Easier to Obtain Financing

In many areas it is actually easier to purchase a small income property than a SFH. The reason is excessive price appreciation. Rental income has just not kept pace with the increased price of SFH ownership. A $200,000 SFH purchased years ago that now has a market value of $300,000 has experienced a 50% rise in price. I can guarantee you that the possible rental income on that same house has not increased 50% in that same time, not even close. There is a much greater correlation between rental property income and small income property valuations. It may sound counterintuitive to many but it is often easier to get a mortgage on a four-unit property than a SFH since a lender will do rental income calculations on both and conclude that it would be safer to collect the payments on the four-unit than the SFH. An investor that could afford the mortgage payments on a $300,000 SFH might also simultaneously qualify for a $750,000 mortgage on a four-unit since the lender would factor into the equation the rental income received from the non-owner occupied units.

The same is also true of obtaining seller financed purchase money mortgages. Many small income properties are sold by investors wanting to retire or otherwise needing the income stream secured by a note on their property. Seller financing with small income properties is quite common, much more than with SFHs these days, and obviously the terms on these mortgages can be quite generous to obtain and with many fewer bank fees and closing costs to pay and income documentations to provide.

Lower Purchase Cost Per Rental Unit and Higher Cash Flow

This fact is more or less common sense but still very important. When you buy SFHs, each house is a separate rental unit. To buy fifteen rental units of SFH housing would require a major undertaking involving fifteen lots of land, fifteen buildings with fifteen roofs and foundations and more. Buying fifteen rental units in one fifteen-unit apartment building is easier. One land lot, in most cases smaller than fifteen SFH lots, and one building with one roof and one foundation. Buying more than one of anything at one time usually costs less on a per unit basis than buying just one of the same item at one time. This is true of buying rolls of toilet paper in bulk, cans of soda by the case, or rental property units by the building.

Since your per unit rental purchase price is lower, your cash flow on that same unit will be higher than through SFH ownership. If a house and an apartment can both rent for $900 per month, the property that costs less per rental unit to buy will yield the greater cash flow. This is almost always true with multiunit income properties, with the largest properties not only having the highest gross rental income but the highest yield per rental unit based on the economy of scale of simultaneously buying many such units.

Easier to Make Improvements That Boost Cash Flow and Valuations

With SFH ownership, improvements are certainly possible but small income properties offer a host of possibilities. Apartments units can be reconfigured with just the addition or subtractions of walls. Tenants can be charged for all sorts of additional service items in income properties, ranging from parking fees to laundry services to storage costs, while none of this is possible in SFH rentals. Converting a basement into an additional rental unit is virtually impossible in many areas (most do not allow separate "mother-in-law" suites) while it is quite easy to convert a six-unit building into a seven-unit with just minor floor plan modifications. Most SFH improvements are great when you go to sell your asset but small income property improvements boost monthly cash flow and future sale valuations at the same time. Using a cap rate of ten means that every additional dollar you can squeeze out of your small income property each month raises the value of your building by $12, a huge windfall.

Improvements also include managing income properties with greater efficiency and not just making physical modifications or renovations. With SFH leasing there really isn't much that can be done to improve leasing efficiencies other than get paid on time and not tolerate prolonged vacancies. But with small income properties good management skills can lead to major financial gains by cutting property expenses, maximizing rental and other property incomes, and decreasing tenant turnover. Going from a 12% vacancy rate to a 6% rate can sometimes mean tens of thousands of dollars in instant equity gains when in reality such an improvement may cost nothing in cash to create.

Tax Deferred Exchange Possibilities and More

Exchanges are a super way to pyramid real estate equity. By not paying the tax man each time you buy and sell, you preserve your equity and let it continue earning money for you. It is just plain simpler to exchange income properties than SFHs. Multiunit property owners tend to be professional investors who are much more familiar and open to the idea of exchanges than the average SFH owner selling their family residence. While exchanges can be done for both types of properties, it is easier for income properties. Any qualified exchanger will tell you this.

The Greatest Advantage of Them All

What sets the income property market apart from SFH sales is one thing. Excessive competition. Pretty much everyone wants to buy SFHs either as investments or as places to live and that competition drives up prices. So you have investors competing against newlyweds, families, transferred executives, first-time homebuyers, empty nesters, and all the rest for the same very limited and finite number of SFHs for sale in any given area at any one time. (Realize that while there may be thousands of SFHs in a city or county, only a tiny fraction are for sale on any given day.)

Income property investors compete against a much smaller class, other income property investors only. And even this class can be fragmented quite easily. Smaller properties like duplexes, triplexes, and quads are usually an alternative to SFH ownership for newly married couples or young professionals starting out. So by targeting properties of six-units or higher you generally weed out most of the "non-professional" buyers. By the time you hit ten or fifteen units, most individual buyers are gone, replaced by partnerships or other institutional investors. Beyond fifty units is the realm of large regional or national buyers like REITs, insurance companies, and other securitized purchasers.

The bottom line here is that lower competition means lower prices, something quite nice when you are in the market as a buyer of properties.

Some Advice for Buying Income Properties

The best way to get a fair price when buying small income properties (or large ones for that matter) is to treat each rental unit as a separate investment and compare it against other investments you could make. People tend to get caught up in the gross numbers of a very large purchase instead of focusing on what a multiunit building really is, just a collection of single rental units. Since rental units are purchased to provide income and cash flow, I treat each unit as if it were a bond paying interest or a stock paying dividends and scrutinize it against what the bond or stock market offers me in a general way.

Here's a very simplified example of what I mean.

