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Lesson 4
Property Selection
In this lesson we will analyze
many of the factors that prospective landlords and investors must consider
before selecting an income property for purchase.
Property Type
Before we get into the details of various
property types, we will state up-front that the most conservative rental housing
investment is a single family home in a stable suburban neighborhood. More
than 50% of the housing in America is rental property, and about 60% of that is
single family housing, so there is always a market for that kind of property.
It also can have the highest appreciation rate over the long term.
Unfortunately, it will usually produce the lowest cash on cash return in early
years and management of a large number of single-family homes is significantly
less efficient than the same number of units in a single complex.
Commercial vs. Residential
There are numerous
differences regarding the ownership and management of commercial vs. residential
income properties. Some of the
important differences are summarized in the table below.
Pros and cons are generalities and do not apply to all properties or all
the time.
Residential
The residential category of real estate
includes a number of different sub categories.
- Single-Family: Occupants have common
access to all parts of the dwelling and ownership usually includes the land
under and about the unit.
- Duplex: A building consisting of two
attached separate family units.
- Townhouse: A two or more story dwelling,
typically in a complex of other such units.
- Apartment: A room or suite of rooms that is one
among a number of such units in an apartment building or apartment house.
- Condo: Short for condominium, one of the units in
a multi-unit building or development where each such unit is separately
owned, but shares the land and some improvements in common. By the
strictest definition of condo, owners only hold individual title to the air
space within the structural walls/floor/ceiling, but usually including the
paint (or non-painted material) and floor coverings. Variations of the
condo include forms where an owner holds title to the structure, yards, or
other components or any combination thereof. In some areas of the
country these expanded variations are call Planned Unit Development or other
special names.
- Co-op: Short for cooperative apartment, one of the units in
a multi-unit building or development where all units, land, and improvements
are owned by corporation in which the occupants own shares of stock in the
corporation.
When evaluating the
functional utility of a dwelling unit, pay special attention to it's use
zones. The living area in a residential unit consists of three major zones: living, sleeping, and work.
1. The living zone includes
living rooms, family rooms, great rooms and any other where a family relaxes
or entertains. This zone should be near the front door, away from the
bedrooms and adjacent to the dining area.
2. The sleeping zone refers
to the bedrooms. It should be located away from the living zone, be in a
cooler portion of the dwelling and adjacent to a bathroom.
3. The work zone refers to
the kitchen and dining areas. This zone should be well-lit and ventilated
and should provide an efficient work triangle: the configuration of the stove, refrigerator and kitchen sink.
Commercial
Buying, managing, and selling commercial real estate is, in general, somewhat different than residential.
Advantages
A
generalized truth is that commercial real estate activity is less regulated than
residential. While consumer protection laws strongly favor the tenant of
residential properties, commercial tenants are assumed to be more sophisticated.
Even if this is a false assumption for many commercial tenants, it is a fact
that the government is considerably less interested in protecting them from
their ignorance compared to residential tenants. And, on average, the
commercial tenant probably is more sophisticated regarding business than
the average residential tenant.
Disadvantages - How
To Eliminate or Minimize Them
In
spite of the above advantages of commercial rental property, there are, as might
be expected, also characteristics that represent potential disadvantages.
These potential disadvantages can be avoided or at least significantly reduced
with proper knowledge. This necessary knowledge can be found on our site,
including in the following paragraphs.
Economy
One potential
disadvantage of commercial property is that it tends to be more easily impacted
by a bad economy. It is much more likely that a tenant will walk away from
a lease for a failing business than from his place of residence. When
times are bad a person still needs a place to live even though he might not need
a place to run a business. In an economy where new business formation and
expansion are actually contracting, lowering the rent will not have the same
benefit for a commercial unit as it might for a residential unit.
Lease Documentation
Although the allowed terms and conditions of commercial leases are more flexible
than residential, and partly because of that, the lease documents themselves are
generally much more complex. Residential leases are governed by the
state's landlord tenant statutes, and, in many states the statutes are
automatically made part of the residential lease.
