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Debbie, Home Buyer in San Jose, CA

Duplex as an investment - 3/2 or 2/1?

Asked by Debbie, San Jose, CA Fri Apr 10, 2009

We would like to purchase a duplex as an investment in either Blossom Valley or Cambrian. My husband and I are debating on a few things. 1) In our price range we see at the higher end 3br/2 ba 2br/1ba units and at the low end 2br/1ba 2br/1ba units. Both fairly equal neighborhoods and similar amenities. He says we should spend the extra $ (roughly $100k more!) on the larger duplex. I'm not sure I agree. Thoughts? 2) What is your opinion on the ability to rent a 2br/1ba versus a 3br/2ba? Both have yards and a private garage. Is a 3br THAT much easier to rent out than a 2br ? Does one or the other have an advantage?

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Dp2’s answer
Michael, no problem. :) I could see that's where you were going, and I wanted to help you to make your point with some real numbers (it's the consultant in me). Besides, I can tell from your comments that you're either an investor (as am I) or you at least work with and understand them, and most investors I know--including all of my mentors--are pretty generous about sharing what they know (because they want to help others to learn how to buy properties the right way).

Debbie, I know for sure that you can buy some duplexes in the bay area (especially closer to some parts of Oakland) with the numbers I presented earlier, because I've seen (and ran the numbers for) some of those deals. However, it will probably be much easier for you to purchase a 4-plex that will yield similar numbers.

The key to buying a property right has less to do with buying it cheaply; rather, the key is to understand how the numbers work and what they mean--whether you use third-party software or write your own software as I do. The point is that your purchase price--even if you were to obtain a property for free (legally)--won't matter if the numbers don't work. Again, Michael is correct: "[there] are so many ways to look at the numbers. . . ."

Additionally, don't let the sticker price scare you. There are lots of ways to finance the purchase of an investment property: seller financing, conventional (commercial and residential) financing, private money, partnerships, etc. Each method has its pros and cons, and you could even use 2 or more of them together. The most difficult part of buying an investment property is finding and structuring the deal itself. if you put together the right kind of deal, then the money will come.
0 votes Thank Flag Link Sun Apr 12, 2009
Hi Debbie, Speaking for myself...You are welcome for the little advice I have tried to give! I won't pretend to have the answer off the cuff with regard to SFH/Duplex. There are so many ways to look at the numbers it can be daunting. Do you HAVE to have your investment property very close to you? Could you possibly consider a12% cap rate and afford a property manger to take care of the monthly tasks? I would reconsider all my options before I gave up on duplexes. Often, obaining a comprehensive spreadsheet, prepared by professionals, will prevent you from becoming overwhelmed with trying to become an Excel engineer?:)

Have you considered a free consultation?


Michael
http://www.MichaelRobertsHomes.com
0 votes Thank Flag Link Sat Apr 11, 2009
Thanks for all the great advice. I'll have to mull this one over, not to mention get out my calculator! But at first glance, it seems nearly impossible to have a 10% cap rate (or anything close to that) in the SF Bay Area! In the the South Bay Area, duplex prices are in the $400k's (very low end for 2/1s) and $500k+ (very low end for 3/2 + 2/1 units). I don't want to much above this. Maybe I should be considering a single family home instead of a duplex???
0 votes Thank Flag Link Sat Apr 11, 2009
Dp2, Ha Ha! Thanks for carrying my Water! You are absolutely on point. I was afraid I would sound like a "Know it All". :) Ecuse the baby steps!

Great info on trulia once again!

Michael,
http://www.MichaelRobertsHomes.com
0 votes Thank Flag Link Sat Apr 11, 2009
First, the 3/2 will be your best option in most cases, because 3/2 properties are the ones that transact most frequently in most markets.

Second, although cap rate (NOI/[purchase price]) is important, it's kind of meaningless to discuss cap rate without also discussing the interest rate of the loan (assuming you intend to finance your purchase). Stated another way, one should use the cap rate, NOI, and DCR (NOI/[12 * mortgage]) to compare apples to apples for rentals (aka income properties). Nevertheless, Michael was correct that many investors use cap rates (and the ROI) to compare different classes of investments.

Third, I'll borrow Michael's 3/2 rent (1900--which I also validated via zilpy.com) to use in some calculations. Although Michael mentioned earlier that he likes to purchase properties minimally at 8% cap rates, I prefer to purchase them minimally at 10% cap rates. Additionally, I also structure all of my deals minimally to have a DCR of 1.2 (usually at least 1.4).

