Basics of Residential RE

May 7, 2008 · 1 comment

As I mentioned in my previous post, I plan to base my real estate investment business around investing in apartment buildings (at least at first). Before I talk more about my investing plan, I should probably explain why I chose apartment buildings over other types of residential real estate investments.

First, some background on the types of residential real estate, and the advantages/disadvantages of each:

The two most common types of rental property are residential and commercial, where the difference (very generally speaking) is the scope of the investment:

Residential Real Estate: Residential real estate is just property designed as living space. Any property zoned as living space for between 1-4 families is considered residential real estate. The most common type of residential property is the Single Family Home (SFH), but duplexes, triplexes, and 4-plexes (Multi-Family Residences) are also common investment vehicles for those interested in residential property.

Commercial Real Estate: Commercial property covers a wide range of real estate types. In the residential real estate world, it covers any multi-family residences with 5 or more units, such as apartment building or apartment complexes.

So, what are the advantages and disadvantages to both residential and commercial residential real estate?

Single Family Homes vs. Multi-Family Residences

As mentioned earlier, the most common type of real estate is single family homes. Likewise, the most common type of investment real estate is the single family home, as well.

There are many reasons why single family homes are so popular among investors:

  • Newer investors prefer single family homes because they are more familiar. Many of us have owned single family homes at some point, or at very least grew up in a single family home. This familiarity provides a certain comfort level to new investors that larger properties don’t; larger properties tend to be outside of our scope of experience, so many people are not as comfortable evaluating and actually purchasing these types of properties
  • In terms of supply, single family homes far outnumber multi-family residences. This provides much more selection for investors, and allows investors to be more picky in the types, sizes, and values of investments they buy. Because multi-family residences are fewer and farther-between, investors who choose to invest in these types of properties have less selection, and therefore often have to be flexible in their purchasing criteria
  • When evaluating the value of a single family home, you often have many, many other similar homes in the neighborhood to compare against to get an idea of how much the house is worth, how much income it can generate (i.e., how much you can get in rent), how quickly similar properties are selling for, etc. On the other hand, multi-family residences are less common, so it’s often difficult to find similar properties to make comparison to, making the job of the investor more difficult when it comes to evaluation how good a deal the property is
  • Single family homes tend to be much more liquid than multi-family properties. In other words, there are a lot more buyers of single family homes than of multi-family residences, so selling single family homes is generally much easier. This is because multi-family residences are generally only bought by investors, whereas single family homes are attractive to both investors and regular folks who are looking for a house for themselves

Based on the points above it should be obvious there are a lot of benefits to investing in single family houses especially for new investors. But, there are also a lot of benefits to investing in multi-family properties (especially for more experienced investors).

Duplexes, Triplexes, and 4-Plexes

These are the smallest of the multi-family properties, between 2 and 4 units. Some of the major benefits to these types of properties include:

  • They qualify for residential (vs commercial) loans, meaning it is generally easier for non-investors to get loans on these types of properties
  • Properties with 4 units or fewer can generally qualify as a primary residence for the owner, assuming the owner chooses to live in one of the units. For the new investor who doesn’t currently own a primary residence, buying a 2-4 unit property, living in one unit while renting the others, can provide a lucrative investment opportunity. In fact, not only does the property owner get the tax benefits associated with the primary residence, but a smart investor will get the other units to cover all his unit’s costs, and perhaps even show a profit. In essence, you’re living for free, and even making money off the deal
  • 2-4 unit properties tend to be relatively liquid, meaning there is generally a market if/when the owner decides to sell. Unlike larger properties where selling can take months or years (due to the smaller number of investors in this area), selling smaller multi-family residences can be much easier

Despite all the advantages to owning 2-4 unit properties, there is one major disadvantage:

  • Duplexes, triplexes, and 4-plexes, because they are considered residential properties, are generally valued in a similar way to residential properties (i.e., similar to houses). While larger properties are generally valued based on the income they can produce, 2-4 unit properties are generally valued relative to the value of the SFH in the surrounding neighborhoods. We’ll have more to say about this in later posts, but suffice it to say that while larger properties have the ability to control their value through good management, smaller properties generally rely on the larger real estate market to determine the direction (and velocity) of prices

5+ Unit Properties

As mentioned, properties with five or more units are considered commercial properties, and require commercial loans. These types of properties are generally referred to as apartments, and even within this category of property, there are various sub-categories, each with their own advantages and disadvantages.

Generally, apartment buildings/complexes are divided into small, mid-size, and large. Depending on who you ask, small apartment buildings are generally those consisting of 50 or fewer units. Mid-sized complexes are those in the range of 50-150 units. And large complexes are generally considered those with more than 150 units.

Small Apartment Buildings/Complexes

The main advantage to owning small apartment buildings is the opportunity to be hands-on its management, and to learn the ins and outs of what it takes to run an apartment building. Smaller buildings may have professional management, but due to economies of scale, you may not actually employ full-time on-site management or maintenance. This gives the owner more responsibility (even if the site has a property manager), which will be useful in future (and larger!) endeavors.

Mid-Sized Apartment Complexes

Mid-sized complexes have the advantage of greater economies-of-scale, both in terms of cost, income, and expenses. But, with these advantages comes the disadvantage of management. These sized complexes generally require full-time property management, and may even benefit from on-site management and maintenance, which can be costly for smaller buildings or complexes. These sized complexes also generally require full-time accountants to manage the books, which is an additional expense and management task.

Large Apartment Complexes

Large apartment complexes may have multiple maintenance folks, on-site management, on-site leasing office, and other staff required to run a large operation serving hundreds or thousands of people. Of course, with this overhead comes great economies-of-scale, in terms of cost, income, and expenses, to the benefit of the property owner. This professional staff often contributes to lower turnover and lower vacancy, again adding to the value of these types of properties.

All-in-all, the larger the property, the more money you will have the opportunity to make, but also the larger the potential management overhead (and potential headaches).

By the way, it is these economies of scale – and the associated upside to potential income – that has enticed me to start my investing in apartments. While I don’t believe I’m ready to jump into large apartment complexes (or perhaps even mid-sized complexes), I am excited about finding buildings in the 5-25 unit range.

One response to “Basics of Residential RE”

  1. Ned Carey says:

    I saw you post over at the bigger pockets forum. This is a good synopsis of options. Good luck in your quest for a commercial building.

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