Length of Leases
The fact that commercial leases are relatively
long was listed above as an advantage, but this same fact can sometimes become a
disadvantage. Since rent increases are usually defined for the term of the
lease, and sometimes even for subsequent renewal, means that the owner may not be able to keep up with rapidly escalating market
rents. Of course, in a bad market, the automatic increases work to the
owner's advantage.
Tenant Improvements
Spaces in commercial properties are often
remodeled or completely rebuilt when new tenants take over. Because
this can be a costly project, the lease should be very clear regarding how the
cost of these improvements are allocated between lessor and lessee.
Purchasing, Financing, Selling
The
purchase and sale of commercial property often requires more documentation and
more investigation than residential. Items more often required for
commercial than for residential properties include Environmental Reports and
Estoppel Certificates.
Any difficulties in purchasing, financing, and
selling commercial properties will be minimized by having complete documentation
and records available.
Special Concerns
Although the government has less interest in many aspects of commercial
properties, there are several areas where that does not hold.
First, environmental issues can be a concern. Second, commercial property can be impacted by
the Americans with Disability Act (ADA), possibly requiring expensive
renovations.
Accordingly, much more investigation is usually required for purchase of a
commercial property compared to residential.
Many Small vs. Few Large
There are numerous differences regarding the
ownership and management of many small properties vs. a few large properties
(e.g., 10 single-family and 5 duplexes or one 20-unit building) that one should
consider.
Some of the important differences between ownership and management are
summarized in the table below. Pros and cons are generalities and do not apply
to all properties or all the time
Although the above table indicates that a few large properties would always be
preferable to many small properties, such is not necessarily the case.
Specific pros of smaller properties could, under certain circumstances,
be more important than the cons.
For example, diversification could be the primary consideration if one were
concerned about the future economic future of the area.
More importantly, a beginning investor will not usually be able to start
with large properties.
Location, Location, Location
Real estate professionals tell
buyers and sellers that the three most important things that determine real
estate values are: location, location and location. For
example: an 1,800 square foot, three bedroom ranch, on the waterfront, sells
for substantially more than the same home on the lower east side of any large
city. You will also note that a typical home in Santa Barbara, CA sells for
two or three times what it would in Cleveland or Detroit.
Always remember that property you consider for
investment should be located in places where people want to live. In a growing
area, or an area that you have good reason to believe there will be future
growth. Communities and their neighborhoods, normally go through four-stage
cycles, progressing through growth, maturity, decline and finally
rehabilitation. Property values rise with growth, stabilize, then typically
fall during the decline stage. The most dramatic price increases usually occur
during the comeback rehabilitation phase. Real estate investors should always
make a careful study of the property's location with these kind of inevitable
cycles in mind.
One can subdivide the umbrella of location in
to the sub topics of neighborhood and government.
Stay Local
If you live in Maine, don't buy income
property in California. That is, unless you are talking about a complex
with hundreds of units that will justify hiring a competent professional
management team, including a property manager, resident managers and
maintenance personnel, you will need to keep close watch over your rental units.
And, even if you use a typical property manager, you can't do that from across
the country or even across the state. See our Web page Selecting
a Property Manager. The subject of
management is discussed further in a later of this course
and will be covered in even more detail in a future csu e-course.
Neighborhood
Prospective buyers should complete a thorough inspection of the
neighborhood and its environs prior to purchasing rental property, . They should also try to get a clear picture of
the neighbors as well as the surrounding a property:
- Is the neighborhood improving, stable, or in the process of decline?
- What is the crime rate, or the perception of crime and drugs?
- What is the quality of the local school system and the neighborhood
school?
- Is the neighborhood accessible by highway or public transportation?
- Is the neighborhood convenient to schools, shopping districts,
hospitals, central business districts, and government offices?
For a balanced view of the area, investors
should visit the property during various times of the day, at night, and on
weekends.
