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You Need to Start Small, Big Deals Are Too Risky (Real Estate Investment Myth)
By eric | November 19, 2007
There is nothing wrong with starting small. Perhaps you’re thinking about buying a $250,000 single-family home and making it a rental property. Or even a $320,000 duplex. But why rule out a $2 million, fifty-unit building? Believe it or not, any of these properties are within your reach.
Of course right now you’re thinking, “No way! I can’t afford a $2 million mortgage!” And to that I say, you may be right, but you don’t have to be able to afford it. Here’s why. Mortgages on smaller properties like single-family homes are almost always guaranteed through the buyer’s own personal earning potential and wealth. You may be surprised to learn that larger investment property loans are secured by the asset itself. In other words, instead of the $2 million building riding on your own wealth, it is riding on its own valuation. This already is less risk to you.
Let’s look at the previous example. The condo I purchased for $116,000 with a $20,000 out-of-pocket down payment was 100 percent my responsibility from mortgage to management. The $9 million project that I owned 10 percent of for no out-of-pocket cost was actually less risky because I had no cash invested and the property was professionally managed. The other property was mine, all mine—for better and for worse. Five years later, I sold the condo for $121,000, a gain of $5,000. Recently we refinanced the 182-unit building, which we had owned less than a year. Its newly appraised value was $11.3 million, more than $2 million above what we paid for it. And since I own 10 percent of the project, I made over $200,000 in less than a year. A testament to the power of buying and managing right and managing well.
This example also demonstrates risk related to valuation. When you buy a house or condo and rent it out, appreciation of the property rests solely on the appreciation of the surrounding neighborhood. You better have bought in the right neighborhood, because there is little you can do to increase the value of your property. By contrast, appreciation in commercial property, like apartment buildings, is based on the cash flow of the property itself. The more money it makes, the more money it is worth. Now you’re in control! When cash flow increases so does the value of the property. Manage your property right and you’ll increase the value. Don’t manage it right, and the value will stay the same or go down.
Another way larger properties are less risky relates to occupancy. When a single-family home is rented, it’s 100 percent occupied. When it is empty, it is 100 percent vacant, and you are covering the mortgage out of your own pocket in its entirety. In a larger property, even an eight-unit building, if one resident leaves, you still have seven residents paying rent. Your exposure related to occupancy is greatly reduced the more residents you have.
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