If you’ve read any piece of financial news lately, you’d know that American real estate is back on an upward trajectory. Last month it was reported that single family homes in the United States had increased in price at the fastest pace since 2006.
This trend looks sustained. Housing is an investment that runs very hot, and very cold, for long periods of time. Now that real estate is back “on,” investors are looking for a way to profit on the trend.
One of the best ways to play real estate is to own it directly. But there’s a choice to be made. Should investors buy a single family home, or should they go for multi-unit properties? There are substantial differences in profit potential, available financing, and operations between the two. Let’s dive into a comparison.
Single Family Units
Single family homes are those which have only one door – there’s only room for one person or family. Single family homes are characterized by having:
- More upside – Single family homes are priced by investors and potential home buyers. As such, home prices in the single family market are not always logical – look back to 2007 to see how much more expensive it was to own a home than to rent one in the most bubbly markets. Single family homes offer much more appreciation potential in that their value is not necessarily determined by rents.
- Easier financing – Financing a single family home is easier than financing a multi-unit property. Single family homes can be purchased with conventional 30-year fixed rate mortgages. Fannie Mae and Freddie Mac will purchase up to four loans on single family homes per person, meaning that banks are more willing to make a loan on a single family home than a multi-unit.
- More costs – A single family home naturally comes with more costs. There is little room for leveraging costs. For example, a new roof or monthly lawn service are costs that have to be covered with the rents of a single tenant. In a multi-family property, these costs can be divided between more families.
- More liquidity – It will always be easier to sell a single family property than a multi-family home. Single family homes have a much bigger market – people who want a place to live. Multi-family properties are sold between investors, who make up a much smaller piece of the real estate pie.
- Diversification potential – Some neighborhoods only get better with time. Others become eventual slums. Investors who purchase single family units can buy property in many different school districts, and neighborhoods to diversify risk around a city or county.
- HOA risks – Homeowners associations are out to protect homeowners, not investors. Homeowners associations can be the death of a great real estate investment if by-laws prohibit investors from renting more than a given percentage of all property in a neighborhood. Additionally, homeowners association fees rarely go down; instead going up, and up, and up each year, taking more from an investor’s ultimate profit potential.
Multi-family properties are those that were specifically built with the investor in mind. As such, these properties tend to offer more for the astute investor, but they require significantly more capital to get started.
Multi-unit homes offer:
- Less upside – Multi-family properties are sold among investors who price the asset based on the return it can give them. Following through with this logic, a multi-family home will not appreciate quickly during bull markets in real estate. A multi-unit property gains or loses value based on the annual profits it can deliver to another investor.
- Difficulty in financing – A multi-family home is more expensive (requiring a larger down payment) and more difficult to finance. Banks typically finance multi-unit homes with adjustable rate mortgages for 20-30 years, and require at least 20-25% down. Multi-unit loans are traditionally issued by the commercial arm of a bank, and never sold. Thus, the bank holds the risk of the loan from the day the investor signs the loan to the day it is repaid in full. Banks are less willing to make such loans because of the inherent risk to the bank. Single family loans are quickly flipped to government sponsored entities like Fannie Mae and Freddie Mac, so banks have little to no risk in making a single family home loan.
- Cost leveraging – A multi-unit property is built and maintained to deliver value to the investor. Having multiple tenants per building can significantly increase cash flow to the owner as costs are spread out between many paying tenants. There are substantial cost savings to be found in the form of lawn mowing and treatment, painting and landscaping, roofing and general building repairs, as well as annual or semi-annual pest treatments.
- Greater turnover – When you own a multi-unit property, you own a community. This community has to get along – problems between tenants can be your worst nightmare when two tenants move out because of complications with one another. Additionally, multi-unit tenants tend not to stay in one place for very long. Families usually favor homes, having a vested interest in a geographic area. Singles usually favor apartments or multi-unit deals, since they are not as “tied down” to where they live.
- Less liquidity – At any given time there are only a handful of buyers interested in a multi-unit property. You should expect to buy and hold a multi-unit property for years and years. Even if you want to sell the process can last for many months or even years. Multi-unit properties stay on the market much longer than single family units, unless the current owner is willing to discount the property tremendously to garner the interest of another investor.
What’s the best type of real estate to own?
It depends on who you ask. Interestingly, real estate investors rarely diverge from what they know. Some have an affinity for low cost single family homes that can be quickly rented to long term tenants. Others prefer the larger cash flow from multi-unit homes, even at the cost of greater turnover and financing complexities.
What is certain is that new investors should start small. A single family unit is a great way to get started in your local market, get a feel for the quality of tenants in a given area, and learn about the responsibilities of being a landlord. Starting with a 20 unit apartment building is an expensive way to learn that real estate investing might not be for you.
All in, real estate offers tremendous long-term opportunity. It’s no surprise that more American millionaires owe their wealth to real estate than any other asset class. For that reason, real estate should be part of a very diversified portfolio, even if you choose to invest passively with real estate investment trusts.