When you invest in real property, whether your
personal residence or as a rental property, you are actually investing in a
neighborhood. As we have discussed above: no matter the size, the decorating or
the quality of construction in the building, location and timing are the most
important factors in selecting a property to buy for income. If a neighborhood
is gang and drug infested, and the surrounding property is owned by that
damnable, unscrupulous landlord we referred to earlier, who never puts a dime
back into his buildings that he isn't forced to, DON'T BUY THERE! Unless
you can afford to buy up all the junk, evict all the bad guys, and rehabilitate
the buildings.
However, occasionally, there are factors that result in our owning a
property in a bad neighborhood in spite of all the reasons that you shouldn't.
Perhaps it was Grandma's house and you inherited it. Perhaps the
neighborhood turned bad after you had invested there. Perhaps you just
made a stupid mistake and bought a "really good deal" where you shouldn't have.
You don't have to give the property away or commit yourself to a life of horror
over it.
Go meet the neighbors. Some will be good guys.
Let them know that you are too. Help start a "Neighborhood
Watch," an excellent, low cost, security program that involves residents in
efforts to deter crime. Another program called "SMART"
is worth exploring as well. There are about as many people trying to save
neighborhoods as there are people destroying them. We have linked to a
government list of hundreds of programs, one of which may
help you.
It always pays to participate in neighborhood
improvement campaigns. You will have to give a little of yourself to the project
for awhile, but the alternative may be social and financial disaster. You might
even want to offer discounted rent to a tenant who is willing to contribute to
the cause. There are a zillion things we can all do to improve any neighborhood,
or our community, if we want to badly enough. Most of us have other priorities
in our lives, but if you end up with a property in a bad neighborhood, your
priorities may have to change for awhile.
Government
There are several types of government controls that affect the income and
value of rental property. The very worst among them, of course, is
rent control. Followed by
environmental pitfalls, strict code enforcement, mandatory inspections,
and zoning and a myriad of other regulations and requirements that seriously
affect income property values. Another type of government control that
can actually increase the value of existing properties is growth restriction.
If a property is located in an area that has,
or is considering rent control, the price of the property must reflect the
impact rent control has on income and the economic feasibility of maintaining
or improving the property. Mandatory rental inspections are also potentially
very expensive; primarily because they are usually subjective. An inspector
who just got chewed by the boss, or recently caught their spouse in a affair,
can cost you really big bucks with arbitrary and often unreasonable demands.
Studies of affordable housing in America show that it costs about 30% more to
provide housing in urban areas with their typical layers of fees and
regulation, that the same property in a suburban or rural location.
Because there are always a few landlords who
are unscrupulous rascals, that stereotype sticks to all of us and allows
government to use landlords as a scapegoat for crime and urban decay. That
coupled with the unfortunate fact that most landlords are apolitical, has
allowed government to regulate the rental housing business in ways that voters
would find abhorrent if applied to hamburger stands, shoe stores, or industry.
Zoning is a major consideration in the purchase
of commercial properties, but affects the permitted uses of residential
property as well. Prospective purchasers should investigate zoning issues
after identifying the uses they contemplate for the property. If you select a
nice single family home in an area that has been re-zoned to another use, you
may well continue to use it as a residence, but you could be unable to make
major improvements like additions or building a garage.
For decades urban governments allowed, or
looked the other way, as property owners cut up large old Victorian homes
into a number of small apartments; although in most cases the homes were not
in an area zoned for multi-family housing. It is imperative that investors who
contemplate the purchase of such a building get a written guarantee that the
local government will continue to allow the non-conforming use and allow the
property to be sold as a multi-family home in the future. Many investors have
been caught in situations where they bought a building based on the cash flow
from six or seven units, only to be told later that they are operating
illegally and they will only be allowed to rent a much smaller number.
