Possibly the biggest thing that troubled Emily about her rental house was that it took seven months from the close of escrow until she deposited her first rent check. She’d been feeding it from her savings, and towards the end her reserves began to run scary short. It got so bad that Banana Pudding made a low ball offer to buy the property, but at the loss of Emily’s entire investment. She wasn’t quite ready to do that.
Sure, part of the dead time was spent in renovation (she could only do it on weekends and after work), but she never expected seven months!
After much consideration, Emily concluded that a part of the issue was locational. She’d bought in a transitional neighborhood. It was originally residential, but in the process of becoming commercial. Families didn’t want to live on a commercial street; businesses didn’t want to locate in a residential area. The area was neither fish nor fowl.
She accepted that the most desirable areas were where there were lots of rich people, but soon another thought occurred to her: that the most desirable areas had well established borders “If you buy my listing,” saith the agent, “your daughter will be in the local school system and have a successful life, say OMG a lot and use #hashtags. But if you buy that other house across the street, well, that’s an entirely different school district and nobody really knows how she’ll turn out. Most likely you’ll have a chance to become friends with her parole officer.”
Although the borders have to be clear, they don’t have to be official. Think of north of Sunset (Beverly Hills); south of Fifth (Miami Beach / South Beach), or south of Broad (Charleston, SC). These informal but definitive lines impact values in their respective neighborhoods.
Clear borders mean the area is defined by a common area amenity, something that benefits all the land within its boundaries but no land outside its borders. It means values are unlikely to migrate beyond the neighborhood, because other properties are not benefited by that specific amenity.
Of course, you pay for it. These properties cost more because their shared amenity draws tenants. The right amenity, Emily hoped, would mean a greater selection of higher end applicants.
Not all amenities affect an entire area, like school districts do. Another type of amenity is limited to certain buildings. Only a relatively few properties “Overlook Central Park!” for example.
So there are two general types of amenities, area and limited. Emily’s opinion was that something specific to a single buildings was unlikely to draw as many possible tenants as an area amenity. A Tier One school district was a better draw than advertising “tutor lives in Unit 3”.
One caution is that nothing lasts forever. If you’re paying money to be in a desirable neighborhood, Emily thought, it seems necessary to understand exactly what amenities you’ll be getting and what it might take to lose them. The valued amenity might be a favorable school district. School borders are politically unlikely to be changed, but they could be. “Overlooks Central Park”, could change, too. What if someone erects a higher building in front of you and blocks your view? How much is your amenity worth now? “Tutor lives in Unit 3” could change before lunch.
Over the following days Emily began to realize there was another side to this issue. Where she bought influenced what she bought. For example, a good school district would cater to families. If she had property there, it probably should be family friendly: large, three bedroom, condo-quality units with a nearby puppy park or something.
If she bought in an area where younger people gather, two bedroom units of standard apartment quality would be just fine, but the address should probably have a high WalkScore (walkscore.com).
When a person makes more poor decisions than good ones, time just drags along. Alternatively, you can tell you’re making predominantly good decisions when time seems to go by very fast. At least that was Emily’s experience. Five or six quick years passed and, one evening after working hours, Shortsy called to invite her for a cup of tea at the corner Starbucks. Of course Emily accepted. It was the first of the month. She expected a rent check.
Both girls ordered tea. Shortsy added a Double Chocolate Chunk Brownie. Emily chose a whole-grain bagel, three butters. Shortsy paid and they walked to a window table where they cross-shared with each other. A little small talk as they nibbled away, then Shortsy got around to the reason for the invitation. “I’m thinking of adding another location, and I have my eye on a large old house by the hospital.” She asked if Emily would care to buy it and lease it to her. Shortsy paused a moment then, to emphasize what a good tenant she was, she took a rent check out of her purse and handed it to Emily.
Emily asked the address and asking price, and said she’d have to think about it. On the way out Emily bought a six-pack of those brownies that Shortsy favored. They were not for sharing.
