Chapter OneProfit wih Income Properties
In this chapter, you will learn why owning small income properties will make you wealthy. In this context, I use the term small income properties to mean multifamily apartment buildings that range in size from duplexes up to, say, 24 units.
You can acquire properties that fall within this category for as little as $15,000 per unit (or even less). But more commonly, you will probably pay a price of $25,000 to $50,000 per unit. In higher-priced cities and neighborhoods, such properties may sell in the range of $50,000 to $100,000 per unit. Even within the same city, you will find that price-per-unit figures will vary by neighborhood, property condition, and type of tenant. In every location, though, when compared to houses, multi-unit properties tend to offer investors lower prices, high cash flows, and numerous other advantages. You can get a feel for the types of properties I'm talking about from Figure 1.1.
Advantages of Multi-Unit Properties
Most small real estate investors begin their entry into the field with single-family houses. This step seems easiest and most familiar because most of these people have already bought their own personal residence. Buying a single-family house to rent out basically repeats this same purchase process.
However, even though I have owned many rental houses, I actually began my investing with a five-unit property, followed that purchase with a seven-unit property, and next added a four-unit to my portfolio. Novice investors need not fear "getting in over their heads" with apartment properties. In fact, I recently told a medical doctor in Atlanta who had asked me for advice that he should look for a 4- to 12-unit property rather than the single-family rentals that he was currently exploring. My reasons for this advice include the following:
* Low cost of acquisition * Higher cash flows * Less search time * Greater ease of management * Increased tax-free, trade-up potential * More potential for owner financing * Enhanced possibilities for creating value
Let's look at each of these advantages a little more closely.
Lower Cost of Acquisition
The median price of a single-family house in the United States has now climbed above $160,000. In higher-priced areas such as San Diego, Boston, New York, and Washington, D.C., the median price approaches $300,000. Unless you want to invest in less desirable neighborhoods-and even there, house prices can seem absurd, such as in East Palo Alto, California, or Chicago Southside-investing in single-family housing is becoming cost prohibitive for many investors of average means.
Hopeful homebuyers, too, have noticed the cost advantages of small income properties. As a result, owner-occupied duplexes, triplexes, and quads are again attracting renewed interest. Individuals or families who couldn't begin to afford the monthly payments on a $350,000 house now find that they can afford a $500,000 or $600,000 quad because the rent collections will go a long way toward paying their principal, interest, property taxes, and property insurance (PITI).
When I talk with homebuyers priced out of their desired neighborhoods, I tell them to look for a small income property. Buy it. Use rent collections to help meet monthly expenses. Create value through improvements and then sell or trade-up in a few years. This same advice holds true for investors.
Given their lower per-unit prices (relative to single-family houses), small income properties can give you a more affordable entry into real estate. In addition, you will typically achieve higher cash flows with multi-unit properties.
Higher Cash Flows
For most of the past 30 years, many renters were shut out of home ownership because they could not qualify for a mortgage. They either lacked acceptable credit or they had failed to save enough money to cover the down payment and closing costs. This situation worked to the advantage of investors who owned single-family houses. Tenants paid relatively high rents because they had no other choice. Even though "owning was cheaper than renting," tough mortgage standards kept people in rentals. Single-family investors enjoyed high positive cash flows.
The New World of Home Buying The days of positive cash flows for single-family investors have disappeared in many cities. During the past five years, low interest rates, easy-qualify mortgages, and little or nothing down first-time buyer home loans have converted millions of previously discouraged renters into homeowners. This mass conversion of renters into homeowners has hurt would-be investors in single-family houses in two ways: It has pushed home prices up to record highs, thus making purchases less affordable for investors; it has also kept rents from rising. New homebuilders all over the country now advertise with the question: "Why rent when you can own?"
With such fierce (and unprecedented) competition from homebuilders, rent levels for single-family houses have fallen behind the increases in housing prices. Lower rents relative to prices means that most new investors must either come up with a 25 to 40 percent down payment or incur negative cash flows.
