This article was posted on Tuesday, Jul 01, 2014

Some owners are passive. They inherited those 8 mortgage-free units over ten years ago, when Aunt Mitochondria passed on. The buildings are located in an established area but hadn’t been properly looked after during her long illness, and in the decade since her death they have been positively neglected. Landscaping is overgrown. The asphalt driveway and rear parking areas are sun-broken; the flat tar roofs are showing bubbles if you know where to look. On the inside, kitchens and baths are dated, carpets need replacing and everything that doesn’t move requires painting inside and out. Tenants don’t complain because the rent hasn’t been raised since Mitochondria got the sickness, and low rent is more important than painted walls.

Since the heirs got the buildings (two adjoining fourplexes) they haven’t done much. Back when Mitochondria was declining one of the tenants assumed quasi-manager status and collected the rents, mailed them in when due and performed any casual maintenance that was absolutely necessary. That role continued even after the estate was settled. Actually, the heirs really didn’t need to visit their property at all and that suited them quite well, thank you very much.

When the heirs got the property the area capitalization rates were about 8% and the fourplexes were worth, back then, about $600,000. Subsequently, area cap rates declined to about 5% and the units – with no rent increases in the interim – have appreciated to $950,000 due solely to the decline in capitalization rates. Of course, should cap rates again rise to 8% the building’s value will return to $600,000 unless the owners can somehow bring the net rental income up. But who really cares? The heirs are still getting their rents regardless of changes in cap rates. They may never know – or care – that their building’s value fluctuates and opportunities are going missing. The heirs are in their happy place. They have no interest in being more involved with the property. Being a passive owner is kind of neat, huh?

But other investors are a little more aggressive. Hypothetically, let’s say George, the neighborhood (seasonal) tax preparer, has lived beneath his means, bought wisely and with maximum leverage, and accumulated three small buildings in upscale areas over the past ten or 12 years. Understanding that the biggest cost of property ownership is the interest expense on the mortgage(s), and being a careful businessman, George refinanced as interest rates declined simply to minimize his long term interest expenses. One of the properties is heavily mortgaged because he refinanced it last month to generate the down payment to buy another property.


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Property A – Triplex

1: Present value           $900,000

Est. net after sale    $828,000

Current loans           $703,500

Equity                     $124,500

2:  $403,500 balance on 1st TD

  • Fixed – Interest fixed for 30 years
  • Prepay: None
  • Index:   N/A
  • Margin: N/A
  • Interest rate: 4.35%
  • Terms: Amortized over 30 years
  • Current NOI: $3,375 (monthly)
  • Payment:  $2,009 PI
  • Cash Flow Before HELOC:  $1,366 /mo
    $16,392 (annually)

3:  $300,000 balance on HELOC
(Used for down payment on Property B)

  • Variable: Interest resets every 6 months
    No ceiling rate.
  • Prepay: None
  • Index:  Prime
  • Margin: None
  • Current rate: 3.25%
  • Terms: Interest only
  • Payment: $813 monthly
  • Spendable: After HELOC –  $553 /mo – $6,636 / yr

Property B – Duplex

1. Present value           $690,000
Est. Net after sale   $634,800
Current loans          $390,000
Equity                       $244,800

2:  $390,000 balance on 1st TD

  • Fixed rate: Interest fixed for 30 years
  • Prepay: None
  • Index: N/A
  • Margin: N/A
  • Interest rate: 3.50%
  • Terms: Amortized over 30 years
  • Current NOI: $2,000 (monthly)
  • Payment: $1,751 PI
  • Cash flow: $250/mo – $3,000 / yr


Property C –  6 units

1:  Present value          $1,600,000
Est. net after sale   $1,472,000
Current loans          $900,000
Equity                    $572,000

2:  $900,000 balance on 1st TD

  • Variable rate: Interest fixed for years 1-5,
    varies thereafter
  • Prepay: During fixed rate period only
  • Index: N/A
  • Margin: N/A
  • Interest rate: 4.25%
  • Terms: Amortized over 30 years,
    first 7 yrs fixed.
  • Current NOI: $6,500
  • Payment: $4,427 PI
  • Cash flow: $2,073 / mo – $24,876 / yr


Why 1-4’s? The Federal Reserve has maintained interest rates at generational lows for an extended period, but it cannot last forever. Financial news reports even now have the occasional article on higher rates, and it seems to have already started. In January, 2013, the ten year T-note was 1.91%. At the time of this writing it has gone up to 2.47%. That’s a 29% increase, or a touch over 18% per year.