She’d occasionally fantasized buying another rental someday, but it never went further. There was no immediacy about it. Shortsy’s proposal moved the matter to the front of the stove.
Did Emily really want to buy another building? Yes, she realized she did. Overall, that first purchase had been very good to her. The value had appreciated. There had been some tax benefits and a tiny bit of equity build-up. The big advantage to Emily was that Shortsy was in the child day care business. Due to the accelerated wear and tear, Emily required and Shortsy signed an absolute net lease with annual inflation adjustments. That provided Emily a very satisfactory monthly cash flow, which she saved. She also continued her regular savings plan from her salary. By the time she and Shortsy had their conversation at Starbucks, Emily had a pretty good savings account. And because of the appreciation, she could refinance and pull some money out of the rental, so Emily was comfortable that she could find the down payment for a second investment. That wasn’t the problem.
Emily’s difficulty was that she hoped to eventually retire, but she didn’t know if she ever could. It was the old inflation problem. She wanted to retire by the time she turned 65, so she had about 35 years to invest. And she knew she’d like an income (in constant dollars) of $10,000 a month when that day came, but how could she know how much cumulative inflation there would be over the next four decades? If she guessed wrong, she might spend her retirement years a lot less comfortably than she hoped. She gave that puzzle a lot of thought.
Late one Friday afternoon, Emily was driving back from Starbucks with another six-pack of Double Chocolate Chunk Brownies. When she had no Friday night date, the brownies were a small comfort. Sometimes she bought a box for Saturday, too, but never at the same time. That would be like admitting she’s not dateable, and that’s bad luck. She didn’t consider herself superstitious, but a girl’s gotta consider these things.
Emily broke into the box at a stoplight and was nibbling one when she suddenly figured out how to deal with compounding inflation over the next two generations.
Let the market work for you: buy investments that automatically adjust for inflation. Two possible examples are secure, large cap dividend stocks (think the S&P 500) and investment real estate. Confine most investment to these two asset classes and inflation adjustment happens as a function of the market.
That problem resolved, Emily’s mind went something like this:
- What she wanted is an eventual net income of $10,000 a month.
- Right now, her area supports two-bedroom rents of $1,500 monthly.
- Expense factors (fixed, variable, and reserves) run around 30 to 40%.
- Each two-bedroom unit (if paid off) would give her a net income of about $1,000 a month. (Math: $1,500 minus 35% expense factor)
- So to have $10,000 a month (inflation adjusted), she’d have to own 10 paid off units.
- This was scalable: Four such units would give her $4,000 a month. Ten units would bring in $10,000 a month. Twenty-five units, $25,000. One hundred free and clear units would generate $100,000 inflation adjusted dollars a month. Not that her fantasies went that far
Suddenly things were much clearer. Emily got home and took the brownies with her. There were two left. She had them with a cup of hot chocolate as she thought about this some more, waiting for those little marshmallows on top to melt.
Could she buy a second location for Shortsy? Yes, she had the down payment. Did she want to? No. First of all, Emily realized she did not want her entire investment portfolio riding on one non-credit tenant. It was not like Shortsy was FedEx, or something. She wasn’t even a regional credit tenant, like maybe somebody who owned a half-dozen successful restaurants. She was a “Mom and Pop” lessee. What would happen to her if Shortsy defaulted for some reason? Emily didn’t want to be left with two empty single family homes in transitional neighborhoods that could only be used for commercial purposes. She already knew how hard such properties are to lease. Having few reserves after buying the second home, she would probably lose them both to foreclosure.
Once Emily started on a line of thought, she couldn’t stop until it concluded in some form of disaster. She wasn’t the only one who was like that. A lot of her girl-friends were the same way. She thought it must be a woman thing, or something.
Shortsy wouldn’t even have to suffer something rare; there were a number of things that could make her unable to pay her rent. At her age, she could get a chronic illness. Or she could be injured in a traffic accident, or perhaps sued by a parent. Something as simple as a measles outbreak traced to her day care business would do it. It wouldn’t have to ruin Shortsy, only make her unable (or unwilling) to make the lease payments for a while. There were a variety of events that might be individually unlikely, but when taken together created a heightened risk profile.
