digest
Short Summary
Main recommendation: Small multifamily properties of two to four units are one of the best asset classes for growing a rental portfolio, and they should be underwritten by evaluating location and asset class, historical trends, in-place and market-comparable income, expenses, and current value. James Dainard says the equity built this way acts as "gunpowder" for buying more property, such as via a 1031 exchange or additional debt. The key is underwriting correctly so cash flow and equity growth can be forecast over the long term.
Key Points
- Two to four units are classed as small multifamily because they can be financed with residential loans (typically 30-year, principal and interest, 20 to 25% down), while five or more units move to commercial financing based on the property's income covering the debt.
- Location and asset class drive vacancy and rent growth: busy roads, nearby commercial, bad neighbors, or crime can lengthen lease times and lower returns.
- Historical trends such as average annual rent growth and appreciation over one, five, and ten years indicate expected performance; higher-growth areas produce bigger equity spreads and cash flow.
- Investors should set their own risk allocation by asset class and adjust the return they require: a Class A deal may accept a lower return, while a Class C deal may need a higher one.
- Current leases reveal in-place income, but comparables are needed to check whether rents are above market (possibly propped up by concessions) and whether there is upside within twelve months.
- Real net income depends on taxes, insurance, utilities, maintenance reserves, and any property management fees, and overpaying for a property creates negative equity that limits later refinancing.
Details Worth Noting
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Concrete instructions:
- Identify the asset class and location you will buy in, and set a required return for each class or area in your buy box.
- Check historical average annual rent growth and appreciation for the area over one, five, and ten years before buying.
- Review each existing lease for term (month-to-month, six, twelve, or twenty-four months), rent amount, and which expenses the tenant pays.
- Pull rent comparables of similar product. Prefer side-by-side duplex layouts with one shared wall over top-and-bottom layouts, which typically comp lower. Check whether in-place rents sit above market, and whether they could be increased or decreased within twelve months.
- Price insurance for the specific state and market before underwriting, since premiums vary widely (Dainard cites about $100 per door in Washington, with much higher premiums in Florida and Texas).
- Budget a maintenance reserve of about 1% of total annual income, and deduct property taxes, insurance, and utilities as core expenses.
- Compare self-management against a property manager's typical 5 to 10% of gross income plus any lease-up fees, and factor the chosen cost into the pro forma.
- Compare the purchase price to market value so you do not start with negative equity.
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Loan-to-value and equity position affect the ability to refinance, pull out cash, or use an investment HELOC later, and he describes equity as the source for a 1031 exchange or additional debt.
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He says he buys in any area and adjusts his return requirement by asset class rather than avoiding certain classes.
Bottom Line
Small multifamily underwriting comes down to accurately forecasting income, expenses, and value so the property builds cash flow and equity over time. Investors who price in insurance, reserves, and management costs, and avoid overpaying, create the capital to grow further.
