Managing Your Money : BREAKING UP : This May Be a Perfect Time to Buy Small Rental Properties
It’s no secret that the housing market in Southern California--and most of the country--is in the doldrums.
Gone are the heady days of the late-1980s, when you could buy a home or small apartment and sell it a year or two later for big profits.
But today’s sluggish sales, lower prices and rock-bottom mortgage interest rates are causing some investment experts to say now is a great time for patient investors to buy small rental properties.
Combine those factors with a sharp drop in the construction of new apartments over the last few years and forecasts that California’s population will rise by 5 million over the next decade, and you’ve got a strong argument to invest in duplexes, triplexes and other small apartments--as long as you don’t count on getting rich quick.
“If you expect to buy a rental property and make a fortune overnight, forget it,” says Michael Layana, a real estate agent at Century 21 Dan Cavanaugh in Culver City. “But if you invest with the expectation of holding it over the long haul, you’ll turn out just fine.”
Although buying a small rental complex in today’s soft market may seem alluring, don’t make the mistake of thinking that owning one is an armchair experience.
“Most small investors have to handle all their property-management duties themselves, because it’s just not cost-effective to hire a management company for a small building,” says Temmy Walker, a broker and president of James R. Gary & Co. in Studio City.
“And assuming you’ll be doing all the work yourself, you probably shouldn’t look for property that’s more than an hour or two away from your home.”
Maintenance duties aren’t the only headaches afflicting small-time landlords. They also face the possibility that those ideal tenants turn out to be rowdy or deadbeats. And don’t forget the paperwork.
If you consider all these responsibilities and still believe that buying a small rental makes sense, you must then decide what you hope to achieve by purchasing one.
You might be willing to settle for a break-even cash flow or even a small monthly loss, especially if you can write off all your losses, the property’s appreciation potential is unusually good, or you plan to live in one of the units to lower your personal housing costs.
But if your primary goal is to establish a steady source of monthly income, you’ll probably have to make at least a 30% down payment to ensure a positive cash flow.
Once you’ve decided on what you want out of your investment, it’s a good idea to visit a bank or other lending institution and set up a modest line of credit.
“You wouldn’t want to lose out on a really good deal just because you couldn’t make a $5,000 or $10,000 deposit,” explains Sandy Sandison, a salesman at Betty Landes Realty in Riverside.
There are a variety of sources you can use to raise the rest of your down payment. If you don’t have a lot of cash on hand, you may want to liquidate low-paying certificates of deposit or savings accounts to raise cash. Or you might be willing to sell some of your stocks or bonds, especially if investing the proceeds in real estate would help diversify your portfolio.
Once you’ve determined how much cash you have for a down payment, you’ll need to zero in on the neighborhoods that have the best appreciation potential. Some of the best prospects are often found in areas where there are lots of new commercial projects.
“New stores and offices indicate that business people have faith in the area,” Walker says. “And besides, all their workers will need a place to live.”
Expansion and remodeling projects are also clues that a neighborhood is on an upswing and that prices will rise.
Schools are important too, because most renters have children. Visit the schools in the neighborhoods that you’re considering, and ask for the results of the state-standardized tests that all districts must administer each year.
Finally, consider the local rent-control laws. These ordinances vary widely; Santa Monica, for example, keeps a tight lid on increases, while other cities have no controls at all.
Investors in big apartment complexes have various ways of determining a project’s value. Some will buy if the purchase price is a certain number of times the annual rent. But those formulas aren’t appropriate for small rental properties. Instead, you’ll need to consider location and how the expenses stack up against income.
To determine the property’s cash flow, ask the seller for a profit-and-loss statement for the building and any other information concerning its annual rental income and expenses. Some investors demand to see the seller’s last two or three Schedule E tax forms, which landlords must file annually with the Internal Revenue Service.
Getting a mortgage to buy rental property is a bit tougher than it used to be, in part because many lenders are skittish about lending in today’s sluggish housing market.
“Figure on showing us your last two tax returns, a recent pay stub, and a year-to-date profit-and-loss statement if you own your own business,” says mortgage broker Steve Eglash of Rockland Financial in Sherman Oaks. “It also helps to show us copies of any rental agreements that have been signed to back up your claims about the building’s monthly cash flow.”
Although Congress has scaled them back, rental property still offers tax write-offs. Assuming that you “actively participate” in its management--an IRS requirement easily met by most hands-on investors--you can depreciate your rental property by 3.64% a year to boost your after-tax profit.
You can also offset rental income by taking deductions for mortgage interest, property taxes, maintenance and other items.
Construction Crunch
The recession has slammed the brakes on California’s once-booming construction industry. The volume of loans for construction of one-to-four-unit dwellings has fallen nearly 70% since 1989, and this will tend to tighten supply and maintain upward pressure on prices.