As Emily continued to think about it, she knew that she did not want her next investment to be single tenant. One underappreciated investment guideline is if you are unsure of the future, diversify. As a single girl, Emily was born unsure of the future and never improved. She therefore knew that she wanted her next property to have several different tenants.
Emily thought this might be a good time to begin buying small apartment buildings with two-bedroom units. Counting Shortsy’s child care property, she was only nine units shy of eventual retirement and she was eager to begin making up the shortfall. She began looking around.
One of the things she discovered was that borrowing money for up to four units was a lot like getting a mortgage on a single family house, and she already had one of those.
Commercial loan territory begins at 5 units. Two significant distinctions are that (a) there are no widely available 30 year fixed rate mortgages offered for five or more units, and (b) the down payments for commercial loans are higher, typically 30% or more.
Emily liked the idea of buying a fourplex. She liked the favorable financing and the lower down payments possible for an owner-occupied purchase. And the prospect of moving out of Banana Pudding’s home was encouraging.
Emily began her next step by refinancing the home she leased to Shortsy. Refinancing is important because creates cash and cash means credibility. No seller wants to seriously negotiate with someone who says, “After we agree on a price, I’ll try to refinance and maybe find the down payment somewhere”.
Interest rates had dropped since her purchase, and she found that she could harvest a touch over $100,000 while keeping her payment about the same. That, plus the cash flow from Shortsy’s lease payment and the $1,000 a month Emily saved from her salary and she’d have plenty of money – she hoped – for the down payment on a nice fourplex.
Emily searched the usual on-line services (zillow.com; realtor.com, and loopnet.com). She ran searches for fourplexes within a 30 minute radius from her work, which is about as far as she wanted to commute each day.
She did not know all the neighborhoods within a half-hour drive from work, so she looked for phrases in the published listings that might suggest particular amenities. Things like, “high WalkScore” or “west of Ahiman Shethar Blvd” suggested there was something indigenous to the area that might make vacancies easier to rent. She hoped it were so.
Her refinance dragged on to almost 75 days. It took a while to find a lender that would allow cash-out refinancing on a rental house leased to a child-care facility, but eventually the process closed.
Emily was at the grocery store one Saturday, shopping for the next week. Over the last several years she’d learned that limiting her diet to animal protein and colorful vegetables worked well for her, as long as she limited her cheating. It was part of her normal diet pattern: weekends of serious carbohydrate binging followed by four or five days of meat and non-starchy vegetables.
While standing in line she scrolled through the CraigsList Real Estate for Sale section and noted an ad for a four unit building that included the phrase, “United Sublime School District”. Emily googled and found it to be amongst the top local school districts. That was one of the classic value-added amenities, and she was intrigued.
Emily called the agent when she returned to her car. He said he would give her the address if she promised, absolutely promised, not to go on the property. Emily lied. She immediately ran the address in Zillow.com and found a map to the property as well as exterior and interior photos of the building. When she scrolled down she found the “Zestimate” of value, a price history of the property (it had been on the market for five months; the price was reduced last month), and (under the “Neighborhood” menu) the WalkScore for the property: it was 87, which is very high.
It had four one-bedroom units (she really wanted two-bedrooms). And it was an older property, built back when separate dining rooms were important. Emily would have preferred a newer property. Zillow said the building was almost 4,800 sqft, which meant the units averaged 1,200 sq.ft. That was really big for one-bedrooms, but Emily thought it might be the dining rooms.
Overall, the school district was good and the WalkScore was high. That ticked two important boxes right there. On the debit side, it had one-bedroom units and she wanted two-bedrooms. And the property was older, while Emily hoped for newer.
Her interest did not rise to enthusiasm, but still she went to see the property and drive the area. And walk around the property. Her promise to the agent didn’t count because her legs were crossed.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
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]
If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com