Many people often ask how to get started investing in real estate. There are certainly several avenues – start by buying a small rental property, co-invest in a larger project with other equity investors, partner with a seasoned developer, buy into a REIT, and more. Yet one of the most popular strategies for first-time investors is to buy an owner-occupied multifamily property.
There are several reasons to consider in making an owner-occupied multifamily property your first investment, which we’ll get into later in this article. As you’ll see, it’s one of the easiest ways to build equity and potentially even live for free! This double-whammy has significant long-term implications for those looking to invest in real estate and grow their portfolios over time.
What are owner-occupied multifamily investments?
The average person lives in either a single-family home, a condo, or an apartment building. These apartment buildings are one form of multifamily home. A multifamily property is simply one that contains more than one residential unit under the same roof, wherein all units are owned by the same entity.
This last point is an important distinction, and it’s what differentiates a multifamily property from a condo building. In both cases, there is more than one unit in the building, but in the case of a condo building, each unit is individually owned and has its own deed reflecting that ownership.
There are many kinds of multifamily properties. A two-family home is often referred to as a duplex. A three-family home is often called a triplex, three-family, or triple-decker. Regardless of how many units are in the building, any building with more than one unit is referred to as a multifamily property. A 500-unit apartment community is considered a multifamily property just the same.
An owner-occupied multifamily property is one in which the owner of the building personally occupies one of the residential units in the building. There are several benefits to doing so, which we’ll touch on later, but in order to reap these benefits the property usually has four or fewer units (one of which is occupied by the owner). Properties with five or more units are considered commercial property and are treated differently by investors and lenders. To be clear, a property can be both a multifamily property and a commercial property (5+ units). The reason for the distinction is how the United States government treats 2-4 unit properties versus 5+ unit properties. The FHFA which is the governing body of Fannie Mae and Freddie Mac treats 2-4 unit properties as residential which means they get almost identical financing as houses and condos, versus 5+ unit properties which are treated as businesses, not residences.
Why buy a multifamily property?
There are many reasons to buy a multifamily property, whether as an owner-occupant or as a commercial real estate investor. The benefits of investing in multifamily properties include:
- Scalability. It is much easier to scale your real estate portfolio by investing in multiple units at once vs. buying single-family homes or condos to rent.
- Shared building infrastructure. Multifamily properties typically have shared infrastructure, such as a common roof, common landscaping, common lobbies, shared HVAC systems, and more. It is easier to maintain one (albeit perhaps larger) infrastructure than it is having to maintain multiple properties with their own individual systems. For example, when you need to repair the roof on a 50-unit apartment building, it’s only one roof that needs to be repaired. When you need to repair the roof on 50 single-family homes, you’re repairing 50 roofs, one by one.
- Cash flow. Leasing multiple units means having multiple income streams coming in every month. If for some reason one tenant does not pay their rent, there are other incomes coming in to offset the impact of that non-payment. When leasing individual properties to a single tenant, if that tenant does not pay their rent, the owner is at higher risk of defaulting on their mortgage if they cannot cover the cost. In other words, there is less risk associated with buying multifamily properties than single-tenanted properties.
- Management efficiencies. Multifamily properties have the benefit of using shared service providers, such as leasing brokers, property managers, contractors, marketing agencies, and more. Larger multifamily properties sometimes warrant having these people on-site every day. It is harder to manage a portfolio of single, disaggregated properties, particularly if these properties are located in different geographies.
Advantages of owner-occupied multifamily investing
In addition to the overarching benefits of multifamily investing, there are specific benefits to owner-occupied multifamily investing.
- Better terms on financing. One of the biggest benefits to buying an owner-occupied multifamily property is your ability to get better terms on financing. We’ll get into this in more detail below. But in short, most banks are willing to give better terms when lending to an owner-occupant, including lower interest rates, less of a down payment, and less onerous personal guarantees.
- Lower barriers to entry. Because owner-occupied multifamily properties provide such advantageous financing, it can make it easier for someone to invest in a property they’d have otherwise been unable to afford. For example, most lenders will require an investor to put down at least 25% when buying a multifamily property. If someone wanted to purchase a 4-unit property worth $1 million, they’d have to put down $250,000 right out the gate – a major barrier to entry for those looking to invest in multifamily real estate. Conversely, if that same person were to owner-occupy the property, they may be able to purchase the property for as little as 3% down depending on their individual circumstances. They’d have to come up with $30,000 as a down payment, which isn’t insignificant, but it’s far less than a non-owner-occupant buyer would need to invest.
