When I first wrote this in the early 2000s, a three-year bear market had only recently ended, and with endless tales of Enron-style corporate malfeasance ringing in their ears, many small investors were returning to real estate. Plug in some different Wall Street names, and the story has been similar since 2008. My nine years managing rentals in a variety of neighborhoods taught me the nuts and bolts of the business, and the Certified Property Manager (CPM) coursework acquainted me with the theory of investment property. This isn’t space enough for a full course in the business—I recently donated a shelf-full of textbooks to the library—but here’s a brief outline. I’d be happy to meet with you to discuss buying or selling investment property.
Back then, investors in this area focused primarily on “units”: duplexes, triplexes and larger buildings. Why didn’t they invest in single-family homes? Some did, but in many price ranges the cost of a single-family home had climbed just as rents declined, although rents bounced back since 2005, and the resulting numbers weren’t promising. An $800,000 house bought with 25% down and the balance financed at 5.5% for 30 years had mortgage payments of about $3400 per month, yet would rent for only about $2500 per month. Add property taxes of $800 per month plus insurance and maintenance and the small investor was digging deep into his or her pocket each month to feed a so-called “income” property. That’s “negative cash-flow”: when you put money into the property each month, instead of the property putting money in your pocket. With a single-family home you could be looking at years of “running a negative”, even if rents were on their way up.
The Great Recession changed that in a big way, at least at the affordable end of the local SFR market. Rates plunged, eventually to below 4%, and home prices plunged with them, while rents and rental demand soared. Many investors bypassed financing and paid all cash. As I update this in 2013 investors are still a factor at the low end, although they don’t have that market all to themselves anymore—first-time buyers are back in force, although they’re finding it hard to compete with investor all-cash offers. Low-end prices have rebounded sharply as they return to their traditional relationship with the midrange. It was inevitable that they bounce back like a rubber band, since the affordable neighborhoods and housing types took a far worse beating during the downturn than further up the price range. It’s not too late to get into cheap single-family homes, but rising prices and demand have made it obvious that this once-in-a-lifetime opportunity is slowly fading. So let’s treat it like the historical aberration it is/was, and focus on a market that’s historically been more friendly to small investors, units.
Units give you a better chance at positive cash-flow at some point in the future, but rarely right off the bat, even with a down payment of 25% or 30%. You’re best chance for positive flow (or even break-even) is units in a marginal area, but as you might expect, they come with plenty of baggage. Units in better neighborhoods carry a substantial premium that makes positive cash flow a distant goal, but they’re far easier to manage.
If big mortgage payments are standing between you and positive cash flow, why not put more money down? You might do that, depending on your goals, but that blunts one of real estate’s biggest advantages: leverage, or as the get-rich-in-real-estate books call it, OPM (Other People’s Money). Investment property lets you get into the asset with less of your own money, typically 25-30% of value, than does the stock market. This dramatically multiplies your return on equity if the value of your property increases. For example, say you put down $250,000 to buy a $1,000,000 fourplex. Three years later that fourplex has appreciated $100,000 for a current value of $1.1M. Your return on equity isn’t 10% (your purchase price of $1M divided by the current value of $1.1M) but 40% (the $100k increase in your equity divided by your $250k down payment).
If leverage is that good, why not get into an investment property for less than 25% down, say 10%? As this is written you may well be able to do that, especially if you plan to live in one of the units. It all depends on how available credit is when you buy. Lenders have typically wanted a larger down payment for investment property because if an owner’s cash starts running short, he or she is more likely to walk away from an investment property than from their home. Lender requirements for financing up to four units aren’t much more onerous than those for financing your home, but with five or more units they get considerably tougher. Then lenders like the property to show a healthy positive cash flow, and in an area like ours where prices are going up and rents aren’t, that means a substantial down payment of perhaps 40% or so.
Another advantage of investment real estate is that you can deduct all your property-related expenses, not just the property taxes and mortgage interest your primary residence allows. That’s big. Even bigger: the IRS lets you claim a “paper expense” called depreciation, a percentage of the rental’s value, each year. In other words, the IRS lets you deduct against your rental income as if your investment property was steadily declining in value, even as it may be increasing in value.
Unfortunately, that depreciation is “recaptured” (taxed, currently at 25%) if and when you sell, but that gets us to another of investment real estate’s tax advantages: the 1031 tax-deferred exchange. This is a complex procedure that if done correctly, allows you to defer the capital gains tax on the sale of investment real estate and put all your gain into another investment property of equal or greater value. Remember, you defer the tax, you don’t dodge it permanently, but that’s still better than giving Uncle Sam and California roughly 25% of your capital gain every time you sell. Click on the link below for a more detailed explanation. This is not intended as tax advice; consult a tax specialist before you buy or sell investment real estate.
Finally, how are investment properties valued? If you’re buying a single-family home, then valuation isn’t exactly rocket science: you’ll pay what owner-occupants would pay, because that’s who you’re competing with. Units are valued differently, yet despite the fairly sophisticated analytical tools available, I’ve found that many buyers, particularly those working without an agent, value units by the seat of their pants much as they would a single-family home.
