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

Continued from Part 24:  Another way to deal with rising rates. The only value of income properties is their (net) income. Although this was not her motivation at the time, Emily offset part of an adverse change in interest rates by increasing the density of her properties. Typically, higher density means greater revenue. There may be a number of ways to increase density. Emily chose the following three:

The Day Care SFR: No change in living area. An old, vacant single-family residence on a busy street was repurposed into a commercial children’s day care center. Leasing the property to the day care operator brought Emily a much greater cash flow than renting to one family. When she sold the property to the operator Emily monetized the higher stream of income and came out of it very well, thank you very much. 

One Bedroom Units into Three’s: Still no change in living area, but greater utility.  Emily’s second purchase was an older fourplex, each unit having one large bedroom. She moved the partition walls, reduced the size of each room a bit, and turned the four 1’s into four 3’s. People pay a lot more for three bedroom units than for one bedroom’s. Once again, increasing density significantly enhanced the gross income.

The House in Back: Added living area, added utility. After refinancing her fourplex and pulling some money out to fund her next purchase, she found a deep lot in a good school district with one old house in front. Emily worked with her loan broker (for the funding) and a contractor (for the physical changes) to renovate the front house and build a second house in back. Both houses now had two bathrooms with 3 bedrooms (front house) and 4 bedrooms (rear). The increased density meant the property gave Emily another splendid cash flow.

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Discussion.  The long term (secular) interest rate cycle drives value. When rates go up, values go down. In the last cycle, the rising-rate portion was only three years. It might be possible to just wait that period out. Alternatively, an investor might wish to add density to an existing site with the intent of increasing the property’s net income. In this case he would begin the back half of the cycle (when rates go down and values go up) with a higher net income from his portfolio, and the potential for greater capital gains as rates enter their lengthy down-trend.

Emily had reached the point where she wanted to own larger apartment buildings. Like most things, this decision happened slowly at first and then suddenly. She went to sleep on Friday perfectly satisfied with the units she had. On Saturday morning she woke up, reached for her glasses, and was no longer satisfied with her portfolio. She had a sudden passion for “real” apartment buildings, those with five units or more. The more units the building had the happier she now thought she would be.

Emily was, however, a reasonably cautious person. She usually researched things before making major changes in her life. Sometimes she researched them again and again. For example, she’d had a weight problem since middle school and had tried numerous diets, but always regained the lost weight. Atkins worked the best for her, but after a while she stopped losing and her weight plateaued. Recently, one of Emily’s friends recommended The Complete Guide to Fasting by Jason Fung, MD and Jimmy Moore. She was taken with Dr. Fung’s explanation of why even Atkins eventually always stops working. After reading the book she decided Dr. Fung’s was going to be her next diet. She hoped it would be her last.

Emily’s problem-solving approach was taught to her as a young girl by her father. He always said, “Do all your hunting before you shoot”. So that was the approach – do all your research before you make the decision – Emily brought to the issue before her. Would she be better off with a portfolio of small (1-4s) units or fewer (but larger) buildings? It was time to write down some of the things she thought she’d learned thus far. She found her yellow legal pad and began her notes under the heading “Benefits of Small Properties”.

Financing: Low Down Payment – While down payments change depending on market circumstances, owner occupied one-to-four unit properties can usually be had for much lower down payments than larger buildings. Sometimes years go by when the acceptable down payment for owner-occupied small units is 10%. Occasionally, less.

Financing: Fixed Interest Rate – One-to-four unit properties have a few virtues not found in five units and up. An important difference is the availability of (a) fully amortized financing (b) at a fixed rate (c) for the entire 30 year life of the loan. Emily thought this was particularly important because fixed rate financing means the lender (and not the borrower) bears the burden of future inflation.

Flexibility: A respectable position might be that even if the total number of units was the same, a single 12 unit building does not provide the same financial flexibility as three fourplexes, or that a 36 unit project does not provide the same options as 12 triplexes. The reason is that the buildings in a small-unit portfolio could be sold individually, with the remaining buildings financially unaffected.

