If you’ve missed some of the prior articles, basic beginner guidelines on successful investing are in my book Stairway to Wealth available at LuLu.com
My clients generally prefer mid-sized apartment buildings from, say, 10 to 40 units. Ok, I Know that’s a wide range, but for a variety of reasons ten units are usually more efficiently run than five units, and twenty more than ten. In both real estate and diamonds, size matters. But that doesn’t mean you should blindly seek the largest apartment building out there. If you are in the market for a single property over 40 units, maybe you’d want to rethink the matter. Two 20’s would give you the same number of units while (a) reducing political risk and (b) possibly increasing marketability.
Political risk is important. ‘s not just rent control, with its ceiling on rent increases, although that’s a big part of it. Additionally, it’s the fact that any municipality that supports rent control will almost certainly be egregiously tenant-friendly in most other matters. The tenant didn’t pay rent? Just try to evict him in a businesslike period of time. There will be all sorts of defenses available to the defaulted tenant. And even if there’s no rent control right now, you can’t ever be absolutely certain that the city you just bought units in will remain supportive of landlords during your holding period. Two twenty-unit buildings in nearby cities may help shield at least a portion of your portfolio from the politicians, at least for a while. I remember many years ago there was a move in Pasadena, where you normally wouldn’t expect it, to institute rent control. Gratefully, the movement failed but it makes the point.
Marketability is just as obvious. When the time comes to sell, there are more 20-unit investors than 40-unit investors, meaning it may be easier to sell two 20’s than for one 40. There are more people with $ X to put down than there are with $ 2X. Even if the units don’t sell for more money, they may sell quicker, which could be a blessing.
So I hope we’ve established at least the concept that the sweet spot is at mid-level unit counts. But sometimes, because the market is stratified, favorable opportunities appear that are outside the sweet spot. We are free to ignore them if we wish.
A few months ago (An Exchange of Opinions 21: Marinated Goat Cheese) we talked about Single Family Residences (SFR’s) in Baldwin Park, and how homes in decent areas of that city were selling for prices that approached break even cash flows right from the close of escrow. The prices are increasingly favorable partially because it’s become harder and harder to qualify for a loan. Difficult qualification means fewer capable borrowers available for the same number of homes. ‘s a supply and demand issue, and, as you would expect, results in a decline in values. The Baldwin Park situation was presented as an indication that prices of small unit properties might soon soften. Dinner was in the oven. Well, a couple of my clients have recently purchased 3 and 4 unit buildings in Pasadena and Glendale that project positive cash flows. Neither of these guys is helpless in the marketplace. One has been my client for years and has accumulated over 100 units during the past two decades, and the other was represented by a really knowledgeable advisor. Interest in well located three and four unit properties appears to be spreading, and occasionally something comes up that’s suitable for FHA financing.
The FHA has programs not only for single family houses, but also for small units. Some of them provide low down payment financing, and that means that new investors, who typically have little cash, now have an opportunity to get on the train.
Clearly, if you’re reading this Letter you probably won’t be fascinated in anything that could be bought with FHA owner-occupied financing. You just wouldn’t want to move out of your home and struggle in and out of a little 700 sq.ft. two bedroom unit like it was a Spanks or something. If you bought a two to four unit property, you’d have to go with a conventional loan because you’d be an investor, not an owner- occupant. You’d have to put 25% down. But if you were an owner-user, you wouldn’t.
FHA 2-4 Unit Loans . . . the Good Things
Recent guidelines for 3 or 4 unit FHA owner occupied properties are that the loans require a minimum 3.5% down, that the entire down payment could be a gift from a family member, and that the Principal, Interest, real estate Taxes, fire Insurance (PITI) payment must be no greater than the effective rent (scheduled rent minus the vacancy allowance). Basically, actual income must cover the monthly payment. The seller is permitted to contribute up to 6% (but the FHA is thinking of reducing it to 3.5%) towards buyer’s nonrecurring closing costs.
. . . the Not So Much
The upfront FHA fee for mortgage insurance is 1.25%. Monthly FHA fees are 1.15% (annualized).
. . . and the Conclusion
Ok, the mortgage insurance makes it expensive, but for the person that has no greater down payment and no other purchase options, it’s the only card to play. Anyway, if the borrower puts 10% down, the FHA mortgage insurance fees go way down.
Given favorable owner-user financing, could an FHA small unit mortgage serve your son or daughter, or perhaps one of your grandchildren? To repeat, it’s starting to get to a point where a person might buy a three or four unit owner-occupied building for minimal down and long term fixed rate financing and still get pretty close to a break-even building (remember, PITI doesn’t include utilities, management, or maintenance). This allows your kids / grandkids to start their investment career just like you did all those years ago when you bought your first fourplex with an owner-occupied FHA loan.