For a more precise idea of value I suggest using a simple technique called the Gross Rent Multiplier. The best way to describe the multiplier is that it identifies the amount of money an investor will pay for each dollar of annual rent. The greater the multiplier, the more expensive the property, given the same rental income. The equation for determining market value using the multiplier is Effective Gross Income (EGI) x Gross Rent Multiplier (GRM) = Market Value. EGI = Gross Possible Income (annual rents if all units are rented at full market value) – a fixed percentage (say 3%) for vacancies and unpaid rent + miscellaneous income (coin-op laundry etc.). You or your agent should know the GRM (or “multiplier”) for the type of building you’re looking for, and for the area in which you’re looking. The rule of thumb is: the greater the number of units, the lower the multiplier. For example, you may have heard something like “duplexes sell for 14, fourplexes for 12”, but it isn’t that simple. Multipliers vary by time period and area. Duplexes in the better parts of Menlo Park and Palo Alto currently sell at a multiplier that’s about 60% higher than the least desirable mid-Peninsula and South Bay neighborhoods. That’s because Palo Alto and Menlo Park are great places to live, and the tenants you’ll get are typically easier to work with. The multiplier appropriate to your market can be calculated by using the equation Sales Price ÷ Effective Gross Income = GRM.
One big drawback to using the multiplier is when trying to value a property with units rented at substantially less than market. Typically this happens when an owner loses interest in doing the landlord thing and tells the tenants, “I won’t raise your rent if you don’t call me for maintenance”. Everyone involved feels pretty good about this, as the building falls apart around them. Low rents create artificially high multipliers, so to avoid skewing comparisons between properties, I value each as if it were rented at full market. I then adjust for deferred maintenance and updating, and mentally adjust for the likelihood of replacing the tenants who live there only because the rent is half what it is anywhere else.
The Income Capitalization method is more precise than the multiplier, since it factors in expenses that affect the landlord’s bottom line. For example, in some buildings each unit is separately metered for water, and tenants pay for what they use; in other buildings, there’s just one meter for the entire building, and the landlord pays the bill. The equation for determining market value by the “cap rate” is Net Operating Income (NOI) ÷ Capitalization Rate = Market Value, where NOI is Effective Gross Income – Operating Expenses. The cap rate can be calculated from recent sales by using the equation NOI ÷ Sales Price = Rate. The problem with using the cap rate is that the MLS entry for most small properties has expense information so incomplete it’s misleading. With larger properties this is less of a problem, since they’re typically marketed with more complete information. Unlike multipliers, the cost of an investment property goes up as the cap rate goes down.
Bear in mind that any valuation method for multi-family properties will be imprecise. For example, as this is written Sunnyvale fourplexes are selling at a GRM of anywhere from 16.45 to 22.14, even with rents adjusted. That’s quite a range; in fact, it’s so wide that, by itself, it’s useless. That’s true of any unit of measurement you’ll use, whether it’s GRM, cap rate, price per unit or price per square foot. Why isn’t there more precision? Because besides the usual variables inherent to determining real estate value, such as size, condition and location, anyone trying to price a multi-family property is dealing with a relatively small market with a very limited number of comparables, and quite often even the comparables differ significantly from each other (this is also true of top-end residential properties). These small “samples” of comparables are inherently broad in their results, and therefore imprecise. The best way to deal with this imprecision is to compare a property to recent sales using as many criteria as possible, and expect its value to fall somewhere within these ranges.
What’s the investment property market been doing lately in this area? Prices and multipliers have gone up since 1995, when the rental market suddenly came back with a bang. During the dot-com bust they kept going up, even as rents came back down. Was this market affected by the late-’90s tech boom? Yes, in two ways. First, rents almost doubled between 1995 and 2000, so prices would have taken off even if multipliers had stayed flat. But multipliers went way up too, by about 50%, and prices more than doubled during that time. Then came the bust, and suddenly a rental market that had been as tight as a drum got very soft. Everything—prices, multipliers, rents—nosedived in early 2001 as renters and their good-paying jobs left the area. But a funny thing happened on the way to the total collapse of the investment market: it didn’t happen. Like the single-family sales market, investment prices and multipliers bottomed in late 2001. As real estate recovered in the early-to-mid-2000s, multipliers went up steadily, even dramatically, dragging prices with them even while rents continue to slide. Prices were as high or higher than they were in 2000, while rents sunk to late-1997 levels.
(It’s interesting to note that in the aftermath of the dot-bust new rents declined more than the existing rents of properties that came up for sale. In other words, many tenants were still paying dot-com era higher rents. That’s a tribute either to the usefulness of long lease terms or to the power of renter inertia. And it suggested that if rents continued to decline, new owners would, in effect, be paying a higher GRM down the road as they filled vacancies with tenants paying lower rents, or as they lowered rents to keep tenants. The recovery of the rental market, and rents along with it, made all this talk about declining rents historically interesting in 2007 but moot since then, as rents sprung back locally, particularly for single-family homes, since late 2005.