As an asset management tool, loans on small units (SFR’s, condos, duplexes, triplexes, and fourplexes) are available at a rate fixed for the entire 30 year term. In a period of rising interest rates, that is an important consideration.

We encourage the purchase of the largest projects one can afford. We’re fans of large projects for their economies of scale if for no other reason. But when one considers the possible effects of interest rates returning to normal levels, it seems only reasonable that (a) large projects should be refinanced, if possible, with the longest fixed rate period available and (b) small units with fully amortized fixed rate financing should be considered as part of any residential portfolio. 

CPU:  The average cost per unit (CPU) of the buildings small unit buildings is $318,000. The CPU of the 6-unit building is $267,000. It’s not always the case, but it seems to be pretty common to find 1-4 unit properties selling for more than 5+ units on a CPU basis.

Inflation: The rate of inflation is incorporated into interest rates. As inflation goes up, so do rates. A fully amortized, fixed rate loan means the risk of rate increases remains with the lender during the entire life of the loan. In most cases this will be 30 years, and during that time the lender absorbs the risk of increasing rates. A variable rate loan (or a commercial loan in its variable rate period) is subject to its rate going up with inflation. A variable rate loan transfers the risk of increasing rates (i.e., increasing inflation) to the borrower.

HELOC: Residential properties up to four units can get secondary financing, while five units or more cannot.  But HELOCs should be used only as a bridge loan. Because most of them are variable and based on the Prime rate (often, but not always, with an additional margin), HELOCs are not a substitute for long term permanent financing: there’s just too much interest rate risk.

Portfolios: There is nothing wrong with having one portfolio containing one to four unit properties and another with five units and up. For example, the bigger projects could be considered a retirement account (with the understanding that retirement is income dependent, not age dependent). The smaller units could be dedicated for certain foreseeable obligations.

The retirement portion of the portfolio should be actively managed. This might involve mortgages that minimize life time (the mortgage’s life, not yours) interest expense. To some people it seems counter-intuitive to close out a variable rate mortgage now at 3% and replace it with a 4.5% loan, but that’s because the landlord is looking only at today’s interest rate expense. He should be looking at expected future rates. If that new loan protects you from rate increases over the next seven years, will that be helpful? Well, what do you think rates might get to three or four years down the road? It’s possible the current loan, now at 3%, will adjust to 7% or more while the new refinance at 4.5% will still be at  . . . 4.5%.

In addition to minimizing lifetime interest expenses, the retirement portfolio could be used for the occasional cash-out refinancing that provides the down payment for yet another building. The new building might be large enough to contribute to the retirement portfolio, or it might be a well-located triplex. As always, the equity in existing properties is harvested to buy the next generation of projects.

Small buildings (1-4 unit projects) have their own set of benefits. HELOCs can be established and held in reserve against times of need.  If more money is needed, a single triplex could be sold without disturbing the larger “retirement” portfolio. But an underappreciated benefit to small buildings (1-4 units) is the potential for dedicated purchases. Your daughter just had a baby boy and in an unusual moment of extravagance you announced in front of everybody you’d pay for his first four years of college. Buy a fourplex, apply all the net cash flows to the remaining principal and pay it off in 15 years: his college is pre-funded with minimal initial cost to you. She names him after you? Buy two fourplexes and he’s set through law school.

It’s even possible that, being paid off, just the net income from the one or two fourplexes might be sufficient to get your grandson through school. When he graduates, these eight units and their income revert to you. You honored your obligation using only the cash flows from a dedicated purchase. It doesn’t get any better than that.  Continued next month . . . 

Disclaimer:  This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.

Klarise Yahya is a Commercial Mortgage Broker, BRE: 00957107  MLO: 249261.

If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]. 

If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book “Stairway to Wealth” available at 

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