When I first began to invest, my single-family houses would generate a positive cash flow-even with 100 percent financing. In those days you could buy houses at a price of 100 times the monthly rent. In other words, you could buy a house for $50,000 and then rent it for $500 per month. Although houses in some areas still yield comparable amounts of cash flow, you will find that, in the more expensive cities, the monthly gross rent multiplier for houses has jumped to 150, 200, or higher.
A house that now rents for $1,000 a month might sell for $150,000, $200,000, or more. To bring in gross rents of $1,500 a month in most major cities, you would need to buy a house priced in the range of $250,000 to $300,000. Although long-time investors in single-family houses are now reaping a bonanza in equity gains due to price appreciation, new investors in rental houses face the worst cash flow situation in memory.
I know because I routinely talk with would-be investors throughout the country. Never before have I encountered so much discouragement, especially from younger investors who want to buy houses to build their wealth. To these investors I say buy "fixers" (see my book, Make Money with Fixer-Uppers and Renovations) or, as emphasized in this book, buy small income properties.
Apartments Provide Lower GRMs and Thus Higher Cash Flows Even though single-family houses now often command gross rent multipliers (GRMs) of 150, 200, or higher, you can still find multi-unit properties in most cities that sell for prices of 80 to 135 times gross potential monthly rent collections. As a result, smaller apartment properties (especially 5 to 24 units or larger) can yield a positive cash flow with just 10 to 20 percent down. In fact, as I show later, you can still buy income properties and achieve a 10 to 20 percent cash-on-cash return.
This discrepancy in cash flows persists (at least for the time being) because investors value income properties primarily according to how much cash flow they produce. If a deal can't be structured to yield a positive cash flow, most property investors will walk away and look for another property.
In contrast, homebuyers value single-family houses according to their personal tastes and their monthly earnings from their jobs. If homebuyers want the house and they can afford the monthly payments, they will pay whatever price the market will bear; therefore, when buying single-family houses, investors must outbid homebuyers who do not think chiefly in terms of annual cash-on-cash investment returns. When investors ignore cash flow and invest primarily for appreciation, they're no longer investing-they're basically speculating on higher prices.
Expect Cash Flows to Fall in the Future Today, most small income properties can still generate positive cash flows. Will this situation persist? I don't think so-at least not with low down payments.
As boomers continue to fret over the source and adequacy of their retirement incomes, increasing numbers will recognize the advantages of income properties. As more investors search out this type of property, they will bid up prices. Although over time rent levels will continue to inflate, property prices will inflate even faster. Relative to property prices, cash flows (rent collections) will not keep pace. We can already see this trend in cities such as New York and San Francisco. In these and other high-priced locations, speculators in appreciation potential have virtually pushed cash flow investors out of the market.
I recently saw a six-unit property in San Francisco sell for $1.2 million. Rent collections for this property totaled just $7,200 a month. On a monthly basis, this price-rent relationship (the gross rent multiplier) came in at 166. With 20 percent down, the rents would barely cover the mortgage payments (debt service).
That means that these investors must either come up with a much higher down payment or go out-of-pocket each year to pay for property taxes, insurance, maintenance, and repairs. An all-cash purchase of this property would have netted these investors an annual yield of just 4.7 percent (not counting appreciation, which, of course, is where they really planned to make their money).
Fortunately for beginning investors, most cities still offer reasonable cash flows and strong potential for appreciation. But don't wait too long. Given that bond interest rates offer very low returns and stocks are clouded with uncertainty, income properties now stand clearly superior to these other popular investments. Yet, with too much money chasing too few good investments, you need to act now. Absent some type of general economic collapse, five years from now, the selling prices of small income properties will have climbed significantly higher, and positive cash flows (under historically normal terms of financing) will be found in fewer and fewer locations.
What Yields Are Reasonable? Throughout the decade of the 1990s,many stock market investors easily earned yields of 12 to 20 percent a year. By the turn of the century, various surveys revealed that most investors had come to believe that they could expect such high yields to continue year after year for as far as the eye could see.