Back in 2005 I asked readers to bear in mind that the rosy boom market scenario I spoke of above applied only to the investment property market below roughly $2M. Much like the single-family market, this number seemed to be the boundary between a seller’s market and a buyer’s market. Why? Larger properties are bought by larger investors, and they have the capital and connections to look well beyond their back yard for investment opportunities. I speculated that our area, which in 2005 had an uncertain future, flagging economy, stagnant job creation and incredibly high real estate prices, must be really easy to walk away from then. Why pay a premium for years of negative cash flow, I asked, when there’s low-hanging fruit in cheaper, less volatile cities like Reno and Modesto? What’s ironic about this statement is that since then our economy has rebounded, keeping prices stable, while the real estate market crashed in Reno and Modesto and other markets that apparently lived and died by subprime lending.
Smaller properties, on the other hand, are bought by smaller investors who tend to limit themselves to local properties. What’s the appeal of Bay Area real estate? Real estate loans are cheap now and the stock market is all over the map; cheaper places like Modesto are a long way away, making it tough for a small investor to stay on top of his or her property. Besides, the Bay Area’s skyrocketing prices have created equity that’s put money into the pocket of many a local homeowner, so local real estate is a proven product. And there’s another factor: it’s not just investors who buy investment property these days. Rising home prices are pushing entry-level buyers into duplexes, often with a friend or relative who’ll live in the other side.
I’m happy to assist you in the purchase or marketing of a small investment property. I’ll also help you lease your property, although I invariably end up working for $5 an hour (if that much). My contract with Coldwell Banker prohibits me from managing property, or even giving the appearance of managing property, and that’s okay by me.
pros and cons
- Mid-Peninsula investment property has shown healthy appreciation for much the same reason as its primary residences have: they aren’t making land here anymore.
- Recent trend out of the stock market and into real estate means a larger pool of potential buyers when you sell, assuming this trend holds. And it may, if the projections of sub-par performance in the financial markets over the near term turn out to be correct.
- The value of a duplex is easier to ascertain than the value of a stock, although neither is without risk.
- The owner of an investment property can, within limits, enhance its value. Try doing that with your shares in Juniper Networks.
- Real estate is a tangible place to put your money and watch it grow. You can see it, touch it and tell your friends to drive past it.
- Financing (see above) is relatively easy and at attractive rates, at least as of this writing.
- Leverage (see above) increases your potential return on equity.
- Tax-deferred exchanges (see above) help you build wealth more quickly.
- Residential investment property is far less volatile than commercial property. Residential doesn’t take off as dramatically, but its landings are far softer. People always need a place to live, even when there are fewer of them and they have less money than they used to.
- By and large, the law favors the landlord, at least in cities not subject to rent control. Not coincidentally, landlords have one of the most powerful lobbies in the state. Pick your battles wisely and use a professional process server, and I like your chances in Superior Court. Just think long and hard before you go there.
- Anyone can be a landlord. No training or licensing is required. Maintenance and people skills are helpful but optional. A working knowledge of landlord-tenant law is essential, as is the name of a good landlord-tenant attorney.
- While anyone can be a landlord, not everyone is cut out to be a landlord. If you’re not, you’ll pay 6-10% of the gross monthly rents to a management company, with a big effect on your bottom line. And good management companies are hard to find.
- If your investment portfolio is just one single-family home, vacancies will kill you. You’re vacancy rate is either 0% or 100%, either feast or famine.
- Turnover expenses—painting, cleaning, carpeting, window coverings, updating—make a vacancy that much more expensive. Don’t do them, or don’t do them well and (especially in a soft market) your vacants will stay vacant longer, rent for less and attract sub-par tenants.
- Units in marginal areas offer a better chance of positive cash flow but come with their own baggage. Turn your back for a second and you’ve lost control of the building.
- A few cities in this area have rent control. San Francisco is the most notoriously anti-landlord, but East Palo Alto and San Jose also have rent control and a few other cities have mild forms of it. Always verify any restrictions on landlords before you buy.
- A bad tenant can be a time-consuming, fairly expensive nightmare. Pick your tenants wisely, cut loose the bad ones quickly. Live by the rule “money talks and everything else walks” and you’ll dodge most of the bullets.
- Fair Housing (discrimination) is the number one issue in the apartment industry these days. A landlord who doesn’t know the latest interpretation of federal and state law, and take it seriously, can easily end up paying someone $10,000 or more to settle a discrimination complaint.
- Remember what I said about the law favoring landlords? That doesn’t necessarily apply to Small Claims Court, where security deposit disputes are resolved. The law is purposely vague when it comes to identifying proper deductions, the judge has lots of discretion and he or she has seen many a questionable deduction. You may not enjoy the experience. Document, document, document—and be able to justify your actions in court.
Interested in investing in real estate? Please contact me at email@example.com.
copyright © John Fyten 2004-2014