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 25: 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.
Late the following afternoon, Emily fastened her yellow legal pad to an old clipboard, snuggled to the end of the sofa, and curled her feet beneath her. After thinking for a moment or two she started to list the advantages of larger (5 or more) units. There were only a couple, but they were important. The first thing she noted was that larger (5 or more) units were usually less expensive on a Cost per Unit (CPU) basis. For example, in a market where two bedroom units in a 12 unit apartment building might go for $300,000 each, comparable units in a duplex may be highly marketable at $400,000 per unit. She’d been aware of the pricing discrepancy almost since she began buying rental properties, but never gave it much thought. It would not have made a difference because in those days she couldn’t have afforded a larger property, anyway.
Now that she was considering buying six or seven units, the businesswoman in her understood what her Uncle Mathew, who raised corn and soybeans on a half-section of Iowa farmland, used to say: “There ain’t no such thing as a free lunch”.
Those financing and flexibility advantages increase the value of small units. You know those low down payments (for owner-occupied only)? Fixed rate 30 year loans? No prepay penalty? These are desirable features in a long term investment. Just getting a 30 year fixed rate mortgage means the buyer is shifting the risk of inflation over the next three decades back to the lender. It seems like that would be worth a lot of money by itself.
The reason small unit buildings cost more on a CPU basis than their larger cousins is that the market recognizes the benefits of the unique loan terms that accrue to small unit buildings. Their prices go up.
It isn’t that the seller is taking some sort of unconscionable advantage. The seller is just trying to recoup the premium he paid when he bought the property all those years ago. After all, the financing advantages in favor of small units have been going on a long time, probably since the FHA first started lending on them at such favorable terms.
On the other hand, larger projects mean greater management convenience and generally lower maintenance costs. Ten triplexes scattered around town can be expected to consume more management time than one simple 30 unit building. Consider the time spent driving between sites, if nothing else.
Or, if we were going to hypothetically consider maintenance costs, think about the time and money cost in the following example. Your 30 unit building must have its main water pipe (the one that runs from the big pipe in the middle of the street to the building itself) replaced. Put the cost and time estimates on your scratch pad.
Now – we’re still making this up – reflect on the cost and time estimates if each of your ten triplexes had the same issue. Wouldn’t that be ten times the cost? Doesn’t that show that there would be a big savings in having only the one building? That’s true even if the triplex’s water pipe failures are spread over a decade: ten water pipes cost more than one.
Same with roofs. Replacing the roof of a 30 unit building almost always costs less than replacing the roofs of ten triplexes.
Emily was basically a simple person. She preferred that complicated questions had answers that could be written on the back of a business card. At this point, she associated small units with two beneficial characteristics. There was the more favorable financing already discussed. Then there was the inherently greater flexibility if she had to sell part of her portfolio to raise money for some reason. Maybe it would be to pay for some family member’s child’s education or perhaps her wedding.
Some thoughtful investors might respond, “Well, can’t you just refinance the larger units?” But what if the interest on your present mortgage is less than 5%, and the rate on the new loan runs 7 or 8%? A portfolio of small units avoids some of those issues.
Emily associated traditionally sized apartment buildings (5 units and up) with an entirely different two item benefit package: cheaper Cost per Unit and less management / maintenance costs.
It may appear that Emily was quickly developing the cold mindset of an aging accountant. There was some truth to that in terms of book-keeping, but she was also a scaredy-poo when it came to major decisions. She was a single woman, now approaching early middle age, and if things somehow went wrong she had nobody to rely upon. The worst thing she could conceive was the loss of the fourplex (with all 3-bedroom units) or the two houses on one lot. Both of those properties, because of their high bedroom counts (there were very, very few 3-bedroom units competing with them) were cash cows. She didn’t want to risk either.
On the other hand, Emily desperately wanted a larger portfolio than six units. If that didn’t work out, if six units were all she ever had, she would accept it and work hard to pay them off. She’d use the discretionary cash flows from both to pay off one of them. That’s something you can do with small units. The one she’d pay off first would either be the property with the highest mortgage rate or the one with the shortest remaining term. After that one property was fully paid off, the combined net cash flows of both properties would go towards paying off the other loan. It would probably go pretty quickly.
Once she had six paid off units she estimated that rents from two units would probably pay her fixed and variable expenses and she could live off the remaining four units. She knew it was chancy, and that’s why she wanted more units. In her mind, the greater the number of units she had, the wider the diversification and the lesser her overall risk.
William J. Bernstein has written on this. In terms of loss to overall wealth, he identified four sources of risk: (1) inflation; (2) deflation; (3) devastation, and (4) confiscation.
Inflation is the loss of purchasing power. It takes more money to buy the same package of goods. A hypothetical example of an investment vulnerable to inflation risk is a perpetual fixed rate bond. As inflation rates increase, the value of such a bond decreases.
The benefits of inflation accrue to people who owe money. Governments, life insurance companies, and those with debt (especially income property debt) all benefit from inflation.
The opposite of inflation, deflation is when it takes less money to buy the same package of goods. Prices go down. Imagine General Electric stock losing (deflated) 30% this year. It takes less money to buy the same number of shares. Deflation benefits people who have cash on hand and can make significant investment purchases when values are deflated.
Devastation: Major earthquakes, floods, the Yellowstone Caldera, biblical plagues of locusts, tsunamis, and Cat 5 hurricanes all cause devastation. Devastation can usually – but not always – be insured around. Properly managed, insurance will return people financially to where they were before the devastation happened. In that sense, devastation is asset neutral.
Confiscation: Confiscation is when the government takes property without full compensation. Examples might include civil asset forfeiture, tax liens, judgments, and eminent domain. Confiscation losses are a net debit, and Emily could think of nothing that would turn them into lemonade. She recognized, however, that total loss by confiscation can be reduced by proper insurance (judgments), good accounting (tax liens), and diversification (eminent domain).
That was enough for one evening. Emily uncurled herself from the sofa, returned the yellow pad to the coffee table, and went for a shower and an early bedtime. The TMC Channel was showing a Humphry Bogart and Lauren Bacall marathon.
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.