Timing
Although location is usually
considered to be the most important factor (in fact the first three factors)
in determining real estate values, many experienced investors feel that
the three most important factors likely to affect the value of an investment
are: timing, opportunity, and information
(inside or otherwise). The timing of a real estate purchase is just
as important a consideration as location and price. Real estate is a local
investment; property values depend heavily on the current state of the local
market. For example, in the mid-seventy's, California was beginning a
period of economic growth; property purchased in Santa Barbara during that
time experienced a high rate of appreciation in value. But if the same
property had been purchased in 1990, the owner would likely have experienced
substantial loses. The northeast saw similar declines in real estate
values during the transition from an industrial based economy to technology
oriented jobs.
The best buy, in the best condition, is worthless
to investors if the rental market is in the proverbial toilet because the
military base or a major employer recently closed. If a property is
vacant it has negative value to landlords. Market value is important to a
homeowner, but is only relevant to a real estate investor in that it reflects
the possible resale value, and the investors net worth on paper.
It is probably best to purchase property in a
market of rising values. Many investors always try to predict the bottom
of a poor market, and make purchases at that time; but often their predictions
are just a little off and property values continue to decline. Remember
too that there is a big difference between investing and gambling. Real
estate does not have to be a gamble.
Age
Chronological age is
the number of years since a structure was built, but perhaps more
important to an investor is the effective age, the age that the
improvements appear to be. Actual age and effective age are similar when a
structure is new, but change quickly when it has been allowed to deteriorate. We can all probably recall inspecting homes that appeared either much older or
newer than their actual ages.
Deterioration is not the only reason that
structures age. Some homes may be in beautiful condition physically, but their
decorating schemes and floor plans become outdated because tastes change or
because needs change. While orange shag carpeting was desirable 30 years
ago, it is a real turn-off to most tenants or buyers today and while a one-car
garage was considered a plus 50 years ago, most tenants and buyers prefer a
two-car garage today.
The greater the effective age of a structure, the
more substantial will be the loss of value. Effective age can often be reduced
by routine maintenance and regular updating. Buyers often compare
properties and estimate values based on the actual ages of the structures. For example, they may assume that a subject property with an actual age of 20
years is less valuable than another with an actual age of 10 years. In reality,
the 20 year-old subject may be more valuable if it has an effective age that is
newer than the comparable.
It should be noted, however, that an older
structure will never have an effective age of "new", regardless of updating. Certain features always betray the fact that the structure is not new: roof
line, windows, woodwork, cabinets, landscaping, doors, electrical wiring,
plumbing fixtures, etc.
A property may be relatively new and in great
condition physically, but if all the carpeting is orange shag, with avocado
green countertops and harvest gold plumbing fixtures, it may only have appeal to
tenants still emotionally tied to the 70s, with an effective age of about 25
years and buyers will discount the price by the amount they estimate it will
cost to update the items.
One other option is new
construction -- either purchasing from a builder or developing it yourself.
Discussion of new construction was provided in the previous lesson and
this specialized subject may be covered in detail in a future csu e-course.
Condition
A property that is a good candidate for real
estate investors almost always looks to be in bad condition. That's OK, if it
has the "right things wrong with it." For
example, needing paint, a sagging porch, bare bones landscaping, ugly
wallpaper, or being dirty and unkempt are easily fixable. Even seemingly
major deficiencies such as old plumbing or electrical, a defective furnace, or
a bad roof can be factored into the price you offer.
However, the "wrong things wrong"
are problems that cannot be cured except at relatively great expense such as
tiny bedrooms, lack of closets, steep narrow stairways, one bath, and, most
importantly, bad location.
When considering condition, remember,
homeowners buy pretty, landlords should buy practical and for the property's
potential.
Price
Many new investors make the mistake of
buying "bargain" property for rental housing - because
that is what the man on TV
told them to do - without understanding why tenants
choose the location the want to live in, and the kind of home they want to
rent. To get good tenants you must own decent, safe and affordable housing in
areas where people want to live. Schools, transportation, shopping, churches
and jobs all affect the amount of rent a tenant will be willing to pay to live
in your property. And that determines the price you can pay for a rental
property.
