio
3. EXAMPLE: $10,000 annual mortgage payments you would need a $12,500 cash flow to have a 1.25 DCR
Q: How do expenses differ in apartments vs. single-family rentals:
1. largest difference (management fees). The need for a quality management company becomes prevalent at 8+ units). Many lenders will require you to hire a manager if you do not have existing rental experience. Fees for management companies are negotiable. You get what you pay for when hiring a management company… usually quality management companies charge more.
2. boiler systems: boiler systems are effective in that one single heating unit heats the entire property. Apartment buildings with multiple furnaces can be more expensive to repair in the long term since each apartment has its own heating system. However, gas forced air furnaces have a higher efficiency with heat production so your utility bills will be less expensive in the short term. Some apartment owners bill their tenants back for utility costs as a way of recouping some expenses if there is one central boiler.
Q: How does writing a purchase contract differ? does the multifamily purchase have a standard form? It depends…
1. Some of my clients use an attorney to draft their contract.
2. However, most of the buyers in 5+ apartment building purchases use the standard Real Estate Commission approved form in Colorado. DISCLAIMER: Every state varies, so please check with a licensed real estate professional if you are not located in Colorado.
Q: Showings? Can you see the entire building at your first showing?
1. usually not… I typically offer 1-3 units for a showing.
2. We are trying to give the majority of tenants privacy and “quiet-enjoyment” of their apartment. Most apartment buildings have similar floor plans that are stacked on each floor.
Q: Inspection? Can you see the entire building when you are under contract during your inspection?
1. Yes, you can see all of the units during your property inspection.
2. The inspector will usually look at all of the major systems and a sampling of the units.
3. The Buyer will usually walk all of the property units with the REALTORs and the inspector will thoroughly inspect 20%-40% of the units to save on time and money.
4. Inspection fees are negotiable.
5. Make sure that your inspector has done other inspections of apartment buildings that are similar in the area.
Q: insurance? There are key differences between multi-family and single-family.
1. When you have a fire or flood claim, you need to be covered to include “Loss of Income” and costs of tenants relocation while their apartment is being repaired.
2. My personal opinion is that every property owner should have an “umbrella policy” on yourself personally to cover your liability.
3. In a complete loss… where the property burns to the ground, a good insurance agent will design a policy to account for required building code compliance updates if you are building a new structure after a fire. For instance, your property was built in 1965 and parking requirements were to have a parking space for 50% of the apartment units (e.g. 5 parking spaces for 10 apartments). You will probably have to comply with the current parking requirements in your jurisdiction when rebuilding the property. A good insurance agent will account for these updates when building your policy. Make sure to ask your insurance agent!
Successfully purchasing properties: You make or break your investment when you BUY (not when you sell). Buy a property that is undervalued within the given market. Ways to generate higher income:
1. conduct rent surveys – there are not set standards for rent rates (in Colorado)
2. utility surveys – some of the utility companies will give you an energy audit to determine if you can install low flow shower heads for example
3. Increasing income and decreasing expenses will increase the value of your apartment building
Q: Do investors use LLCs? Limiting your liability. It depends on how you are buying your property a lot of the time. A lot of lenders will not allow you to use a LLC to purchase the property in 1-4 unit purchases. Many Buyers use a LLC when purchasing a 5+ unit building. You can register for a LLC with your Secretary of State, and you can have an attorney draft your Operating Agreement for the LLC. Many investors set up an individual LLC for every individual property that they own. If you own two properties (123 Main and 235 Cedar), you could have a LLC called 123 Main LLC and 235 Cedar LLC as separate entities. This strategy can further limit your liability by isolating the risk to the single entity thart owns the rental where an accident happens. That way if a law-suit occurs at 123 Main… it might not necessarily effect your property at 235 Cedar. However, filing your taxes with many LLCs can be very cumbersome as you add more properties to your portfolio if you use a single LLC for every property.
Q: Have you seen investors purchase apartment buildings with retirement Funds?:
1. Self Directed IRAs – there are IRS rules related to investing with a self-directed IRA. I suggest that you contact an investment advisor that can serve as a compliance officer regarding IRS rules/regulations
2. 401(k) – you can potentially take a loan from your retirement account. DISCLAIMER: you need to check with your plan administrator first. Every 401(k) plan is designed differently.
Q: Last minute thoughts? I am very conservative. I suggest that new investors start small. There is nothing wrong starting your investment career with a single-family rental. Then as you get experience, you can move your way up to multi-unit properties.
Next show in March: 1031 Exchanges!