A portfolio containing a single apartment building, even a large one, lacks that option.  Regardless of how desperately your grand-daughter wants you to pay for her expensively memorable first wedding, an owner can’t just carve out four units from a 12 unit apartment building and sell them individually. The only option in the case of the larger project is to sell or refinance the entire building.

Example 1: Phred worked hard all his life, lived beneath his means, and over time began to accumulate fourplexes. One here, another over there, and a third on the other side of town. He never had a plan, he just kept his ears open and sometimes an opportunity presented itself. By the time he died he had a small portfolio of five 4-unit buildings, all well maintained and in better than average school districts.

His sister, Hortencia, walked out of a divorce with a large settlement. She later remarried but was widowed within the year, again receiving a large sum of cash. Realizing she had to invest wisely, because the money she had must last the rest of her life, Hortencia bought a recently built twenty unit building and prepared to live off the net cash flow.

Two weekends later both Phred and Hortencia died in bungee cord accidents. The last thing Hortencia was heard to say was, “Race you to the bottom!”

In their respective wills Phred and Hortencia independently left their estates to their five nieces and nephews. Hortencia’s 20 unit building had to be sold (one of the nephews called it “monetizing”, as in “turning into money”) before the heirs could receive their shares. That meant, among other things, that all five heirs had to agree on every action taken: whether or not to sell (some wanted to sell immediately, some wished to wait until next year for tax reasons, and some didn’t want to sell at all); who to list the property with and for how much; how to respond to the offers received, etc. It was very difficult to achieve universal agreement on these (and other) items. By the time the matter was settled and they finally received their portions none of them were on speaking terms.

Phred’s fourplexes? His will instructed that their respective addresses be individually written on tags of paper and the tags put into a paper sack. The heirs, by turn, were to choose the property they’d get by picking one tag from the sack. Whatever address they got was the property they’d receive. Not everyone was entirely satisfied with the property drawn, so there was some horse-trading right there in the attorney’s office. When that was done the five heirs and their spouses adjourned to the Guido’s New York Pizzeria where they celebrated their new wealth with many glasses raised to the memory of Uncle Phred.

Example 2: The spinster Mitochondria would sit in her rocking chair in the darkening twilight and stroke her cats, wondering why her sister’s daughter never visited, never even called. She did everything she could for the girl. Mitochondria even paid her niece’s entire college tuition bill although she majored in “Communication”. Mitochondria had known her niece for almost two decades, and she never knew her to lack “Communication” skills. In Mitochondria’s day, young women studied to be nurses or teachers, depending on whether they hoped to marry a doctor or a divorced policeman.

Mitochondria funded the girl’s tuition by selling a triplex she’d bought not long after the girl was born. The purchase was specifically to pay for her university tuition. Mitochondria closed escrow on the little building just prior to the infant’s first birthday. With a fifteen year note, her idea was that by the time the girl was ready to go to college the triplex would be paid off and thus could be sold to fund the educational expenses. It turned out even better than that. Mitochondria bought the property for $50,000 and now, twenty years later (the girl repeated fourth grade twice) the property was mortgage free and the income alone was enough to pay for four years at a State university, with some money left over.

But that wonderful gesture was not enough to move the girl to visit Mitochondria in her lonely years. Mitochondria now wished she’d given the money to one of those places that take care of unwanted cats.

Tentative Conclusion: Emily hadn’t yet deeply considered larger units so it was still pretty early to make definitive conclusions, but from her notes she thought it might be reasonable that small (1-4 unit) properties could be superior to larger properties from two perspectives: financing and flexibility. Small properties with fixed rate loans and low down payments were most useful at the beginning of an investor’s career, when larger properties were out of reach. They are useful in the middle, when one fourplex could be sold (or refinanced) without disturbing the others. And they might also be useful at the end, when specific properties could be given to each heir.

It was nearing lunch time on Saturday. Emily put her legal pad down and stood to make lunch. After lunch she planned to read more of Dr. Fung’s book. She would devote some time to the larger units tomorrow.

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 real estate, Klarise Yahya can probably help. Find out how much loan the building will support. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]. This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.