Single Vs. Multi-family Rental Property
Updated January 1, 1 . AmFam Team
If you’re in the market for investment opportunities, purchasing rental property can offer a big return on investment, but you’ve got to know where to put your money first. Should you buy a single-family property, a multi-family property, or both? The answer has a lot to do with how comfortable you are with investment risks, and even more to do with your real estate investment strategy.
Learn how single-family properties can be a better bet in the short run, and a why multi-family housing purchases offer both a bigger risk and a more handsome reward if you’ve got the time and the money. To better understand the pros and cons of single-family vs. multi-family housing purchases, a deep dive into the benefits and drawbacks of each can help with your decision.
Consider Your Exit Strategies Before You Bid
Prior to investing in a real estate, it’s really helpful to have an idea of your term length — the amount of time your money will be tied up in the property. Are you looking to diversify your investment portfolio as a real estate investor? Getting the optimal return on investment can be hooked directly to your goals.
If the idea of a long, slow progression of property value is appealing, and if you have enough capital to buy a number of apartment units, condos, duplexes, or townhomes, a multi-family buy may be exactly what you’re looking for.
When smaller amounts are going to be financed, getting a single-family home to rent out may be a way to achieve a shorter-term return. If property value conditions are right, and you’ve got a consistent, reliable tenant paying the rent, you really may benefit. Save even more cash by being your own property manager if you’ve got the time and know-how. By following these simple steps, your short-term exit strategy may pay off with improved property that can bring in thousands more when you decide to sell.
How Are Single-family Homes and Multi-family Home Purchases Alike?
Most investment property purchases, whether single or multi-family, have similar loan requirements. Real estate loans for rental properties are considered business loans by most lenders. As such, interest rates are typically higher than mortgages for first-time and private home purchases. And be aware that business tax benefits extend to real estate investment properties and rental income. You’ll be required to put at least 20 percent of the purchase price down, too. Whichever way you decide to go, you should look for investments that return at least 1 percent of the total purchase price per month to clear a decent profit.
How Are Single-family Homes and Multi-family Home Purchases Different?
Obviously, one of the biggest differences is the price. But that’s just the beginning. There are many ways multi-family dwelling purchases are different when compared to buying a single-family rental home. For starters, the assessment and valuation process isn’t the same. Single-family homes are assessed according to value of the property, while larger multi-family units are valued according to the amount of rental income they generate. Take a closer look at each option.
What Are the Pros and Cons of Purchasing a Single-family Home
When purchasing a single-family home, there’s a lot to consider:
You’re tenant dependent. You’ll be locked into a more limited income stream when your sole renter is your single source of income, and a vacancy of the home results in total loss of revenue.
Single-family homes can draw long-term tenants. Rental homes in neighborhoods with good schools, local parks and easy access to shopping areas are a good fit for renters that are ready to settle down and sign a multi-year lease.
Better short-term benefit. Homes offer a better exit strategy. Unlike owner-occupied dwellings, investing in a single-family home can out-perform the financial gains made by multi-family properties — in the near-term — because the home usually appreciates in value more quickly.
Insurance for single-family homes is cheaper. Because the value of the property’s less, so will your cost for insuring the space. Regardless of the landlord’s insurance policy you purchase for the space, keep in mind that your tenant’s items will not be covered by this policy. It’s important to either have a clause in your lease strongly encouraging or requiring them to get renters insurance. Check with your state and local codes to determine which action is right for your area.
What Are the Multi-family Home Purchase Pros and Cons?
While a multi-family costs more, a long-game strategy potentially pays big dividends, but you’ll be spending more too:
Property taxes are higher. This cost is usually passed through into the rental fee, though high vacancy rates could mean you’re paying some of this expense out of pocket.
Long-term benefits are more likely. When you buy multi-family home rental properties, you may find the property appreciates more slowly compared to rental homes. But overall, if rents increase year over year, you may see a healthy profit upon selling.