Say I can buy a twelve-unit building for $1 million. Each unit is identical and can be rented for $900 per month. I'll take a 10% vacancy rate to be safe.

This means that each unit costs $83,333 to buy and provides $9,720 per year in rental income. ($900 per month x 12 months x 90% or .90)

So the yield here on a cash-on-cash basis (no mortgage interest or other expenses figured into the equation) is 11.66%. (That's excellent, by the way. In the real world the amount would be closer to 6% these days.) Since I'm investing in real estate as opposed to something safe like U.S. Treasury Bonds, I want a 400% risk premium over the safe rate. This is an individual decision I make to be compensated for putting my money in something that is not a sure thing like a U.S. government bond interest payment. If we assume the risk-free rate is 2%, I want at least 8% to feel compensated. So this investment at 11.6% would suit me very nicely.

This is my first threshold test and the most important for me. I obviously want to know what rental units are selling for in the area I'm considering, what the replacement and construction costs of these units would be, and much more but always focusing on the per unit costs of owning this building. You always want to break down production or managing costs on any project, product, or service to the lowest measurable unit possible and in the case of rental properties it is generally the single rental unit. (If you were leasing out bedrooms in a boarding or rooming house, it obviously would be bedrooms or even beds.)

When buildings have units of unequal size or dimensions (say five two-bedrooms and seven three-bedrooms), you apply the same analysis for each type of unit. What is my yield on owning a two-bedroom unit in this building? A three-bedroom unit? Then do the math and come up with a blended yield, in this case 5X + 7Y divided by 12 x 100 (for the percent calculation) with X and Y representing the individual yield of each type of unit. (Say X is 6% and Y is 8%. Then the blended rate would be (5(.06) + 7(.08) divided 12) x 100 or (.3 + .56/12) x 100 or .0716 x 100 or 7.166%. You should even break all this down even further for vacancy rate and rental income purposes, for example, two-bedroom apartments in the front of the building with a view versus two-bedroom units in the rear without one.

Some Basic Advice on Buying Small Income Properties

There are many excellent books on the subject of buying and managing small income properties and this article is really only designed to get you to think about owning this type of rental real estate as an alternative to SFHs or condominiums. Many investors feel multiunit properties are "beyond them" or "too expensive" and that really is not the case. So here is some basic advice on looking for, evaluating and buying these properties.

Avoid older properties in declining neighborhoods. The per unit rental costs are great on properties in bad parts of town since few people want to own these buildings. On paper the best per unit costs can be found in "War Zone" neighborhoods where you need a gun and a battalion of heavily armed Marines to collect your rents. These properties are not worth the trouble unless you suspect a neighborhood is going to gentrify within the next few years. Stick to solid neighborhoods where college students, young professionals, or working people live. Remember you might not want to live there but many honest and hard working people do.

Verify not just current expenses but future ones too. A classic investor mistake is to verify all the current property expenses like taxes, utilities, water and sewer, and the like but fail to anticipate future ones just on the horizon. Many owners of income properties dump them onto the market when they learn of special assessments, major property tax increases, or other events which dramatically can affect cash flow. Frequent trips to City Hall and knowing your local investing area like the back of your hand (just basic advice from my Investing in Land Home Study Course) will minimize any chances of ambush. Remember that the windfall possible with rental properties works both ways. Every dollar per month that you boost net income makes your property worth $12 more (using a cap rate of ten), but every dollar you lose of net income costs your property $12 in value.

Try to buy low maintenance properties tenants like. The best income properties to buy are those with brick fronts or brick facades that never need painting. If you are buying a duplex, try to buy side-by-side units rather than over-under. Many tenants do not enjoy living under another person due to noise (Ladies in high heels or wooden clogs walking at night on hardwood floors, YIKES!) and that long staircase to the second floor is an inconvenience for many tenants like the elderly or the lazy. Buy units that have high quality materials no matter what their condition. I'd rather have high quality kitchen cabinets in bad shape than brand new cheap ones that will be broken in a year or two. Tenants like views out their windows even if they look upon ugly things like back alleys or industrial sites. It has more to do with sunlight and the fear of claustrophobia than anything else. Windows with brick walls for views or neighboring buildings just a few feet away should be avoided if possible. Always try to think about your buildings as what they truly are, depreciating assets that need constant maintenance and repair just to stay in the same condition they are right now. So minimize your repair costs by selecting building types and materials that last longer and are more durable. Why buy a building with a flat roof in a snowy climate like Vermont? Or a building with a basement in an area prone to flooding? Half the way of avoiding trouble is not seeking it out in the first place.

Only buy properties where you can quickly improve their value. Regular readers of my articles know I enjoying selling brand new turnkey apartment buildings but I'd never buy one myself unless it was a foreclosure or a forced sale. There are three profit centers from owning income properties:

Leasing them for maximum cash flow
Physically improving them for additional income and cash flow
Holding them for future appreciation

#1 involves raising rents and cutting monthly expenses and reducing tenant turnover, all things you should plan on doing when evaluating any prospective property.

#2 involves creating additional cash flow at a property by adding new units, new amenities, or new income sources (like building garage spaces or storage lockers for tenants to rent), again all potential instant money makers you should plan for any property you decide to buy.

#3 is what you hope will happen, you have no control over it other than pick a good neighborhood after a detailed review of demographics. So therefore when examining any potential property purchase, focus on #1 and #2. How can you INSTANTLY increase the cash flow and value of what you buy?

There is an old expression that says there are just two ways to get rich:

"Either find hidden values for sale that others miss or create value yourself."

Buying small income properties in need of improvement allow you to do both simultaneously, making them very powerful investment vehicles for the average real estate investor.