Investing 101: Acquiring Multifamily Property

Real estate can be an excellent way to build wealth over time and create an additional income source, but it also requires a significant amount of capital to get started. While you can venture into stock or mutual fund investing with just a few hundred dollars, it is a whole different story when it comes to buying multifamily property.

With that in mind, before you start shopping for properties to invest in, it’s important to know if you can afford to become a rental property investor. 

The question of whether you can afford a property or not isn’t a simple one. There are several considerations to think about before you can determine if you can afford to take the plunge into rental real estate investing:

Let’s take a closer look at these considerations, one at a time:

 

Are you financially ready?

Before you consider investing in multifamily property, there are two basic financial things you should do:

• Pay off high-interest debt: It’s silly to invest money in the hopes of earning a 10%–15% annualized return (the most common range), while simultaneously paying a higher rate to borrow money. If you have high-interest credit card debt, you should aim to pay it off or at the very least get a 0% APR balance transfer before you buy a rental property.
• Establish an emergency fund: What good is an investment if you’ll have to sell it if you face any unexpected expenses? Before you start investing in real estate or anything else, it’s a good idea to build up a bit of an emergency fund to help you deal with unexpected expenses or financial hardships. Most financial planners suggest that you should aim to keep six months’ worth of expenses in an easily accessible place. This is certainly a good goal to aim for, but you don’t necessarily need to get there before you start to invest.

 

Do you have enough capital to buy a multifamily property?

Once you’ve established that you’re ready to invest, the next step in rental property affordability is determining whether you have enough money to purchase a property. This depends on the cost of the property itself. All other things being equal, it’s going to require more capital to buy a $300,000 property than a $100,000 home.

One common rookie mistake is assuming that the down payment is all you need, but that’s simply not true. Here’s a rundown of the various initial expenses you need to prepare for:

 

Down payment

Many new investors aren’t quite sure how much to expect, but generally speaking, lenders will require a minimum of 20% down as it is nearly impossible to find private mortgage insurance (PMI) for an investment property mortgage. 

If you are an extremely well-qualified buyer and are purchasing a single-family rental property, it’s possible to get a conventional mortgage with a 15% down payment, but that’s about the only exception we’re aware of. Most lenders want at least 25% down, especially on multifamily properties, so that’s a good figure to prepare for.

Alternatively, you can choose to buy a multifamily property and live in one of the units, which can qualify you for low-down-payment mortgages designed for owner-occupants. This is commonly known as “house hacking”.

 

Closing expenses

Unless the seller has agreed to pay for closing costs, you’ll need to budget for this as well. Closing costs can vary considerably and can be higher on investment properties than primary homes. 

For example, property taxes are often higher for investor-owned homes than for owner-occupants, and you’ll be expected to prepay a certain amount of your property taxes at closing. Origination fees also tend to be higher on investment property mortgages.

As we mentioned, closing costs can vary dramatically, and typically run anywhere from 2% to 5% of the property’s sale price, although higher closing costs aren’t unheard of.

 

Repairs

If you buy a rental property that is 100% rent-ready and in overall great shape, you may not have to worry about this, but if you buy a property in need of any rehab, be sure to include this in your budget. Your inspection report can be a good indicator of the need to budget for repairs, even if the property is in good working order. 

For example, let’s say you recently bought a property where everything was operational, but the inspection report revealed the water heater was on its last legs. With that information, you can plan and set aside money to replace it after closing.

 

Reserves

If you obtain a mortgage for your rental property, your lender will often require a minimum balance in reserves — typically between six and 12 months’ worth of mortgage payments.

This is a good start, but you may want to err on the side of caution and wait until you have more cash in reserve than you think you’ll need. Maybe your property will sit vacant for a few months after you buy it. Maybe something major will break, like the HVAC system. 

Before you buy a rental property, it’s best to be sure that even if setbacks happen, you can absorb them without having to dip into your savings.

 

Will your asset cover its ownership costs?

If you’ve established that you can afford the upfront costs to purchase a multifamily property, the next step is making sure the property won’t be a money-drain after you buy it. In short, you need to make sure that you’ll get positive cash flow.