Better distribution of mortgage-paying income. Because multiple tenants act as your source of income, you’ll benefit from a distributed risk that extends across all tenants. This offers a safer income stream potential because it’s unusual for all units to be vacant at the same time. Monthly passive cash flow may likewise be greater here.
Expect higher turnover. Multi-family dwellings draw typically higher-risk tenants versus those that apply for single-family homes. You may experience more frequent vacancies with this type of purchase. Costs related to finding new tenants could be higher too.
Multi-family insurance rates are higher. Although coverage for multi-family dwellings are usually more costly, you may be able to write off some or all of this business expense.
Upgrades pay off better. The landlord can upgrade the space to maximize rental prices, driving up valuation and helping to ensure a better resale value.
Multi-family properties are typically more difficult to sell. The valuation process for larger multi-family dwellings is based more on the amount of rental money it can potentially generate and less on actual property value. If you do find yourself in need of selling a similar property, it may be difficult to find a buyer.
What’s the Best Strategy for Investing in Profitable Rental Property?
Figuring out which of these rental properties is the right investment for you all boils down to where you’re most comfortable. Both can be profitable. Rental income has a proven track record of building wealth, and if you weigh out stability versus risk correctly, you’ll find the option that fits your finances and your comfort level best. As you explore your investment opportunities, check in with your American Family Insurance agent (Opens in a new tab) and review the coverage options available to you. You’ll find our expert agents make insurance easy to understand, and you’ll have the protection your investment needs.
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- When Should You Invest In Rental Property?
As a landlord, you know that an investment property has great potential. When everything goes according to plan, it can be an exceptional source of income. But seeing a consistent return on investment means you’ve got to keep a close eye on the numbers before you close on a property.
Although there’s a fair amount of risk involved in making a purchase, you can lean on a few key rules, formulas and indicators to help guide your decision. Next time, when you’re wondering “Should you invest in this rental property?” refer to these important purchasing tips to help make the right choice — and quickly rule out real estate that may not be worth the investment.
Start with the “One Percent Rule”
Answer a simple question: Will your monthly rent for the space equal at least one percent of the purchase price? If your answer is yes, then your place may be able to turn a profit in the years ahead. Congrats, you’re off to a good start. Be sure that the rental’s priced competitively for spaces of similar design. Here are few other factors to consider:
Understand the formula
If the total purchase price of the property is $200,000, rent should be no less than $2,000 per month or one percent of the total cost. Likewise, a $600,000 purchase price for a multi-unit rental property should meet or exceed $6,000 per month in total monthly rent earnings.
Get the purchase price right
When factoring in the purchase price, remember to include closing costs, property taxes and insurance. One way to better estimate these costs is to use an online closing costs calculator which can approximate appraisal fees, home inspection fees, application fees, prepaid interest among a host of other out-of-pocket expenses that can up your purchase price, sometimes by thousands.
Factor in repair costs now
Because real estate investing as a landlord requires the space to be “habitable” upon tenant occupancy, you may need to make certain repairs or upgrades before renting the property. As a result, you’ll want to add the total cost of these repairs into the purchase price.
Consider the “Class” of the Neighborhood
Neighborhood classifications help buyers understand the potential return on investment in a given area. If you’re new to being a landlord, you’ve got to pay close attention to what the neighborhood’s telling you.
One good way to check out an area — specifically if it’s an investment that requires some traveling — is to use Google map’s street view. Is trash left out on the front lawn? Do neighbors maintain their property? What can the cars parked on the street tell you about the demographic? Here are details on the four distinct neighborhood classes real estate agents use to classify a region:
Class A neighborhoods
High income neighborhoods, combined with a home that is move-in ready will usually get an A class rating. Because homes are expensive in these neighborhoods, and their higher than average tax burden, real estate investors usually won’t buy a home there because the one percent rule fails the test. Tenants in these areas tend to be very reliable, high-quality renters.