When investors buy a property just
because it is priced $10,000 to $20,000 below market value, they often learn
too late why it was priced so low. Don't get caught up in the most common
mistake made by inexperienced investors; when you become blinded by the "good
deal" you are about to make, you usually don't see the rest of the story. The
price you can pay for income property must be a factor of the
Net Operating Income that it will eventually produce and the resale value
of the investment -- should you need to liquidate.
If however, you intend to put the investment in
your Four F
Portfolio, and fix it up for a quick resale, your criteria is totally
dependent on a recent
Market Analyses for that kind of property, in that location, when the
likely rehabilitation is complete.
There are legitimate reasons for a decent
property to sell well below market. For example: divorce, death, and
taxes, can motivate sellers to take a quick cash offer that they would never
agree to under normal conditions. But perhaps the most common reason a seller
can't get a fair price for their property is inadequate professional marketing
or "deferred
maintenance".
If you are buying property for rental
housing, the purchase price can be relatively unimportant. What is as
important is: -- the amount of money it will take to make the property decent,
safe, sanitary and desirable to a desirable tenant, the terms of the sale, and
the market rent for that type of property in that neighborhood.
What can you afford
Most real estate investors have a limit on the
cost of the property that they can buy, and, unless you're Donald Trump, that
limit is probably not in the billions of dollars. However, even if you
are Donald, you still have a limit.
There are several factors that affect that
limit. First, there is the amount of cash that you have available to
cover the down payment, loan costs, and escrow costs. However, even if
you buy the property with nothing down, zero loan costs and the seller covers
all escrow costs, there are still limits. One limit is usually imposed
by certain principles of economics. That is, the higher the leverage the
less the positive cash flow, even when there is no vacancy and no deferred
maintenance. Unless you manage to "steal" the property because of
special circumstances (e.g., distress sale), it is likely that a zero-down
purchase will have a significant negative cash flow. While you might be
able to cover a $200 per month negative cash flow from a small single-family
house purchased with no money down, few investors can or want to cover the
$10,000 monthly negative cash flow from a 30-suite office building.
Another related limitation comes into play as
soon as you need financing from other than the seller. For a residential
property larger than a 4-plex and for most commercial properties, lenders will
loan only 70 to 75 percent of the value. Furthermore, the lender will
usually want to see that the buyer has 10 to 20 percent of his own money in
the deal, so the seller's willingness to carry 25 to 30 percent will not
usually allow you to buy with no money down.
So, the bottom line is that the maximum value
property that you can buy is limited to that for which you can afford the down
payment necessary to reduce financing to the level that the property will
produce at least a small positive cash flow or a negative cash flow that you
can carry with minimum risk until the property's Net Operating Income
increases sufficiently. While this varies with (1) the current interest
rate and financing costs, (2) the price you pay relative to gross income, (3)
the expenses relative to income, and (4) how much deferred maintenance comes
with the property, you can typically buy a property costing in the range of 3
to 4 times the cash that you have available.
What's It Really Worth
No one wants to pay more for
anything than it is worth. Understanding how to determine the value of
income property is probably the most important single skill for successful real
estate investment. RHOL has an e-course,
Valuing Income Property, that discusses value in considerable detail and
shows you how to value a property using a variety of methods. If you have
not yet taken that course, you should do so. While you will not have to
complete that course prior to finishing this one, you will have to understand
how to determine value prior to applying the information of this course to an
actual purchase or sale.
Tax
Ramifications
The IRS code is designed to provide
incentives or penalties that promote or discourage financial activity in
America, according to the political and public policy of the moment. Home
ownership and investments in rental property are perhaps the primary examples of
how effective the tax code is at effecting the value in what is purported to be
a free market place.
Although we do not believe that investors
should build or buy rental housing just for the tax benefits, they are certainly
a very important part of any investment plan. We provide further
discussion of taxation in a later lesson and will the subject will be covered in even more detail in a future csu e-course.
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