In other words, if a property rents for $1,000 per month but you’re paying $1,200 per month in various expenses, it’s going to drain your bank account over time. On the other hand, a property that brings in $1,200 and costs $1,000 will cause your bank balance to increase as time goes on, which is a far more desirable outcome. So, you need to learn some basic cash flow analysis. We highly recommend you click on that link, as we have dedicated an entire article to determining cash flow.

 

Rental income

If the property is already rented, this is easy. If it isn’t, your real estate agent can be a good source for an estimate, and you can also order a rent appraisal that can let you know what to expect (if you obtain a mortgage, your lender might order a rent appraisal that you can use).

Many investors have rules of thumb when it comes to rental income. For example, we won’t buy a rental property unless the purchase price is at most 100 times the expected monthly rent. So, if we expect a home will rent for $1,000 with minimal work, we’re willing to pay as much as $100,000. This is a pretty common rule and can help you separate the better property deals to pursue.

 

Operating costs

There are lots of potential costs of owning a rental property, but for cash-flow purposes, we’re just going to focus on the recurring expenses. These can include, but aren’t necessarily limited to:

• Mortgage payments
• Property taxes
• Hazard insurance
• Property management fees
• Any utilities you pay
• Lawn maintenance
• Pest control

 

Vacancies and maintenance are important too

It’s not enough to simply subtract your operating expenses from your income. That’s a common mistake and you’d essentially be planning for an ideal scenario forever.

At some point, your property will be vacant — maybe it just needs a couple of weeks’ worth of repair work between tenants, or maybe your real estate market will slow down and the property will sit vacant for a few months at some point. Similarly, at some point, you’ll need to spend some money on maintenance.

There’s no way to predict these situations with 100% accuracy or to know when they will occur, so it’s important to set aside a portion of the rent you collect to cover them when they happen. We recommend setting aside about 15% of the rent you collect for vacancies and maintenance — adjust this to be a bit higher if the property is older and slightly lower if the property is brand new.

 

Can you qualify for a mortgage?

Unless you’re planning on paying cash for your multifamily property, you’ll need to qualify for an investment property mortgage, which can be just as important to your affordability question as to the other items on the list. After all, if you have enough money for a down payment and have identified a rental property that produces great cash flow, it doesn’t matter unless you can obtain financing to buy it.

With that in mind, there are two main types of mortgages you can get to buy a rental property:

 

Conventional financing

What you need to know about a conventional investment property mortgage is that you’ll need to personally qualify for the loan. These generally cannot be made to any other type of entity, such as an LLC.

This means that your credit, income, employment history, and assets will need to be sufficient to justify the loan. You can consider some of the property’s expected rental income for qualification purposes, but for the most part, your qualifications are what the lender will be looking at. Where investors often run into trouble is if the investment property’s mortgage payment would make your debt-to-income (DTI) ratio too high for the lender’s standards.

 

Asset-based loan

As the name implies, this type of financing is mainly dependent on the underlying asset — in this case, the multifamily property you’re attempting to buy.

To be clear, you’ll still typically need to meet the lender’s credit standards. However, the loan approval isn’t dependent on your income or employment qualifications.

On the contrary, the main qualification is whether the rental property you want to buy will deliver enough cash flow to justify the mortgage. Asset-based lenders use a metric known as the debt service coverage ratio, or DSCR when evaluating loan applications. This is the estimated rental income expressed as a multiple of the monthly mortgage payment including taxes and insurance. 

For example, if an asset-based lender requires a DSCR of 1.3, this means that if your mortgage payment will be $1,000, the property needs to bring in a rental income of $1,300.

In addition to ignoring your personal DTI ratio, another big advantage of asset-based investment property loans is that they don’t need to be made to you as an individual. Many asset-based lenders prefer to loan to an LLC.

To be clear, asset-based loans tend to be more costly than conventional loans. Still, these can be great ways to finance investment properties in many cases as long as the property still generates positive cash flow despite the higher cost of the loan.

 

The bottom line

 

To sum it up, several factors determine rental property affordability. It isn’t enough to just have enough money in the bank now. You need to be sure that your financial health is strong enough to invest, that you can cover all of the costs of buying a property with some cushion in case things go wrong, that the rental property won’t deplete your savings after you buy it, and that you’re able to obtain financing.

If you answered yes to all of the questions discussed here, you could indeed be ready to take the plunge into investment property ownership.