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This morning a friend asked my opinion of buying single family homes as rental properties. Believe it or not, I think it can be a great idea.
A lot of people don’t understand that investing in rental real estate can be tailored to your goals, risk tolerance and lifestyle.
There are several advantages of owning rental homes. First, leases for these properties typically require the tenant to pay all the utility bills, mow the lawn, and shovel the walk. The owner, or landlord, has fewer ongoing responsibilities. What’s more, in the event you want to sell the property and move on, there is a large pool of potential buyers in the marketplace. Some people believe this makes owning single family home rentals a more flexible investment.
The most significant disadvantage of single family home rentals is that when the house is vacant, your vacancy rate is 100%. If you can turn (repaint, recarpet, clean) the home quickly, this may not be an issue. However, if there is damage that requires more extensive repair, you may be vacant for some time; which will, of course, require you to dig into your own pocket to pay the bills.
One of the challenges I’ve personally found is if prospective tenants have children, they generally aren’t willing to move in after Labor Day. It’s, an important consideration if the home is family-friendly.
As with any property, it is absolutely essential to do an income property analysis before you write an offer. That is too complicated an excercise to try to explain here, but feel free to give me a call. I’d be happy to help.
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The Minneapolis Area Association of Realtors (MAAR) released its weekly market activity report yesterday. And, incredibly, there was some good news.
Seven hundred and fourteen (714) purchase agreements were signed the week ending May 17. This figure is 1.7 percent above the number of pending sales during the same period last year.
This is only the first time in the last ten months, and just the second time in the last two years that this has happened.
Of course, there’s always a “but” these days. Of those transactions, 27.5 percent were foreclosures or short sales. And, over the last three months, the total number of pending sales is down 10.3 percent from 2007.
New listings have also dropped 13.9 percent for the same time frame. In fact, there are 700 fewer homes for sale right now than there were at this time last year. This number should increase as more and more sellers wait to put their homes on the market.
Which leads us back to that darned high school economics class: as supply decreases, eventually, prices should go up.
Unfortunately, MAAR doesn’t split multi-family properties out as a separate statistic. However, I can tell you that using my rather mediocre statistical abilities, during the week ending May 17, 38 duplexes went from Active to Pending status. During the same time last year, only 15 properties were pended. That’s a 253.33% increase over last year. Of those properties, a staggering 78.9% were either bank owned or short sales.
Stunned? Yeah, me too. I thought things were picking up. Nice to know I’m not hallucinating…this time anyway.
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Since it’s Memorial Day, a time when we remember people we’ve loved and lost, I thought it would be nice to write about Irene and her Rule of Real Estate. Have you heard of her? My clients have. And she’s earned them more money than Carleton Sheets ever has.
Irene was my grandmother. Irene Balle. She would want you to know that.
My grandparents were part of America’s Greatest Generation. They grew up on western Minnesota farms, survived the Great Depression, relocated to San Francisco during World War II to build ships for the Navy, then returned to Minnesota where they bought their first (and only) home.
Thankfully, there’s some longevity in my family. As a result, I had the great privilege of getting to know them as an adult. I marvelled at them, really. They stayed in their home well into their 90’s; even surviving the tornado that swept through St Peter, Minn., in 1998.
I came home and visited them the summer after the tornado. Most of their windows had been blown out in the storm, scattering shards of glass everywhere; even embedding it in the carpet. When I stopped in, the old carpet had been removed. And for the first time, I got to see the absolutely pristine oak hardwood floors that lied beneath.
Grandma was agonizing over carpet choices. I was incredulous, and said, “Grandma, these floors are beautiful! Don’t cover them with carpet!”
Irene gasped and put her hand to her mouth. “But we wouldn’t want people to think we were poor!”, she exclaimed.
Huh?
Read the rest of this entry »
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OK, since I mentioned it yesterday, I suppose I should explain what the cap rate is. More formally called the capitalization rate, like the gross rent multiplier, it is used as a tool to compare one property to another.
The cap rate is a ratio between the cash flow produced by a property and its original purchase cost. To find the number, you must first subtract all of the expenses from the amount of rent a property generated in a year. Do not factor in the mortgage payments. The remaining balance is called the net operating income or NOI. You then divide this amount by the original purchase price of the building. More simply stated: annual cash flow/cost.
For example, let’s say you paid $200,000 for a duplex. Every year, it takes in $24,000 in rent (we’ll pretend it was occupied 100% of the time). You had, oh, say $7500 in the total annual water bill, insurance, repairs, rand real estate tax and advertising. $24,000 – $7500 = $16,500 as your net operating income. You would then divide $16,500, by the total purchase cost of $200,000, giving you a cap rate of 8.25.