- Offset mortgage costs. Another benefit to owner-occupied multifamily investing is that the income from the rental units offsets the cost of the mortgage. For example, a 1,500 square foot single-family home that sells for $400,000 with 20% down at a 4.125% interest rate will cost approximately $1,500 per month. Add taxes and insurance, and that could jump to approximately $2,000 per month. An individual might be pressed to afford a $2,000 payment each month, and therefore, this home is no longer within their reach.Alternatively, let’s say that same person looks at owner-occupying a multifamily home. They look at a triplex where each unit is approximately 1,500 square feet. The property is selling for $815,000. Initially the person who couldn’t afford the $400,000 home may laugh at the suggestion that they consider a $815,000 home instead. But that’s the beauty of owner-occupied multifamily investing. That $815,000 home with 25% down at a 4.125% interest rate is now looking at a monthly mortgage payment of $3,100 per month, or about $4,000 a month with taxes and insurance included.$4,000 per month sounds expensive, but the owner now has rent coming in from the other two units to offset the mortgage costs. If the owner can rent each of the other two units for $1,500 per month, then they’re just paying $1,000 to live in a 1,500 sq. ft. unit – nearly half of what they’d be paying for the single-family home. In an even better scenario, each unit would rent for $2,000 per month, thereby covering the entire cost of the mortgage, taxes and insurance. In that scenario, the owner lives for free while building equity in an $815,000 home.
- Ability to test the waters. The benefits of owner-occupied multifamily investing are balanced with the reality that this approach means becoming a landlord. Some people think they want to be a landlord, others aren’t so sure. The benefit of owner-occupied multifamily investing is it allows someone to test the landlord waters before investing in a larger multifamily property. When you live on-site, you can ease into being a landlord. It’s easier to respond to repair and maintenance requests, easier to collect rent checks, etc. After managing the owner-occupied multifamily property, you can get a sense for whether this is something you want to commit to on a larger scale (or alternatively, if you’d prefer hiring a property manager in the event you go on to grow your real estate portfolio).
Disadvantages of owner-occupied multifamily investing
Owner occupied multifamily investing isn’t for everyone. Before taking the plunge, it’s important to consider some of the disadvantages of owner-occupied multifamily investing, including:
- Becoming a landlord. Becoming a landlord seems like a great idea, until you’re faced with your first middle-of-the-night call from a tenant whose pipes have frozen and are at risk of bursting, or until you’re dealing with a tenant who habitually locks themselves out of their unit and asks you to come let them in, or a tree comes down in a wind storm and damages your roof. These issues can be hard to predict, but inevitably arise and require a landlord’s speedy attention. Some issues are easier to resolve than others, particularly if you have strong relationships with contractors, but some issues are more complicated (and costly) and can weigh on a landlord.There are other issues, such as a tenant who is habitually late paying their rent. In the worst-case scenario, you then have to deal with evicting a tenant – a stressful process that can be lengthy and costly and particularly unpleasant if they are living in the same building you occupy as owner.
- Reliance on cash flow. Related to the point above, when you’re a landlord counting on rental payments to cover your monthly expenses, a sudden gap in cash flow can prove problematic. Using the example of the $815,000 three-family home where two units rent for $1,500 per unit, if one tenant vacates the property or otherwise doesn’t pay rent, the owner now must cover that $1,500 plus their own $1,000 contribution – a $2,500 outlay that may be hard to afford. This is why it is so critically important for owner-occupied multifamily investors to set aside some cash reserves in the event cash flows are disrupted for one reason or another.
- Sharing your space. Simply put, some people just prefer having their own space and, in this case, buying a single-family home is likely a better option. When you owner-occupy a multifamily property, you’re more apt to interact with the tenants living in your building, whether in the driveway, foyer, backyard areas or otherwise. Sometimes, people just prefer solitude, which is hard to come by when living in a multifamily property.
