New options for the small real estate investor.

New options for the small real estate investor.

It strikes me that, for a guy who for nine years did nothing but manage and lease small investment properties, I haven't done much writing about buying small investment properties. There may be several reasons for this:

I spent nine years doing nothing but manage and lease small investment properties, with a Germanic attention to detail (see Web site) and insistence on rules which must be obeyed! which upon mature reflection was, considering the nature of the properties and the career opportunities they offered, overkill of a magnitude guaranteed to lead to early burn-out. So when Coldwell Banker told me "no managing", I told them "no problem".
For most of my career in sales it's seemed like the days of the small real estate investor were over, at least here on the mid-Peninsula. Even back when I was managing in the early 1990s, when prices were a fraction of what they are now, all my intentional investor-clients (as opposed to my accidental investor-clients, who were clients only because they couldn't afford to sell in the downturn or were leaving this area for a short time) were long-time owners who'd bought in the 1960s or 1970s. Make money buying a string of single-family rentals, like they did in the old days? Not unless you could afford to wait for appreciation to bail you out while you dug deep in your pocket every month to carry your so-called "income properties". Even "units"—duplexes, triplexes, fourplexes—that sent more cash their owner's way each month were still expensive propositions to own around here. You had to go far afield, to Oakland or Vallejo or Reno, to find rental properties that even paid for themselves, let alone paid you something extra each month, and going that far opened up a whole new can of worms.
I've come to the conclusion that owning small investment properties is a young man's (or young woman's) game. Because it helps if you're pliable and a quick healer (mentally as well as physically) and handy, or willing to be handy, or willing to try to be handy, or just willing. Most of us in our peak earning years have become disinclined to crawl under a house and probably shouldn't for a variety of reasons, while most younger buyers are stretched to the limit just paying the mortgage on their primary residence. And also disinclined to crawl under a house. Plus you need a fairly long timeline, since residential investment real estate has usually not been a get-rich-quick proposition. The exception to this might be when an over-reacting market (and is there any other kind?) has depressed investment property values far below even their likely short-term level.

That's not to say that I've ignored the investment property market since 1998, just that very few of my clients have been interested. But the real estate investment landscape has changed dramatically over the past year-and-a-half.

Yes, I'm saying "there's gold in them thar foreclosures", or at least a few bucks to be made from the effect that a glut of properties with motivated sellers has had on the prices, not only of low-end single-family homes, but on low-end investment properties as well. Because it's becoming obvious that not only did loose underwriting move lots of low-end buyers into homes they couldn't afford, it also let lots of people become small real estate investors who shouldn't have. Someone's got to pick up the pieces, and it might as well be you.

Note that the word "low-end" appeared three times in the above paragraph, and I'll use it again, just for emphasis: low-end. Low-end low-end low-end. There may be "bargains" or, better put, really cheap properties, out there these days but they're at the low end of the price range. And take it from me, investment properties in low-end (there's that word again) neighborhoods are a) high maintenance, at least if you care about what's going on at your property, although many low-end investment property owners don't and seem to do just fine, and b) not the kind of properties you'll fall in love with, although there are exceptions, and c) not in neighborhoods that look especially prosperous, although they may have other charms.

And lately these properties have been selling at prices that won't send you to the poorhouse. And there's tax advantages to owning investment property, above and beyond those available to the homeowner, that cushion the blow even more. And there's the possibility that in sending prices back to 1999 levels the market has over-reacted and will come to its senses in a few years. And investor loans in this price range are cheap, even though they're slightly more expensive than loans for owner-occupied residences.

Entire books (many entire books) have been written about analyzing, buying, managing, selling and exchanging investment real estate, so I'll confine myself to giving you a few brief examples of what I've turned up in the past few weeks while looking for a client. All these properties are located in central San Jose, perhaps twenty to thirty minutes from my Menlo Park office.

Here's my favorite, duplex A. Duplex A isn't a hundred years old, as so many central San Jose duplexes are, and hasn't been hacked up by fifty years of clueless owners, as so many central San Jose duplexes have, and was built as a duplex, as so many central San Jose duplexes weren't. It also has a view of a large commercial storage yard across the street, ringed with barbed wire, but it's in a decent mostly-residential neighborhood convenient to 101. And for those of you who like a little bonus income from your investment property, permitted or maybe otherwise, it sure looks like someone converted the building's laundry room to a studio with kitchen and bath. With permits? Who knows, and in this neighborhood not many ask. Aside from the studio, the property appears to be a legal and fairly modern duplex with two 2-bedroom/1-bath units, one of them townhouse style, that will rent for about $1400 per month each. Throw in the studio at about $700, and that's gross monthly income of about $3500 when fully rented and all hands paying rent.

Expenses? Figure monthly mortgage payments of about $1800 with the required 25% down payment, one point and an interest rate of 5.75%. Property taxes would come to about $425 a month, "other" an estimated $700 per month. What's "other"? Maintenance, if you're the kind of landlord who's into it. Landscape maintenance, if the duplex has landscaping and you're the kind of landlord who cares what happens to it. Garbage pick-up, an expense that'll be tough to duck. Water and sewer, unless each unit has its own water meter. Electricity and gas unless, again, each unit has its own meters. Insurance, something your lender will insist on. And besides these basics, the ever-popular "miscellaneous". And maybe management expense, although if you pay someone to manage your property you're not a gung-ho go-getter small real estate investor.

