The 2-4 unit multifamily home

Not glamorous, but very effective

The 2-4 unit dwelling is one of my favorite topics to talk about. Boring on the surface, but yet very effective upon closer examination. To me, it is a cornerstone of building wealth, especially when you first start your adult life.

In a previous post, I talked about how currency is created by our fractional reserve banking system where banks only have to keep a small percentage of currency in reserve (i.e. a fraction as the name suggests) and can lend the rest out. When this happens over and over again, currency is “created” and demand increases for whatever is being borrowed against. In this case, it is homes, including apartment buildings. The government plays a role as well via loans created or backstopped by Fannie Mae and Freddie Mac, and also by fiscal policy.

Housing makes up about 40% of our costs, according to the CPI (consumer price index). There is much debate as to whether the CPI accurately reflects housing costs, however, under any scenario housing is a large expense for people. Further, the combination of fractional reserve banking and government involvement has created an “artificial” price for housing such that owning a home is out of reach for many Americans as shown below.

Housing bubble 2.0?
home prices versus real median income

How do we combat this? A 2-4 unit dwelling as the post headline would indicate. This type of property has many advantages. One, you can purchase as a primary residence which then falls under residential lending requirements. Residential housing requires a smaller down payment, from as little as 3% down to 20% or more if you desire. Commercial properties usually require a larger down payment AND have a higher interest rate associated with the loan. Two, the rental income obtained from the other units can offset the costs of owning the property, and in some cases create a surplus. This is known as “living for free”. Third, there is a great ROI (return on investment) or cash on cash return when combining one and two above. In other words, a small cash down payment of 3% to 20% which then reduces rent paid by you to zero or near zero. Fourth, the tax advantages that come along with purchasing as an owner-occupied investment. All the tools and supplies that you purchase, repairs that you make, vendors that you hire in the maintenance of the property are tax-deductible. The property can also be depreciated every year, which is an accounting expense but not a cash expense! In other words, one can hypothetically generate a positive cash flow however show an accounting loss!

To summarize, housing costs have skyrocketed in the US and have become unaffordable for many whether they rent or own. To mitigate this, I suggest to purchase a 2-4 unit multifamily dwelling rather than rent or buy a single-family home. The primary advantages of this strategy include:

  • Low down payment requirements
  • reduce or eliminate rent
  • tax advantages including depreciation
  • great cash on cash return

Another “hidden” benefit is that in owning a property such as this you have a great hedge against an increase in the supply of currency (inflation), both in cash flow and capital appreciation. In short, an outstanding investment, AND a place to live.

Real Estate craziness

These people just watched a house flipping show

I started investing in Real Estate back in the good ole days of 1997 when I bought a loft in the south loop of Chicago. Little did I know we would be entering a 20 plus year (and still going) bubble and bust roller coaster. In retrospect it makes sense given the financialization of the economy that went into overdrive in 1999 when retail and investment banks no longer had to be separated. That of course is only part of the story.

The short story is the Fed proceeded to lower interest rates to record lows following the Nasdaq bubble burst and 9/11, raise them, lower them again even lower during and after the “Great Recession”, and then injected steroids into the economy with quantitative easing which has blown the biggest bond bubble in history.

By the end of 2018, approximately 11.3% of housing purchases in the US were for investment purposes (source: Core Logic). This is the highest since Core Logic starting tracking data in 1999. During this time, a flood of cable shows have popped up which showed people flipping houses and making tons of money along the way. It’s that easy, right? Wrong.

What is not glamorized is the people who bought at market highs in the 2005-2007 period, only to be left holding the bag as value of their real estate plummeted 30% or more. That event aside, the more troubling aspect is the mentality of “flipping” for a capital gain rather than holding for a cash flow. Of course this sentiment has spread to other parts of the “economy”, notably the stock market. With real estate, however, it is even more dangerous due to 1) leverage and 2) illiquidity. Leverage of course refers to making a small down payment (5-20%) and then borrowing the rest. Illiquidity means you can not buy and sell instantly. Even in the best case you have to wait a couple weeks to close.

So, here we are in 2019 and behavior has not changed. Not only with flipping either. Folks I know are buying houses and dumping in 50-100K or more before they even move in. That is great if you intend to live there for at least 5, 10 years or more. Usually though it is a striking example of poor money management and putting too many eggs in one basket. Alternatively, I have long been an advocate of generating cash flow by buying houses or 2-4 unit buildings and renting them. Why is this not sensationalized? Because it is more work and you do not get the “sugar high” of the quick capital gain by flipping.