Rules of Thumb, Part 1.
In the previous article, we defined what an investing rule of thumb was and how they were useful in real estate investing. A rule of thumb is a guideline that provides simplified advice regarding a particular subject, in this case investing in real estate. The first three rules of thumb that were introduced were,
- Cash on Cash return
- Debt Service Coverage Ratio
- Cap Rate.
It is vital for investors to master these three ratios to become successful in real estate, and to follow these rules of thumb in any market cycle.
In this article, we are going to tackle unit mix. This ratio deals with what is the optimal unit mix in an apartment complex. As we mentioned previously, we are going to discuss guidelines pertaining to this ratio, and how to have this rule of thumb help you sniff out a good deal.
Listen to the Audio version of this Blog:
Demographics in the U.S. have shifted the past ten years, and we are increasingly becoming a renter nation. Baby boomers are down sizing and electing to rent, while millennials, saddled with student debt and delaying getting married and starting a family, are delaying the purchase of a home and choosing to rent instead.
The transient nature of the workforce, with the ability of many workers to work from almost anywhere, has also contributed to the allure of renting.
Finally, the American dream of home ownership was put to the test during the Great Recession of 2008, where around 30% of single-family homes were converted to rentals. The cost to purchase and maintain a home far exceeds the cost of renting in many markets.
For an in-depth dive into demographics, listen to our podcast with Chris Porter, author of Big Shifts Ahead: Demographic Clarity for Businesses.
Unit mix is simply the different number of bedroom apartments in a property. Apartments range in sizes from efficiency to 5 bedrooms. An efficiency apartment is usually occupied by a single person and combines the sleeping, living, and kitchen areas.
Studio apartments are larger versions of the same footprint, but tend to have a larger kitchen. We tend to shy away from properties that are predominantly efficiency or studio these types of apartments because the tenant base tends to be transient, which means that the tenants move in and out and create a high tenant turnover.
One of the largest expenses that a landlord incurs is tenant turnover because the unit has to be prepared for the next person to move in and, in the meantime, the unit remains unoccupied. In multifamily, we are selling time, similar to the airline industry. Once the airplane takes off, any seats that are left empty is lost revenue. If your apartment is vacant, that revenue is lost forever!
The next size is a one-bedroom unit, which can also have a higher turnover rate, but not as high as the aforementioned smaller styles. Typically, municipalities allow two tenants to occupy an apartment for each bedroom, and in turn, it shrinks the tenant pool.
However, it all depends where the units are located. Studios & one-bedroom units are favorable for college students, senior citizens, and couples. We own a 36-unit property that contains all one-bedroom units, and we have no problem maintaining the occupancy at 95%.
Our favorite unit size to work with is the two-bedroom units.
They’re ideal for most demographics yet larger families can’t occupy them. Larger families tend to cause more deferred maintenance on a unit, another costly expense for landlords. Two-bedroom units are usually the most cost effective for tenants and are the easiest to rent out.
The two bedroom unit mix increases the asset value due to increased rental income, and will make it easier for the landlord to rent out the units as well as choose from a larger tenant base. Tenants also have the option of moving up or down a size without having to leave the property, which also benefits the landlord in that it reduces vacancies.
The three-, four-, and five-bedroom units conclude the sizes for apartments, but it’s rare for apartment buildings to contain four- and five-bedroom units. These sizes are found more often in single-family homes. When it comes to apartments, the more bedrooms, the higher the rent, so investors should try to acquire properties that have more bedrooms.
The key to unit mix is to acquire an asset that has a favorable number of two-bedroom units in relation to one-bedroom units. The ideal ratio is 2 two-bedroom units to 1 one-bedroom unit.
For example, on a 100-unit property, we like to see 66 two-bedrooms and 34 one-bedrooms. This is just a rule of thumb, and this metric is only one of many that influence our underwriting criteria. We wouldn’t discount a property solely on the unit mix. It’s only one piece of the puzzle, but a rather important one
We discussed our aversion to investing in a property with a predominance of efficiency and studio apartments. After reading Big Shifts Ahead, we have shifted our investing strategy to include properties that contain a small amount of studio apartments, especially in areas that have a higher concentration of millennials who are looking for a smaller footprint. The key is to understand the key demographics in your market, and what type of unit mix would be in greatest demand.
One of our most recent purchases was in a downtown area, and the unit mix was as follows:
- 16 Studio apartments
- 52 1 Bedroom apartments
- 75 2 Bedroom apartments
After analyzing the market, the downtown area had a huge demand for smaller units, and we noticed there were less families renting. There was demand from millennials and baby boomers.
Let us know what you think is the best unit mix and leave us a comment down below. The key is to understanding your market and what the demand is in your market.
By Gino Barbaro
Co-founder, Jake & Gino