Is there a rule of thumb for investment property "other" expenses? A quick look at what's sold lately suggests 20% of gross income is a good rule of thumb, although I'd encourage you to at least attempt to verify your likely operating expenses because they can vary widely, depending on a number of factors including metering and your tolerance for deferred maintenance. Foreclosed properties present a problem in this regard because the owner isn't around to tell you what his or her operating expenses have been, although even non-bank owned properties are often sold with sketchy information. Just don't release your contingencies until you've done your due diligence and have a good idea of what you're getting into. Better yet, get a handle on likely operating expenses before you make an offer.

So is there an upside to all this? I think so. For one thing, Duplex A is priced at a "multiplier" of about 10. In other words, you're paying only about $10 for each $1 of gross annual rent. How is this a good deal? Well, tomorrow I could show you not one but two duplexes in San Carlos priced at a far more typical multiplier of around 20. And in Palo Alto, they're priced at over 30, which may explain why most Palo Alto duplexes I've seen lately have been offered as land value unless they're on the historical list and can't be torn down to build a new single-family home. So 10 is a good deal, even by central San Jose standards, although with Duplex A some of that good deal comes from a potentially illegal unit. And we haven't talked about the tax benefits or potential appreciation.

Let's take a quick look at another intriguing possibility, an attached single-family home, only four years old, in a decent residential neighborhood close to San Jose State. It sold for $700,000 when new and is now on the market at just over $400k. Rent would probably be about $2500, based on Craigslist asking rents of comparable homes. At first glance, expenses would seem to run a bit more than the rent, say, $2750 a month: mortgage payment of $1812, prorated property tax of $433 and "other" of about $500 calculated at 20% of gross income. But the home is almost new and, aside from needing new carpet and paint—it was lived in pretty hard—there shouldn't be that much building maintenance. What about landscape maintenance? There's a small back yard liberally landscaped with weeds. The home has its own meters for water, electricity and gas. You pay for garbage pick-up. At a 14 multiplier this isn't the deal Duplex A is, but the home is a real anomaly for the area, modern and with nice finishes, which should help when you sell.

Here's a third bank-owned option, an older single-family home with five bedrooms and two baths, also convenient to SJSU. At 1800 apparently legal square feet, the house is unusually large for the area, yet it's offered at just over $300k. Stuff it full of students, at maybe $500 per room, and the numbers work out to a nice friendly multiplier of about 11.

Next is Duplex B, typically antique at 102 years old and offered at a higher 14 multiplier, but with all Section 1 termite work done (most likely a staggering expense that the new owner won't have to worry about, assuming he or she would worry about such things) and in a good area a block south of SJSU. You pay a little more than Duplex A, but you get a better location with a built-in rental market and, as any smart landlord will tell you, that's worth a few bucks. Yours for a down payment of about $118k and monthly expenses of about $3100, partially offset by monthly rental income of about $2800. And Duplex B been on the market for over two hundred days, so I think you could get it for closer to a break-even price.

Let's wrap things up with Duplex C, also near San Jose State, a bank-owned single-family home with attached one-bedroom/one-bath unit that looks like it might actually put about $200 a month in your pocket. An income property that generates income? What's up with that?

Not every central San Jose income property is a screaming deal. Here's Duplex D, not bank-owned, priced at a 16 multiplier, but within walking distance of a happenin' downtown and with both units upgraded to owner-occupied condition. Duplex E is also not bank-owned, and the multiplier is a hefty 17.6. Duplex F is well-priced, but a quick check of RealQuest reveals foreclosure activity and suggests a short sale with all its complications and futility. Speaking of short sales, Duplex G is on the market at over $100k less than the loan balance.

I mentioned that there can be tax advantages to owning investment real estate, over and above the usual owner-occupied tax breaks. Coldwell Banker gets justifiably nervous if any of its agents attempt to give tax advice, so I'll just hit the highlights and give you links to these IRS publications: http://www.irs.gov/pub/irs-pdf/p527.pdf and http://www.irs.gov/pub/irs-pdf/p925.pdf.

Depreciation is a paper expense that gets treated for tax purposes like a real expense. In other words, the IRS lets you claim that your central San Jose duplex, which in reality was fully depreciated about the time Calvin Coolidge was president, has a useful life to you of less than a few decades, during which time you get to depreciate a portion of the value of the structure (but not the land) and deduct that "expense" from your annual taxes.
Unlike the homeowner, the owner of investment real estate can deduct repair (but not improvement) expenses within certain limitations. Improvements must be depreciated. What's the difference? A "repair" keeps your property in good operating condition. An "improvement" adds to the value of the property, prolongs its useful life or adapts it to new uses.
Your loses on investment real estate are deductible, subject to certain limitations. Your allowable deductions will be higher if you, rather than a management company, are actively involved in managing the property: finding new tenants, dealing with existing tenants and initiating repairs.
Perhaps the most favorable tax advantage of real estate is that, again subject to certain limitations, you can defer the capital gains tax when you sell by doing what's called a 1031 exchange. This can get arcane, as can all tax issues, but essentially it allows the real estate investor to own progressively more valuable investment properties or an ever-larger portfolio of properties without immediately paying capital gains tax on each transaction.

For this and all investment property tax questions, study the relevant IRS (and California Franchise Tax Board) publications and/or see a qualified tax advisor. And to go out and kick tires and hear old war stories, contact me at jfyten@cbnorcal.com.