(where 7.41 = [12 months]*[.95 occupancy]*.65 [assumes 35% operating expenses])

NOI = 7.41*1900*2 = 28158

purchase price (at 10% cap rate) = NOI/.1 = 281580

(assuming 30-year fixed at 6% APR at 80% LTV with cap rate of 10%)
mortgage = (.8*NOI/.1)*(.06/12)/(1-pow(1+.06/12, -360)) is roughly 1350.57
DCR = NOI/(12*mortgage) is roughly 1.74
monthly pre-tax cash-flow = (DCR-1)*mortgage is roughly 995.93

purchase price (at 8% cap rate) = NOI/.08 = 351975

(assuming 30-year fixed at 6% APR at 80% LTV with cap rate of 8%)
mortgage = (.8*NOI/.08)*(.06/12)/(1-pow(1+.06/12, -360)) is roughly 1688.21
DCR = NOI/(12*mortgage) is roughly 1.39
monthly pre-tax cash-flow = (DCR-1)*mortgage is roughly 658.29

Glen also made a pretty good point about considering the cost for any immediate repairs (required to get the property into rentable condition), but that will mainly effect your cash on cash (or ROI), and they need to be added to the operating expenses.
0 votes Thank Flag Link Sat Apr 11, 2009
Hi Debbie, Most everyone will agree that we will see a continuing tightening of available Single Family Homes for the better part of this year. Blossom Valley is a pretty robust market. There are fair school choices and community friendly services nearly within walking distance of all neighborhoods.

Rental prices are very good still. I would venture to estimate only 1 in 10 properties stays vacant over 6 weeks. Those are usually condition challenged. :)

With the investment dollars you are considering...Would you consider different options/locations?

Michael
http://www.MichaelRobertsHomes.com
0 votes Thank Flag Link Sat Apr 11, 2009
So in your opinion(s), how is the rental market now, particularly for Blossom Valley?
0 votes Thank Flag Link Fri Apr 10, 2009
Hi Debbie, Cap rate is the quotient of rental income divided by purchase price less cost to maintain not including loan cost and potential repairs. Using a number of other factors loan costs, repairs etc. will give you a net cap rate.

When you are comparing properties for investment , cap rate is a key indicator of the performance you can expect from your investment. There are software programs available that cover a number of the factors you will want to know. Some cover more than others so I created one that meets my criteria.

Trying to figure future returns (appreciation) would be another equation and would need to addressed with imperical data derived from historical sales and trends. Maybe more of an art than science.

Michael
http://www.MichaelRobertsHomes.com
0 votes Thank Flag Link Fri Apr 10, 2009
If you make $100k a year on your rental and it cost you $1 million to purchase this is how you would calculate the cap rate.....

annual net operating income / cost (or value) = capitalization rate

$100,000 / $1,000,000 = 0.10 = 10%

All things equal (ie condition of property) the higher cap rate offers the higher return. It's a formula you can use to compare different buildings to see which is the better investment. If the 2 bed 1 bath unit has a higher cap rate then the 3/2 that may be the better investment. You still need to factor in repairs and vacancies potential changes in rent down the road etc. If you knew you could invest your money risk free in a bank for 12% that would be a better investment.

PS It will most likely be a very long time before you get 12% at the bank :)

Glen Mitchell
Broker
408-497-1838
0 votes Thank Flag Link Fri Apr 10, 2009
All makes sense. I'm a little nervous about the additional investment $ for a 3/2 vs. 2/1. Doesn't give me as much buffer as I'd like, but you all bring up good points. I like the financial spreadsheet approach. But what is the cap rate you discussed?

Also, when you say it shows a better return do you mean in the long run (including appreciation) or do you mean in terms of rental income?

Thanks,
0 votes Thank Flag Link Fri Apr 10, 2009
Hi Debbie, After owning several investment properties in Blossom Valley I learned That a three bedroom with 2 baths has always shown a better return. Glenn's post reminds you of the importance of cap rate. I use an excel spreadsheet to do my calculations and I include a number af factors to drill down the numbers to really understand my investment in clear terms. I look for an 8% cap rate most of the time and use. in Blossom Valey, a 5.3% vacancy rate to help my net numbers reflect reality.

Here is a hint: 3/2 rents are appx. 1900-2200 per month...2/2 rents are appx. 1200-1600 per month and finally 2/1 rents are 1100-1400per month. These are best used today through Spring and will usually see a change after Spring. These ranges are based on condition for their respective upsides.

Have a Happy Easter weekend!

Michael
http http://:www.MichaelRobertsHomes.com

Keep up your hard work! It will pay off. Pencil the numbers as many ways as you can.
0 votes Thank Flag Link Fri Apr 10, 2009
My opinion would be the 3/2 as a better return on your investment.
0 votes Thank Flag Link Fri Apr 10, 2009
It’s not really that a 3 bedroom is easier than a 2 bedroom to rent out; it’s a 2 BATHROOM as opposed to a 1 bathroom.

Most people do not want to share a bathroom. :)
0 votes Thank Flag Link Fri Apr 10, 2009
Do you have current rent amounts, or projected rent amounts? I would start there and evaluate the rent income first before looking at other factors. Calculate the Cap rate and see which offers a higher return. You will then need to look at future costs of each building. Just because one has a higher return doesn't make it the best deal if it is going to need a lot of repairs and upgrades in the near term while the investment with the lower cap rate already has a new kitchen, roof etc and will not need as much money put into it. Start there and see what you come up with and then factor in 3br vs 2 etc. feel free to email me with questions or thoughts.

Glen Mitchell
Broker
0 votes Thank Flag Link Fri Apr 10, 2009
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