As most people now realize, these grandiose expectations bore no relationship to reality. Because the U.S. economy grows (on average) just 3 to 5 percent a year, it is mathematically impossible for the stock market to grow continuously at a rate three to six times as fast. As we look to the future with clearer vision, virtually all stock hypesters have toned down their rhetoric. Even that great bull Jeremy (Stocks for the Long Run, McGraw-Hill, 3rd ed., 2002) Siegel now tells stock investors to prepare for stock market returns of no better than 7 percent a year for at least a decade-and that 7 percent is before deductions for brokerage fees, mutual fund expenses, and income taxes!
Implications for Real Estate With dividend yields (positive cash flows) on stocks of less than 2 percent a year and total returns of 7 percent (if and when the stock market again moves steadily upwards), investors are longing for higher yields. Yet at present, only real estate (and especially income properties) can offer investors those double-digit returns that for one brief and exceptional moment in history were previously experienced by stocks.
Surprisingly, relatively few investors understand this opportunity. Many still cling to the false hope that stocks will rebound and replay their glory days. Others are pushing money into risky hedge funds or merely sitting on the sidelines with their money market funds primed to pour into the next big thing.
However, this mass ignorance won't persist very far into the future. I know from the sales figures of my own books and talks with readers who call me that increasing numbers of investors are seriously considering real estate. My conversations with real estate agents around the country also reveal heightened interest in real estate by investors. As noted earlier, most of this newly generated interest centers on single-family housing-until, that is, these would-be investors discover the reality of negative cash flows.
To counter this problem, many new real estate investors have begun to search for foreclosures, distressed owners, and fixer-uppers. Several best-selling books have led people to believe that they can routinely buy real estate "wholesale" at discounts off "retail" of 30 to 40 percent. Naturally, increased competition for these types of properties makes good deals tougher to find. So what other options can beginning investors pursue? Small income properties and condominiums, which I explain in my book, Make Money with Condominiums and Townhouses. But as the merits of these properties as investments become more widely known, opportunities here will also become relatively less rewarding for new investors.
Twenty years ago, fewer than 10 million Americans were seriously saving and investing for retirement, their kids' college education, and other longer-term financial goals. Today, that number has grown to 50 million or more.
It doesn't take an Einstein to figure out that because the middle class has joined the moneyed class in pursuit of solid investments, cash yields will continue to fall. It defies reason to believe that 50 million Americans can all find safe investments that yield cash-on-cash returns of 15, 12, or even 10 percent a year.
This is why I urge you to get started now. Even though the cash flow returns today don't look as good as they did 5 or 10 years ago, they look far better today than they will look 5 or 10 years into the future. The total number of investors searching for high yields has grown far faster than the capacity of the economy to generate high investment returns. Mathematically, the majority of these investors must end up disappointed.
Less Search Time
In contrast to single-family houses, you can build wealth in multiunit properties with far less search time. Even in high-cost areas, a $5,000,000 or $10,000,000 portfolio of houses would (or at least should) include at least 20 or 30 separate properties. In lower-priced areas, a portfolio of this amount might include as many as 50 or 100 separate properties. Obviously, to buy that many houses would require at least several thousand hours of looking at homes, evaluating neighborhoods, negotiating purchase contracts, and applying for loans.
With smaller income properties, though, you can work your way up to a $5,000,000 or $10,000,000 dollar portfolio with as few as 3 to 10 acquisitions. Even if each multi-unit deal takes two or three times as long to complete as a single-family purchase, you've still saved a considerable amount of search time. Of course, as you move up to a 20, 30, or 50 million dollar portfolio of properties (should you plan to grow that wealthy), such a large collection of single-family houses would become virtually impossible to acquire and manage. For real estate investors who want a life apart from making money, multi-unit properties give far more investment return for each hour invested in property acquisitions and negotiations.
Greater Ease of Management
When you own 15 or 20 houses, you've got 15 or 20 furnaces, roofs, air conditioners, electrical systems, and yards to oversee. If you own two or three multi-unit buildings instead, you cut down the components that at some point will need attention. Although maintaining a multi-family property will cost more per building, it will cost you less per unit both in terms of dollars and time.