Since I’ve been in real estate, I’ve seen investors infatuated over 2-4 family dwellings (i.e., duplexes, triplexes and fourplexes). The reason: these properties have the ability to produce high cash flow, and conforming loans are available (30-year, fixed rate mortgages) for long-term financing.
When a real estate investor finds one of these deals where the returns look compelling, they are often frustrated by the fact that the ARV is not proportionate with the income it produces, and many times that blows up their deal. How does this happen? Most of the time the investor is using a rental multiplier approach or the NOI approach to determining the value, and that gets them into trouble.
Consider the following example. Our client John was recently looking at a duplex that had 3 bedrooms and 2 bathrooms on each side, and would rent for $950 per side per month. With $1,900 per month in total rent, John assumed the value could be based on a gross rent multiplier (GRM) of at least 100 (meaning 100 X rent), making the ARV worth $190,000. Although appraisers do look at the GRM on investment properties, it’s not going to be used to determine the value for a conforming or conventional loan.
Even worse is when investors start to analyze fourplexes as small apartment buildings using a net operating income (NOI) calculation, which is the commercial property approach. This approach to value takes the total rent minus total expenses, not including the debt service. Although it’s always good to know what the NOI is, the lender in the transaction will not allow the appraiser to use this method to determine the value.
The Challenge and Reality
Although they are multi-family by nature, 2-4 family properties are considered 1-4 family from a lending perspective. This means they will be appraised just like a single-family property does using a sales comparable approach. In many markets in Texas, there are not enough sold comps to support a value equal to what you would get by taking either of these approaches. Why is this the case?
To answer this question you have to ask yourself: who buys these types of properties? With some exceptions, most of the time the buyers are investors. How do investors buy? Most investors try to buy at a discount to the market value, and many times are buying off market. When there is not enough sales data available, the value becomes more difficult to determine, and this in turn tends to lower the value of the property.
Many times (but certainly not all) we see the value in the 2-4 family deals coming in at the purchase price plus the repairs. In the scenario above, John’s purchase price was $152,000, with $16,000 in repairs. The appraised value was $170,000. However, his positive cash flow is almost $800 per month with a cash-on-cash return of 24%. He had to bring $40,000 to closing, but wanted the returns this deal offered. The point here is don’t get too disappointed if the value is not where you think it should be for these types of properties. Just set your expectations up front and know what returns you need to make the deal happen for you. You might end up finding a deal that works.