Here is a recently sold example:
1219 West Burbank Blvd, Burbank, CA
Three 1 + 1’s, each with garage parking and their own washer-dryer hookups, large side yards, and hardwood floors. Sold in Oct 2011 for $430,000. Days on Market: 186. Previous sale was Jan 2004 for $450,000. Fronts busy street. At the most recent sales price and with 3.5% ($15,050) down the numbers look like this:
Monthly income: $2,990
Less Vacancy @ 5% -150
Minus Insurance -125
Real Estate Taxes @ 1.25% -448
Net Monthly Operating Income $2,267
FHA financing @ 4.5% fixed
for 30 years -2,103
Positive Monthly Cash Flow $164
It isn’t that the buyer just gives escrow $15,050 and they give her the keys. There’s more to it. There will be additional charges, including the up-front mortgage insurance premium (figure around 1.25%), the monthly FHA mortgage insurance fee (1.15% annualized) and some other bits and pieces. And they won’t let her spend her last dime just to get into the property. She’ll have to have three months of PITI as a reserve before she gets the keys. But overall, its way cheaper than putting 25% or more down. ‘s a way for a young person to get started.
And here’s another one:
6839 Valmont St, Tujunga, CA
Triplex. There is a two bedroom, 1 bath house in front with its own fenced yard. In back is a duplex consisting of two 1 bedroom units. The upper unit has a high ceiling with an open balcony for mountain views and the lower unit has a small covered porch. Both units have their own washer-dryer hookups. There is space for six cars between the two buildings. Lots of shade trees. Triangular lot siding to concreted flood control channel. Sold Jan 2012 for $350,000. Days on Market: 100. Previous sale was Nov 2003 for $315,000. At the most recent sales price and with 3.5% ($12,250) down the numbers look like this:
Monthly income: $2,800
Less Vacancy @ 5% -140
Minus Insurance -125
Real Estate Taxes @ 1.25% -365
Net Monthly Operating Income $2,170
FHA financing @ 4.5% fixed
for 30 years -1,711
Positive Monthly Cash Flow $459
Now, neither of these properties were purchased by my clients. My client’s purchases are not identified in these Letters. You knew that.
Can you imagine, just a few years ago, thinking that 3.5% down would permit someone to buy a small unit property in an area where a significant percentage of the population is actually employed? And get a break even property? Kind of nice for the young people, huh?
Here’s the takeaway: Yes, small properties are becoming more affordable but it’s not because higher interest rates are pushing values down. That’s still to come. Properties are cheaper because “ although the flood of foreclosures hasn’t hit yet “ banks are tightening loan qualification standards almost to the point, as the old saying goes, that the only people who can get a loan are the ones that don’t need one.
So is this a good entry point? I think so. If you can put minimal down and get a close-to-breakeven property in a decent area, it’s probably time to enter the market.
But what’ll happen when the banks release all their foreclosures? I was recently told by a reputable person who usually knows about such things that there were 5.5 million purchases in the entire country last year. The banks, however, have 8 million foreclosures in the pipeline. If only 500,000 foreclosures were released to the market each year property values would probably plummet. Even if nobody else defaults, we currently have 16 years of foreclosures in inventory.
Changes in the SFR market will probably affect apartment vacancy levels, and, later, rents. When house prices go up, more folks move to apartments. When SFR prices go down, more folks move to houses. Think of a teeter-totter. Many investors who purchase foreclosures will rent them at competitive rates that still generate a satisfactory return on their (reduced) purchase price. These rates may be low enough to induce tenants to move to a house rather than continue in an apartment. The resulting increased apartment vacancies reduce net income and erode value.
If nothing changes, we’re probably looking at a long time of first declining 1-4 unit values, then a period of sideway values before the housing recovery really begins. But there’s no reason we can’t help the economy recover.
As prices decline we can start to buy properties “ apartments, SFRs, small units “ when prices drop to the point where 25% down payment (remember, we’re investors, not owner-users) yields a satisfactory cash flow. We can continue to buy during the sideways period, and even during the early part of the future nascent upswing. Once prices rise to the point where we can no longer buy using that satisfactory-cash-flow-with-25%-down formula, we . . . just . . . stop.
If interest rates rise before that pesky 16 year backlog of foreclosures are cleared through the system you might be shocked “ shocked! “ at how many buildings you could wind up buying.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected]