Many first time home buyers wonder if they should consider purchasing a multi-family property to help defray the cost of home ownership. Rental income tempts many buyers to start out with a multi-family home that can be retained as an investment property in future years.
A multi-family property is defined as a two, three or four unit property. Properties with five or more units are considered commercial properties, and as such require commercial mortgages. Single family homes with in-law apartments usually are not considered two family properties, but may be depending on the size of the unit in relation to the entire home.
Before jumping into a multi-family property, a home buyer must consider both the financial and lifestyle ramifications. Many inexperienced home buyers think that being a landlord means depositing a rent check. When a buyer becomes a landlord, he or she essentially takes over a small business. The asset of the business is the property, and the tenants are the customers. The landlord must maintain the physical asset, provide customer service to tenants and hopefully earn a profit on the operations.
Most multi-family home buyers make two financial mistakes when planning for a purchase. The first is to assign the maximum possible market rent as the rent that they will receive from their tenants. There is a direct correlation between rent prices in relation to competing apartments and the amount of turnover among tenants. In other words, the higher the rent, the more likely that a tenant will move within a short period of time. This is due to the basic laws of supply and demand: tenant consumers will constantly seek out the best value for the lowest price. In addition, the higher the rent, the more incentive a tenant has to attempt to purchase their own home. Landlords should consider pricing their rentals competitively to reduce turnover, marketing expense and time taken to rent units.
Potential landlords also fail to make adequate provisions for rent losses due to vacancies and repair expenses on the rental units. If an apartment normally rents for $1,000 per month, most buyers will simply figure their monthly payment and subtract the $1,000. No apartment anywhere has ever stayed 100% rented forever. Even the normal process of tenant turnover will often cause the loss of one month’s rent. Prudent landlords should budget at least one month of vacancy per year in good rental markets, and two to three months of vacancy per year in softer markets. This means that in a good market, the property in the example above would generate $917 per month on average instead of the ideal $1,000.
Repair expenses are also vastly underestimated. If a new landlord is able to make most simple repairs, then costs should be limited to materials only. A landlord who must hire out all repair work however, will quickly find bills mounting. Holiday weekend midnight calls to plumbers for broken pipes can inflict major casualties on a property’s cash flow. Landlords must set aside a portion of rent revenues each month to prepare for these expenses.
Tenant relations is another vital function of property management, especially when the tenant is directly above or below the landlord. Issues such as noise, parking and garbage are hard enough for one family to manage, but the landlord must help between
two and four families manage these issues without driving each other crazy. Landlords can issue rules to tenants, but there is little recourse against non-compliant tenants except eviction.
Owners of multi-families must also understand that their property will take longer to sell and will probably not appreciate in value as fast as a single family property. Multi-families suffer faster physical deterioration due to tenant wear and tear that is much heavier than owner-occupied dwellings. Moreover, less than five percent of the general home buying public actually purchase multi-family properties as their primary residence.
Multi-family homes have often had additional apartment units created without proper zoning approvals. For example, many landlords convert the large attic of a two-family into a small studio or one-bedroom apartment. Owners avoid obtaining approvals either because zoning would not allow the change or because they fear higher tax assessments with an additional income unit.
No buyer should attempt to purchase a property that does not have proper zoning approvals, building code compliance and certificate of occupancies. Lenders will not permit a buyer to obtain a mortgage that is missing any of these vital elements. More im
portantly, insurance companies will deny any claim by a property owner for a loss on a property that did not have all approvals in place. The last problem a new owner wants is to have town officials knocking on your door the day after you move telling you that you are going to be fined for a zoning or building code violation.
Finally, multi-families are treated differently by the IRS for federal income tax purposes than a single family home. Specifically, the home mortgage deduction is only available for the portion of your home that is used as your residence. A home owner who lives on the first floor of a three family home may only deduct one third of the mortgage interest for the property.
While many parts of being a landlord can be overwhelming, owning an income producing property can be an excellent long-term project if managed properly.
Michael Licamele is the Editor of MortgageAlmanac.com and President of Residential Finance Network at rfnc.com.
