Should You Invest in Five Single-Family Units or a 5-Unit Multifamily?

Posted by on Sep 30, 2017 in News | No Comments

investment real estate
I’ve heard more and more people ask lately whether they should buy a handful of single-family residences (SFRs) or one larger multifamily residence (MFR). Regardless of how many properties or units you are considering, the question remains—buy several SFRs, or one MFR?

There are essentially two questions embedded in this one question, and you should evaluate the pros and cons of each in order to determine which is right for you:

  1. SFR or MFR?
  2. Residential or Commercial?

Residential MFRs can hold up to four units. An MFR with more than four units is considered a commercial property. So let’s consider the questions I’ve posed, beginning with the first:

SFR or MFR?

As with most things, there are pros and cons to both options. For more detail on comparing the pros and cons of SFRs vs. MFRs, read this, in which I further explain the two types of properties and what to consider before investing in one.

In less detail, the factors I consider when weighing SFRs vs. MFRs are as follows: property cost, financing, maintenance expenses, management, vacancy expenses, cash flow, location, tenant quality, tenant turnover, appreciation, and exit strategy. In my opinion, there’s no right or wrong answer to which one to buy—SFR or MFR—when you are only considering residential properties. The only time you can go wrong is if you invest in an MFR that either has the same cash-on-cash return, or a lower cash-on-cash return, as an equivalent SFR. This is because typically MFRs come with slightly more inherent risk, due to the lower tenant quality and higher tenant turnover that can come with multifamily units. [Note: As with anything, my advice is completely dependent on individual situations.]

If we are comparing apples to apples with SFRs vs. MFRs, the MFR should come with a higher proposed or advertised cash-on-cash return, because you assume more risk with an MFR. There’s no point in taking on a lower return if you are still running at higher risk levels. I am only willing to accept lower returns if there’s a tradeoff—that I’m investing in a lower-risk property. Make sense? If you aren’t overly familiar with calculating cap rates and returns, this article will help you get up to speed.

For the most part, I believe that the pros and cons of residential SFRs vs. residential MFRs tend to balance each other out. There isn’t necessarily a wrong decision.

Ultimately, what you should first consider with either type of property is the numbers. Which scenario offers the highest returns? Whenever considering which properties to invest in, always run the numbers first. If the numbers are similar, the next things to consider are your own personal interests and risk tolerances: Maybe you’ll love the look and feel of a particular SFR so you’ll buy it. Or maybe the idea of having more than one unit under one roof really gets you excited. Maybe the idea of multiple units terrifies you, or you are absolutely bored with the thought of simply having a single unit.

Remember that certain markets may be more favorable than others for SFRs or MFRs. In some markets, it’s often easier to get a good cash-flowing SFR over an MFR. When investing, I’ve worked within several states at a time. And at any given moment, half (or less) of the markets I’m working in offer good cash flow on MFRs. More than once, the markets that have offered good returns on MFRs have offered significantly higher returns on MFRs than on SFRs. So again, it’s really all about the numbers. Depending on what the numbers look like, you may not even have to think too hard about which type of property to buy.

Now that you have a general understanding of SFRs vs. MFRs, let’s move on to the second question:

Residential or Commercial?

As you may have guessed, there are pros and cons to both residential and commercial property investments. Keep in mind, I’m creating this pro list to address buying several SFRs vs. one larger MFR, so a consideration like “entry price” will not be included since I’m assuming the price will be similar for either purchase (ie. buying five SFRs vs. one 5-unit commercial MFR).

Residential pros:

  • Diversification. If you have one property that struggles to perform, you’ll have four more completely separate properties to help carry the weight of the lower-performing one. You could even sell the low-performing property while keeping the high performers, continuing to optimize your portfolio. Basically, your metaphorical eggs will be spread throughout five baskets—and you can even spread those eggs out in different geographic locations to further diversify your portfolio.
  • Market appreciation. Residential properties get to take advantage of market appreciation. Depending on where you buy and when, this could mean a tremendous amount of appreciation per property. Commercial properties, on the other hand, are valued based on income.
  • Tax benefits. Residential rental properties are the single-most tax-advantaged asset class in the tax system. Writing off five separate properties on your taxes can be freakishly beneficial to your bank account.
  • Cheapest loan options around. Residential mortgages get the best loan rates!
  • Exit strategy. If you decide to ditch the property, you’ll have the option to sell it to a primary homebuyer and not just to fellow investors. Primary homebuyers will almost always pay more for a property than an investor will.

Commercial pros:

  • One roof. One address; one property; one source for management; one tax return; one hassle; less confusion. This notion, all by itself, is typically what wins over a lot of investors.
  • Financing. This could go either way, because a higher down payment is usually required for commercial buildings. However, I’m putting this in the pros list because the financing qualification for a commercial property is based almost solely on the income the property generates. This is highly advantageous for anyone who won’t qualify personally for a mortgage or residential loan.
  • Market independence. Commercial properties aren’t completely market independent, but they aren’t likely to crash as hard (or as fast) as residential properties. Again, commercial property values are based on the amount of money they make, not the market. A crash could affect the rent that each unit brings in, and that can in turn affect the property value—but it won’t be as directly affected as a residential property.

As I said, I’m writing these lists by considering the advantages of buying five SFRs vs. one 5-unit MFR. If I were to delve into other types of commercial buildings such as retail spaces or triple-net buildings, there would be added pros like lease lengths, business tenants rather than individuals, stability over time, and more. Keep these in mind if you are diving further into the commercial realms, but for the sake of this article, I’m leaving them out.

Which is better? Five SFRs or One 5-Unit MFR?

This is where it’s going to come down to your own personal preference. As I’ve displayed, there are advantages to both.

Use this checklist to evaluate your options:

  • The numbers!
  • Diversification
  • Options for adding value
  • Risk
  • Exit strategy
  • Financing options
  • Financing qualifications
  • Management options
  • Tax benefits

You should have a working understanding of how each property type affects the factors listed above in order to determine what best suits your situation. Numbers matter; the market matters; and make sure you are comparing apples to apples not apples to bananas; and then make your choice!

What do you think? Are you leaning towards buying several SFRs or one larger MFR?

From Bigger Pockets