Investors need to work harder to find good deals than they did five years ago due to the more competitive real estate market. Our real estate company decided to use data and insights to figure out which investing class to target.
From our analysis, we have found that the sweet spot to investing is the 3-15 unit building due to lower purchase demand. One caveat to the analysis: We invest based on IRR over a 20-year period. We aren’t flippers, and we aren’t trying to guess at highly appreciating markets. Each investment class has deals in it; we simply think that 3-15 unit buildings are the easiest deals to find.
Single Family Homes
Let’s start with single family homes (SFHs). SFH buying demand comes from two major buckets. First, there is the obvious group of people who buy a SFH for their primary residence. The other major demand bucket is high net-worth individuals who buy these as investment properties. Doctors, lawyers, executives, etc. are looking for a place to invest some money. They typically aren’t experts in real estate. They are usually looking for a safe bet that won’t take too much of their scarce time. Also, they often want to acquire a property where they feel secure (both from crime and financial risk)—usually taking away low income housing as an option.
We acquired our first couple of properties from this investment class. The returns have been OK (not great or horrible). They are also easier to manage and have less variance of evictions and maintenance costs. Typical cap rates in Kansas City range from 5-8% for class A and B SFH properties.
On the other end of the spectrum, 15+ unit buildings are attractive to syndications and funds. Managers of big pools of money want to put their money to work in one major transaction. It’s simply not time efficient for them to acquire smaller properties because they need to deploy major amount of money. Syndications have risen in popularity as seasoned investors raise money from individuals and deploy that money all at once to a multifamily complex. This growing demand coupled with a revived economy has pushed cap rates for these complexes much lower into the 5-7.5% cap rate range.
3-15 Unit Buildings
We believe the sweet spot for investing right now is the 3-15 unit building space. The only demand for these properties are, for the most part, local real estate investors. These properties are too time-consuming for the major national investment syndications and funds to acquire. The high net worth individual is typically not interested in the complexity of multi-unit buildings. Outside of a few house hackers out there, it also doesn’t work for people looking for a primary residence.
To get even more specific, we believe the REAL sweet spot is 5-15 unit buildings because these buildings get commercial appraisals. If you use the buy, rehab, rent, refinance, repeat of buying properties, the appraisal is key to returns, as it dictates how much money you can pull out of the property. We have found commercial appraisals often appraise higher for strong cash-flowing properties, especially once you have the property leased out.
Downside to 3-15 Unit Buildings
There are two major downsides to building out a portfolio of 3-15 unit buildings. First, the acquisition of these mid-sized buildings is harder than buying one massive apartment complex. Negotiating terms of the deal, financing, closing, tenant communication, and initial property repairs can be much more time-consuming with 3-15 unit buildings.
The other major downside to this approach is the property management time commitment. For an apartment complex, it simplifies things having all tenants in one location due to common property features and centralized geographic location. On the other side, SFHs often attract higher rent tenants, who are usually easier to manage. Owning units across multiple 3-15 unit buildings requires strong systems/partners to make sure rent is paid and maintenance costs stay low.
One important note is that there are a ton of caveats, and this was a very broad generalization. Investors can lose or make or lose a lot of money in each investment class. It is just a lot easier to get high returns by targeting unsaturated markets.