Investment Questions - 10/4/07

 

Question 1: "I am interested in purchasing some investment property.  What considerations should I keep in mind as I decide between targeting single family homes versus multi-unit (i.e. duplex, two-flat, three-flat etc.) properties?"

 

There are pros and cons to both single-family and multi-family rental properties:

 

Single Family

Pro:  These properties tend to appreciate well if located in a desirable location.  In addition, upon reselling the property down the line, you will likely have a much larger pool of potential buyers, which can make for a quicker sale.  Keep in mind that your potential pool of buyers will include both investors and individuals who wish to use the home as their residence.

Con: A single-family home will typically have only 1 tenant (except in the case of a rooming house).  This can be a drawback if the property is located in a slow-renting area, given that the exit of one tenant will result in the loss of 100% of rental income until another tenant is found.

 

Multi-family

Pro: A multi-family rental property has several tenants and therefore will not result in the loss of 100% of rental income when 1 tenant vacates. Often the rents on the other units will be enough to cover most, if not all of the underlying mortgage payment until a new tenant is found for the vacant unit(s).

Con: Resale of multi-family properties (3 units and up) require a larger down-payment than single-family units or duplexes. At the time of this writing, 5% down-payment residential funding is available for 1-2 unit rentals, while 15-20% is the minimum down-payment for a 3-4 unit.  Any property over 4 units will require commercial funding, which is another discussion in itself.

 

I’ve found that many new investors find 1-2 unit rentals easier to start with given the availability of financing for these types of purchases.  In the ideal case, an investor’s portfolio will have both single-family and multi-family rentals.  The US tax laws have many loopholes available to property owners, one of which allows the owner of a property to sell without realizing an immediate tax hit on the gain (IRC Section 1031). This mechanism can be a strong ally in growing your investment portfolio.  Leveraging this resource alongside a portfolio with easy-to-sell 1-2 unit rentals and larger multi-family properties can be a powerful resource for buy-and-hold investors.

 

 

Question 2: “A couple of friends and I have discussed pooling our funds to purchase some investment property. How should we organize ourselves to make things, such as the mortgage, taxes, and hopefully the future addition of new properties to our portfolio, go smoothly?”

 

I’m glad you’re considering pulling your group’s resources together to invest in real estate.  Keep in mind that working with friends can make for a fun and fulfilling learning experience, or it can end a friendship, if handles inappropriately.  There’s quite a bit of legwork you need to do upfront to prevent the latter. The key is to be very open with your partners up front to avoid disagreements down the line.

1. Discuss each of your goals to be sure these are in line.  If one of you wants to flip and other wants to buy-and-hold this conversation will offer an early indication that you may not want to venture into this partnership because is unlikely your actions and expectations will line up.
2. Put everything in writing upfront.  Ideally, you’ll speak with an attorney to set up an entity (LLC, Corporation) or a limited partnership (LP) to invest through.  The operating documents for these will spell out almost everything you’ll need to know up front (roles, initial investments and other monies required form each partner) the goal of the entity, etc…
3. Plan your exit are the outset.  Don’t leave this part undone.  When will your company dissolve?  What requirements does the group require before a partner can exit?  Will there be penalties if a partner decides to pull out early?  Given that you are pooling your money together, it might not be fair to allow partners to exit early on because if will leave the remaining partners with a heavy financial burden.  How will liability and profit be split between you?
4. If you plan to purchase property directly into your entity (LLC or Corporation), you’ll need to speak with a commercial banker.  Residential lenders will not allow a buyer to purchase a property in the name of a company, because they want to have direct recourse against the owner in the case of default.  Commercial lenders will allow this (but will likely require a personal guarantee from each partner) but commercial funding typically has higher rates and higher down-payment requirements, so depending on your combined financial strength, there may a drawback to this avenue if you are just starting out.
5. Speak with a CPA - as a group on behalf of the entity, and also individually with your personal CPA/tax preparer.  The way you set up the partnership (C-Corp, S-Corp, LLC with flow-through taxation, LLC taxed as a corporation, LP, etc…) will have a direct impact on your tax burden, so plan accordingly.

 

These are just a few items to consider.  A lengthy and open conversation with your partners is the best place to start.  Then speak with a CPA, corporate attorney (if you choose to set up an entity) and any other professionals related to your cause.  This will be time consuming, but trust me, it will save a lot of headache down the line.  Other than that, sharing the research and learning process with your friends can speed up the learning process and give you an outlet to share ideas and concerns with others who are on the same page, which is a benefit many individual investors don’t have. Keep me posted on your progress and good luck!