Class B neighborhoods
Typically populated by those earning a moderate-to-high income, B class neighborhoods are frequently considered a good investment for landlords and fertile ground for tenants seeking rentals. Purchasing “as is” properties that can be cheaply updated and rented above the one percent factor is typically possible here with minimal risk. These areas will usually experience increased turnover and vacancy rates.
Class C neighborhoods
Because the risk is a little higher in neighborhoods that land in the C class category, the opportunity to see a high rate of return on fixer-upper places is good if you buy a For Sale by Owner property, or one not listed on the MLS (multi-listing service for real estate sales). Populated with blue collar workers with relatively low-to-average income, C class areas typically have higher crime rates and under-performing schools. Landlords should expect less-than-optimal tenants and periods of vacancy.
Class D neighborhoods
Areas riddled with crime, properties damaged upon a tenant’s exit and high costs for property upkeep can be anticipated in D class neighborhoods. Buyers usually consider these types of purchases high risk. It should be noted that many property management companies are reluctant to accept properties to service in these areas because the risks associated with the area. Investors tend to seek properties in more stable neighborhoods.
Use the Capitalization Rate as a Predictor of Value
Another key way of understanding the rate of return on an investment is the capitalization rate or “cap rate” for short.
What is a cap rate?
A cap rate determines a profit ratio that a property can generate. It’s best used as a quick way to compare investment opportunities to determine which one is the better value. Start by dividing the total of one year’s rent by the current market value of the home which should include costs and upgrades required to get the space habitable — you can’t rent the place if it’s not livable, right? The resulting percentage is your cap rate. The higher the rate, the better your annual profit margin.
How to Calculate the Cap Rate for an Investment Property
Although the cap rate’s a useful tool to quickly analyze the relative value of comparable real estate opportunities, it’s used as a rough guide to qualify properties for consideration, given the state of today’s current market climate. First, estimate your property’s overall purchase price:
Figure the acquisition value
Simply put, this is the total purchase price. It should include all upgrade costs, closing costs, taxes, business insurance, fees, points, etc. Let’s assume a property you’re considering has a total purchase value of $200,000.
Calculate one year’s rent
If you’re collecting $2,000 per month, you’ll have twelve payments at the end of the year, or $24,000. This figure is your gross annual income.
Account for half a month’s vacancy
Because turnover typically requires some painting and repairs, it’s fair to consider that half a percent (two weeks’ worth of rent) of your total annual income will be deducted to cover the mortgage payments. Assume that your new tenant will cover the remaining pro-rated rent for the other half of that month. Once the vacancy amount is deducted, the result is your gross operating income.
- Gross annual rental income: $24,000
- Less the cost of vacancy: -$1,000
- Gross operating income: $23,000
Factor in operational costs
These costs will include money required to keep the property habitable, like paying for trash collection, making repairs, fees from property management, and landlord insurance. Let’s put that cost under fifty percent of the gross operating income, or $9,300. Some years it will be more, some less.
- Gross operating income: $23,000
- Less operating costs: $9,300
- Net operating income (NOI): $13,700
Divide the NOI by the total value of the property:
$13,700
--------------------- = 0.0685 or 6.85 % - That's your cap rate.
$200,000The capitalization rate for this investment is 6.85 percent annually. If another property under consideration returns a higher cap rate like 8.23 percent for instance, you may want to explore opportunity with the higher annual yield in order to maximize your profit potential.
What is considered a good cap rate?
Generally, a cap rate between 8% and 12% is considered good. However, an optimal cap rate is really going to depend on several factors including location, risk and current rental income. For example, in high-demand like big cities, a cap rate of 4% may be considered good.
Reach Out to Your Agent Today
With so many different ways to look at profitability when determining where to invest in rental property, it’s important you do your homework before you decide to buy. And while you’re making that big decision, remember to contact your American Family Insurance agent and discuss your upcoming purchase. When it comes time to close the deal, you’ll have peace of mind that your property’s insured carefully.
This article is for informational purposes only and includes information widely available through different sources.
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