As the headline implies, this is the third column in a series about real estate investing. I started with single-family homes, moved to duplexes and four-plexes, and now I’m on to small apartment complexes (residential real estate with 5-12 units). These come with advantages and disadvantages; they have a better price-to-income ratio than the smaller investments, but they require different financing, for example.
Small Apartment Complexes
Five units or more means you cross an invisible threshold where the trusty 30-year fixed-rate loan is no longer available to you. You must now delve into commercial financing. Many lenders buy and sell the 30-year fixed loan. However, with a commercial loan on a small apartment complex, the lender probably won’t resell the loan. Typically, whoever makes the loan keeps it in their portfolio. The commercial loan comes with a higher interest rate and a lower loan-to-value ratio, a shorter term, and/or a requirement that the rate be adjustable.
The commercial lender is unlikely to be the same lenders you’ve worked with on standard residential mortgages. A typical commercial loan has a loan-to-value ratio of 70 percent or less and interest rates that are one or two percentage points higher than a home loan. And the interest rate is often adjustable based on some index. If not, it may have a balloon payment at the end of five or ten years. To make matters worse, when money is tight, even these loans become more difficult to find. This is offset by the economies of scale you get from owning a larger complex.
When you reach complexes of more than 16 units, things change again. First, you are required by law to have an on-site manager. The job description for the on-site manager can be fairly brief, but he or she must live on the premises. Our on-site managers show vacant units, maintain the pool and laundry room, do light yard work, and deal with that noisy tenant at 2:00 a.m.
Large vs Small
While bigger complexes can lead to bigger revenues, they can also be harder to sell. Very large complexes, say more than 50 units, are actually easier to finance because different lenders get in the game. Large institutional lenders like insurance companies are not usually interested in $500,000 loans (small apartment complexes), but they are interested in $5 million loans (large apartment complexes).
Most of the pros and cons of investing in residential property apply to large complexes. The 20-year-old resident still thinks he can have a party until 3:00 a.m. and the guy next door still wants to have a dog. On the other hand, vacancies are filled more quickly and there are tax advantages for multi-family residential real estate (as opposed to commercial real estate like office buildings or retail space).
Commercial space usually requires a five-year lease and has more dependable tenants (with far fewer 2:00 a.m. parties), but residential properties have a better price-to-income ratio. And, with apartment complexes, you benefit from economies of scale (per unit, your maintenance and management costs are less).
As I’ve said before, real estate investing isn’t for everyone, but if you look at the return on real estate as compared to other investments, it can be quite lucrative.
If you have questions about property management or real estate, please contact me at firstname.lastname@example.org or call (707) 462-4000. If you have an idea for a future column, share it with me and if I use it, I’ll send you a $25 gift certificate to Schat’s Bakery. To see previous articles, visit www.realtyworldselzer.com and click on “How’s the Market.”
Dick Selzer is a real estate broker who has been in the business for more than 40 years.