The data coming out on home prices is rather clear. Home prices are moving up steadily in the last year now increasing at a rate last seen in 2006. Of course, little of this is coming from wage growth but more from easy access to debt, investor demand, and historically low supply. One thing that people fail to remember is that during the last housing bubble, people were supplementing a lack of income growth with easy access to debt to add fuel to the housing market. This time, the easy money is being supplied to banks and hedge funds that are simply chasing higher yields [6]. Anyone that has a hand in the housing business, especially in the grind it out rental business understands that it is no hands off endeavor. This is why it is surprising to see how much money is now being funneled into the market by brand new small time investors, especially in places like California. You know things are getting frothy when new money is willing to chase the rental business.
Investing big in Southern California
I saw this interesting post over on Redfin [7]:
“We are a working couple first time buyers in La California. We have 300K$ down and were preapproved for 900K loan.
We never owned property before so we are seeking expertise advice and answers to these questions
1. We were wondering about what people who have gone this route have to say or give advice on that.
2. Is this the right way to go?
3. As we understand how important location can be, we are debating whether we buy it in Burbank N Hollywood Sherman oaks, La near USC or West Hollywood? Investment wise what would make the most sense?
4. Also for maximizing investments and cash flow what’s best 2, 3, 4 units or more is best?
5. What things do we look for when we go see the apartment?
6. What questions should we ask the seller?
7. What to look for in the surrounding? Besides school public transportation and safety obviously?
Any comment and/or advice is greatly appreciated!”
Think about what is being asked here. A first time buyer is looking to dive into a $900,000 investment property (almost $1 million) and has many questions that are basic for most investors even considering a $100,000 investment [6]. So let us just pick a place in Burbank that fits the $900,000 mark:
[8]
283 N Florence St
Burbank, CA 91505
# of Units 4 Units
Beds 4 Bed
Sq Ft
Lot Size 7,379 Sq Ft Lot
Year Built 1947
The above place is a 4-unit property. The place is listed at $895,000. From the income sheet we find that the property will produce a gross income of $41,580 with expenses of $5,633. The expense amount is incredibly low in my estimation. From practical experience by the time all is said in done with taxes, insurance, vacancies, repairs, and just the operation of a mulit-unit you are likely to get a net operating income of something close to 50 percent of your gross income. Even with that said, the rents here are essentially $3,465 per month (or $866 per unit).
Let us assume this investor goes with this property. In more expensive areas of California investors are now buying to flip whereas in lower cost areas like the Inland Empire [9], more are buying to rent. From the initial notes, this potential buyer will put down $300,000 for the $900,000 property. Let us be generous and say that everything goes well and they manage a 60 percent NOI on their first year (meaning they kept expenses at 40 percent*). What is the cap rate here?
$24,948 / $900,000 = 2.77 percent
*Mortgage payments and depreciation are not considered operating expenses so that does not impact NOI
Keep in mind the above assumes a very optimistic scenario. In the end, this investor is going to be putting $900,000 at play for a 2.77 percent rate of return and they will be working for that money. If not, they’ll certainly be paying someone for that rate of return and this will cut into the overall rate.
Keep in mind we still need to factor the actual $600,000 mortgage payment. It looks like they were pre-approved and with everything said and done, the APR on this thing will likely get close to 4 percent on an investment property. So here is the principal and interest:
PI: $600,000 loan at 4% = $2,864 per month
The place is only producing $3,465 gross per month! Not factoring anything outside of principal and interest, which is big for a multi-unit, you are looking at a gross minus PI amount of $601. Bwahahahaha! What is amazing is they tried to sell this place for $1,000,000 last year:
[10]
Any seasoned investor looking at this is probably shaking their heads. Even the press now understands exactly what is happening:
“(Reuters [11]) Home prices have been rising since last year, helped by investor demand and tighter inventory. The top five states with the biggest gains in prices were Nevada, California, Arizona, Idaho and Oregon.”
Helped? The market is being driven by this. In SoCal 35 percent of all purchases last month came from the all cash crowd. The only reason you would buy a place like this example is if you believed in solid appreciation. This is what many of the flippers are doing [12]. Buying a place, fixing it up, and selling it into the current momentum for a quick profit. The fact that people are considering diving into the current game in LA and OC for rental cash flows boggles the mind, especially new investors looking to put down $300,000 on a $900,000 property that will throw off a yield lower than you can get in regular bonds.
Saving $300,000 is no small task. I'm curious as to what the perspective would be on buying a place like this?
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