A cap rate can be used as a way to determine how fast an investment will pay for itself. If the cap rate is 10, then 10 percent of the purchase price will be paid back every year, with the total paid off in 10 years. Or, you can also think of a cap rate as the rate of cash return on the property if it were entirely paid off.
The rule of thumb here is the higher a cap rate, the bigger the return on the investment. Be forewarned, however, most properties with high cap rates usually have a higher degree of risk. They are often found in neighborhoods with greater management demands, or, in a property with a great deal of vacancies.
Cap rates for duplexes and small multi-family properties are usually very low. The cap rate is a much more accurate measure when applied to larger, commercial properties.
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I read a Reurters article the other day about a gentleman in California who since the year 2000, purchased nine single family homes. All of them are now being foreclosed upon. The article blamed negative amortization loans for his demise. What the article doesn’t say is just exactly what this man’s investment strategy had been. Had he intended to simply ride the appreciation? Was he renting the homes out?
I’ve had my California real estate license. And I know, at least in the Los Angeles area, that investors use a little tool called the gross rent multiplier or GRM. In fact, it is so prevalent that it’s even calculated and displayed on the MLS.
What’s a GRM? Well, like its big sister the cap rate, it’s a way I use to quickly look at an investment property and decide whether or not it makes financial sense compared to the others on the market. Call it a quick and easy way of comparing apples and oranges.
To determine the GRM, simply take the purchase price of the property and divide it by the amount of rent it generates annually. So, if a property is listed for sale at $200,000, and it takes in $2000 a month in rent, or $24,000 a year, its GRM would be 8.33 (200,000/24,000= 8.33). Conversely, if it only generated $18,000 in rent a year, the GRM would be 11.11 (200,000/18,000 = 11.11)
A general rule of thumb is the lower the GRM, the greater the cash flow.
I’ve done too many of these to count. And after endless late nights doing entire spreadsheets on properties, I realized that in the Twin Cities market, anything that’s got a GRM higher than a 10 isn’t going to cash flow. There are exceptions, yes. But we’ll cover those some other time (hint: owner occupied & tax write offs).
If the property meets my criteria, I will stop and do an investment worksheet. I’ll consider all the costs involved in ownership, as well as the market’s current vacancy rate. If I see a negative cash flow, I don’t necessarily discard the property. I just know it’s probably overpriced, and deserves a lower offer.
In the boom years, I warned buyers they wouldn’t hear from me very often. Properties that paid their own way were few and far between. Most of my clients stayed on the sideline. None of those who bought, however, are in predicaments like the California gentleman. Why?
Nobody can predict how much appreciation any real estate market will experience in a coming year. Any agent who tells you otherwise is either the world’s best psychic (and should be sharing lottery numbers) or full of it.
At one point, the market in southern California was experiencing appreciation of as much as 20% a quarter. People bought simply on the hope the value would skyrocket. But they never stopped to do the math. The properties may well have had negative cash flows from the start, meaning the owner had to go into his own pocket to make up the difference. This guy may have been doomed from the moment he started.
Remember, when a property manages to pay for itself from the first day of ownership, it’s a great investment. Any amount it goes up in value is a bonus, not a guarantee.
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A recent scan of the pending and closed duplex transactions in the Twin Cities since the start of the year stunned me. Now, nothing scientific here, just some observations.
I haven’t done the math, but the majority of the pending small multi-family sales right now have an average number of days on market (DOM) in the double digits. Less than 100 days. Less than three months! Granted, there’s no way to know which of these were cancelled and re-listed at a lower price, but nonetheless, it’s encouraging.
In the last month, several unique duplexes have come on the market in the “waterhoods”; those by the lakes or along the river. They’ve been listed at pretty big prices, and their status has changed to pending in just a month.
I intended to get over to see a unique foreclosure duplex on the bluff in the Cherokee neighborhood of St Paul. It had a beautiful banister, a widow’s walk, and was built years before most of the properties I get to see. At $409,000, I was sure I had plenty of time to get there. Wrong! Market time of a month. Another, a gorgeous home in the Kenwood area which had been converted to a fourplex lasted just 44 days. At a price of $674,000 no less.
As I dug through the records of the properties that have sold and closed already this year, I noticed something interesting about the foreclosures. To illustrate, let me give you an example. There was a unique Queen Anne duplex in the Wedge neighborhood that lingered on the market all winter. When the bank first listed it in September, they did so at a price of $339,000. When that listing expired, they relisted it at $259,000.
Now, a lot of people watch these foreclosures, waiting for the bank to reduce the price to ridiculous. I noted several properties where this had happened, and learned that almost without exception, they ended up selling for well above their asking price. I guess the bank’s agent had the forethought to put the property on the MLS at a price so low it could do nothing but start a bidding war. In those cases, the properties sold at prices $50,000 – $70,000 above list.