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How to finance owner occupied multifamily homes
One of the biggest benefits to owner-occupied multifamily investing is the advantageous financing available to buyers. With a traditional investment property, most lenders will look for at least a 75% loan-to-value ratio, meaning the buyer has to put down at least 25% of the purchase price (or the appraised value – so if the purchase price is more than the appraised value, the buyer has to cover that spread and then put down 25% in addition). As we showed with an example early on, that can be a lot of money.
In fact, coming up with a 25% down payment is one of the largest barriers to entry for those looking to invest in rental property. The key is getting over that hurdle.
That’s where owner-occupied multifamily investing comes into play. If you owner-occupy a property, in some circumstances a bank will allow you to put down as little as 3% down. The interest rates are also lower for owner-occupants, often times as 50 basis points lower. Whereas a traditional investor has to put down 25% and may be paying a 5% interest rate, an owner-occupant can put down as little as 3% and may get an interest rate closer to 4.25% or 4.5%. It may not seem like significant, but those savings add up.
There are several loan programs that owner-occupiers can use to invest in multifamily property. The most commonly used program is an FHA loan, which are loans backed by the federal government. FHA guidelines require the property to be owner-occupied, and in exchange, allow buyers to put down as little as 3.5% as long as they have a credit score 580 or higher. However, buyers who use the FHA program and put down less than 20% are required to pay what’s known as “private mortgage insurance,” or PMI, which can cost a few hundred dollars each month. PMI is essentially an insurance policy for the bank since they’re offering a loan with such a high loan-to-value ratio.
We mentioned being able to put down as little as 3%. Anyone considering an owner-occupied multifamily investment will want to talk to their local banks. Many states have programs in place for first-time homebuyers that are similar to FHA, but even more advantageous to the buyer. For example, some states have what’s known as a “soft second” mortgage program. These programs allow banks to issue two loans on an owner-occupied property: the first loan is for 80% LTV, the second loan is for 17% LTV. The second loan, which is the “soft second,” is guaranteed by the state, which offers the bank some level of protection. Programs like these often have relatively low interest rates (lower than 4%) and can be structured with no PMI. However, these programs are often income-restricted, meaning you must earn less than a certain threshold to qualify for the program. (Note: you only need to earn less than that threshold in the year you purchase, making this a great program for young people or those who have higher-income earning potential as they grow in their careers).
There are also programs that offer 100% financing, or zero percent down. The Veteran’s Administration (VA) has a loan program that allows enlisted or former military personnel to purchase owner-occupied property with 0% down as long as they have a credit score of 620 or more.
Of course, there are traditional bank loans available to owner-occupied multifamily investors as well. Most will look for the buyer to put at least 20% down or will charge PMI until the loan is paid down to an 80% LTV. And please note, all these different kinds of loans vary over time and in requisite qualifications so be sure to check with your local banker for details.
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Is an owner-occupied investment strategy right for you?
Investing in owner-occupied multifamily real estate is a great option for someone looking to buy their first rental property. One common misconception is that you must owner-occupy the property indefinitely. That’s not the case. You can invest in an owner-occupied multifamily property, live there for a few years, and then move on to your next investment (perhaps even another owner-occupied multifamily). There are additional tax benefits to doing this, as well. For instance, if you want to sell the property and it has significantly appreciated in value, you can take a capital gains deduction of up to $250,000 (or $500,000 per married couple) if you have owner-occupied the property for the last 3 of 5 years, for that part of the property in which you lived.
As you can see, owner-occupied multifamily investing has some significant benefits for all of the reasons noted above. Yet this approach isn’t for everyone. You must weigh the pros and cons – particularly the decision as to whether you’re up for becoming a landlord. It’s no easy task, but it can be worth the effort over time.
Anyone who is considering investing in an owner-occupied multifamily property should start by doing their homework. What are multifamily homes selling for in your area? What is the rent potential for the units you’d want to lease? How does this impact how much you’d be able to afford to buy? How much maintenance will a property need and are you willing to invest your time and effort in managing a building?
Indeed, as a condition of FHA, soft second, and VA loan programs, many banks will even require you to attend a “landlord training” class before entering into a purchase and sale agreement so you fully understand your obligations as a new landlord (legal and otherwise).
All these questions and considerations are important to answer particularly when thinking of purchasing an owner-occupied multifamily residence as way to get into real estate investing.
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