In the case of the Queen Anne, however, a buyer wrote and had an offer accepted at $183,000, which is nearly half what the property originally came on the market for. That buyer got a deal because he or she had the courage to write an offer while others lingered, stalking the property until it couldn’t help but sell in a bidding war.
Lessons? If it’s a unique property in good shape and a great location, write the offer today. Even in this market, it might not be there tomorrow. And, as I’ve said before, the only person who “gets a deal” is the one who wrote the offer.
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OK, so I mean duplex. But house sounded better in the headline.
At this point, we’ve all been absolutely inundated with media reports about declining property values and the present buyer’s market. And, on many levels, those reports are right. There are countless properties on the market right now at prices well under what someone paid for them two, three, or even five years ago.
But many buyers think if a property is a great deal now, they can offer half of what the seller is asking — and steal the house. Let’s be realistic. If it was THAT much of a buyer’s market, wouldn’t EVERYBODY be buying?
I can think of one property in a south Minneapolis neighborhood that’s a perfect example. It sold in 2006 for $320,000, and was on the market at one point last summer for $359,000. It’s a beautifully maintained Craftsman, with built-ins, fireplaces, hardwood floors, newer boilers, a new roof…on an on. It’s a terrific value, and likely, very close to the right price.
It’s on the market now at $239,000. Twenty-eight percent less than what it sold for two years ago.
Buyers seem to love the place. But they’re all waiting for the price to be reduced to the ridiculous… like $150,000!
It will be long gone before then. After all, it’s not a great deal until you buy it.
And then will come the “shoulda, coulda, woulda’s“…
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Over the years I’ve met countless first time home buyers. More often than not, they in a popular area (near a lake, river, shopping or great architecture) and understandably have decided they would like to put down roots there.
The trouble is, these popular neighborhoods aren’t exactly a real estate secret. Almost everybody wants to live there — which is where that stuff from that high school economics class kicks in — the law of supply and demand. There are only so many single family homes in these areas (supply), the demand for which is high, thereby forcing the price upwards.
In the Twin Cities market, most first time home buyers are uncomfortable spending more than $250,000. More often than not, the homes in the neighborhoods and with the features they like start at that price.
OK, yeah. What about a fixer? Well, fixer’s require cash. Lots of it. And most first time home buyers don’t have the thousands of dollars required for immediate repair.
It’s usually at this point that I ask whether the buyer has thought about a duplex. And I usually get a dumbfounded look as a reply.
Instead of looking at the whole price for a duplex, why not take the number and cut it in half? So if a duplex is listed at $400,000, the buyer would only pay for half, or $200,000. The tenants would pay for the other half (providing, of course, the rent was substantial enough). And, typically, properties can be found at or near those prices in these neighborhoods — in part because not as many people have thought of it!
“Yeah, but…,” buyers say. “I can’t afford that much”. Well, if the property has been a rental for more than two years, 75 percent of the rent can be counted toward the buyers income to qualify.
There’s more. The buyer can depreciate and write off the half he or she doesn’t live in on his taxes. Not to mention the ability to get a higher deduction for the amount of interest paid on the home loan (because the property cost more than a $300,000 single family home).
Finally, in coming years, if the buyer chooses to sell the property, the income he earned from tenants can be counted as income to help qualify for the loan for a new property.
Then again, it’s always nice to own a piece of property in a neighborhood everybody loves. Better still when it pays for itself!
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One of the questions I am most frequently asked by people considering purchasing their first multi-family property has to do with plumbing. More specifically, the toilet.
It seems the biggest fear about becoming a landlord is there will be a phone call in the middle of the night that a tenant’s toilet has backed up. And it will be up to the landlord to fix it.
First, I have been a landlord for over a decade. And in all those years, the only time I ever had a middle-of-the-night plumbing call was when a water heater actually burst and was spewing water everywhere. My inconvenience? Calling the plumber and signing the check! (It was the least I could do — my tenants were buying me my property after all.)
When it comes to toilets, however, a plumber charges too much. And, here’s a tip: they’re really, really easy and inexpensive to repair.
I had zero experience with fixing them prior to becoming a landlord. But I’d had the good fortune of stumbling across Home Depot’s book, Home Improvement 1-2-3. It had pictures, well, more accurately, how-to cartoons of almost every conceivable home repair or improvement. I took that book with me everywhere: propped it up on the back of toilet tanks, crawled under sinks with it…you get the idea.
The good news is, Home Depot still publishes it. The bad? No more cartoons. Just pictures.
And, if Home Depot’s actually closed, there’s always www.fixatoilet.com. No kidding.
