By Jan B. Brzeski and Gregory S. Hebner
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The Case for Investing in Rental Homes
Why should I be interested in investing in single family homes now?
How can investors gain exposure to U.S. single family homes in their portfolios?
Economics of Single Family Homes
How big is the residential real estate market? How should I consider the market when I look at the opportunity?
Is capital appreciation likely for long-term investors who buy homes today?
What is the upside scenario in investing in single family homes?
How does renting single family homes compare to owning and operating apartments? Which is better?
How long will prices be attractive?
What kind of yields can single family home investors expect?
What are the operating costs of a single family home?
How do yields differ from one region or neighborhood to the next?
What about investing in an area that has a crime problem?
How does using leverage affect returns?
Is leverage available for rented single family homes with today’s challenging lending environment?
What is the tax treatment of investing in single family homes?
How does investing in homes compare to investing in commercial real estate?
Challenges and Risks of Investing in Homes
Is it hard to find homes that work well as rental properties?
What can go wrong if I invest in single family rentals?
What are the challenges of investing in rented single family homes?
What are some of the main risks of investing in single family homes?
What are property-specific risks?
What are examples of market, legal and execution risk?
What are the risks of buying homes and leaving them vacant?
Market Conditions in 2012
How long do I have to invest in single family homes?
Can investors expect appreciation? If so, how much?
Participants in the Market
Which large-scale investors are targeting this area? Why are they so interested?
Will there be REITs devoted to single family homes and if so, when?
What challenges will the larger funds investing in single family homes face?
Investing Passively vs. Managing Actively
What if I want to invest in this sector passively?
What should passive investors look for in a sponsor/active manager?
What if I want to invest in this sector actively? How do I know whether direct ownership of investment homes is the right choice for me?
How can I purchase a home at a favorable price?
How should I decide where to buy?
How do I analyze whether a particular home is a good investment?
What about investing in a condo as a rental? What are the special considerations?
What are the advantages and disadvantages of buying at foreclosure sales?
What about buying bank-owned homes that are listed by real estate agents on the Multiple Listing Service (“MLS”)?
What are the pros and cons of buying via a short sale?
Should I renovate a home after I buy it? If so, how much should I spend on renovations?
Can I hire a property manager? What do they charge?
What if there is a major repair required, such as replacing the roof?
How important is resale value of the home? How can I determine resale value?
Should I be concerned if there are lots of other rental houses in the neighborhood?
What happens if a tenant does not pay his or her rent?
What if my tenant files for bankruptcy?
Can I invest in non-performing loans secured by single family homes? How does that work?
Where can I find more information about investing in single family homes?
What are the advantages and disadvantages of active versus passive investing?
Are the fees that fund managers charge justified?
The Case for Investing in Rental Homes
There are number of reasons why investing in single family homes has become more attractive over the past 12 months:
(1) Home prices have fallen substantially and are now 34% below their 2006 peak and in many markets prices have now fallen well below their replacement value. This significant drop in housing prices has created an investment opportunity for investors to purchase properties below their fair value.
2) Given current house values, there exists a good chance for homes to appreciate over time. This increase has already been seen in some markets such as Phoenix, where homes prices are up 12% over the past quarter according to the S&P/Case-Shiller Index.
3) The underlying home ownership equation has undergone a fundamental change in the U.S., substantially increasing rental demand. The U.S homeownership rate fell to 65% in the first quarter of 2012, the lowest it has been in the U.S. in over 15 years. Some experts project another five to six million households will lose their homes due to foreclosure of delinquency in the next five years, driving even further rental demand.
4) New construction levels in the U.S are far below historical levels and there are not enough new housing units being built to support the growth in the population and households. These factors create an opportunity to acquire assets at attractive prices and by renting them out, achieve a good yield on investment. In many markets, a yield of 6-7% can be achieved.
5) Single family rentals provide a strong hedge against inflation and have limited correlations with other widely-held investment assets such as stock and bonds. Home prices tend to be positively correlated with inflation so if it does begin to erode the value of other investments in a diversified portfolio, single family properties can provide a good hedge. Additionally, single family rental returns have shown a very low correlation to commonly held assets such as 10-year Treasuries, corporate bonds and major stock indices such as the S&P 500 and the Dow Jones index.
The most direct way to gain exposure is through direct ownership of single family properties that can be rented to tenants. Investors can purchase homes directly or can engage a local real estate agent to assist them. If an investor prefers to invest in a more passive manner, they can invest in a real estate fund that purchases and leases out the homes or can partner with a local operator that will purchase homes and manage them on behalf of an investor in exchange for some agreed upon profit split and other fees.
In addition, investors can invest in loans secured by homes to earn high yield fixed income-type returns. For more information on this strategy please reference our Trust Deed Investing FAQ
Economics of Single Family Homes
According to a late 2011 study from Morgan Stanley, there are approximately 20 million housing units in the single family rental market (defined as properties with between one and four units). This number represents just over 50% of all rental units in the U.S. at an average value per unit of $150,000; this represents a total market value of approximately $3 trillion. Another important consideration when looking at the single family rental market is the expected increase in the number of properties that will be converted from primary residences to rental units. Some forecasts project that between five to seven million additional properties will be liquidated and converted to rental properties to meet the demand from former homeowners that need housing units.
In our view, several factors working in conjunction are likely to drive prices higher for entry-level homes in many hard-hit areas. First, inventory levels have started to drop and demand from both investors and end users has strengthened. This combination has led to the stabilization of housing prices in a number of markets. We expect this trend to continue as large Wall Street investor funds continue to roll out programs to acquire single family homes for the purpose of renting them out. As more capital enters this investment category, we do expect prices to rise.
In addition, in many areas homes sell for dramatically less than “replacement cost,” which is the cost to build a new house, plus the cost of land improvements such as streets, curbs and utilities. In areas where the population is rising, we believe that a home in a solid neighborhood will not sell for a price dramatically below replacement cost for too long‚Äîperhaps a few more years, but not 10 more years. To put it another way, if an investor can purchase a home for half of replacement cost, and make it “like new” with a total cost still 30% below replacement cost, then that home should be very attractive when compared to a brand new home in a new subdivision located farther away from jobs. By the time home builders can justify returning to building out their suburban subdivision projects, more centrally located homes in solid neighborhoods in the same metropolitan areas are likely to have appreciated relative to their current values.
Lastly, in many harder hit markets, there exists a significant discount between distressed and non-distressed sales. Distressed sales primarily consist of short sales and REO (bank “real estate owned”) properties, which are discussed in more detail below. This discount takes into account the condition of the distressed properties and the nature of the sales, which are often made to cash investors or investors using private financing (vs. conventional mortgage financing). This “distressed discount” is as high as 40-50% in some markets such as Atlanta and Cleveland and between 15-25% in major California markets such as San Diego, Los Angeles, and Sacramento. These distressed sales continue to drag down the prices in these areas and as less distressed sales take place, there should be a general rise in housing prices as non-distressed sales makes up a larger percentage of the total sales in a local area.
Suppose you can acquire homes that once sold for $250,000 for $100,000 (total cost, after renovation). Assume a 6% return on your investment and a loan of $65,000. If that home appreciates to $160,000 during the holding period and is sold, with $15,000 of selling costs (broker fees, repairs prior to resale, etc.) the investor will have roughly doubled his equity, plus collected reasonable cash flow in the interim. If this happens over five to seven years, the annualized return will be in the neighborhood of 20% and could approach 25%.
The basic premise of investing in homes and apartments is very similar. Tenants in single family homes are more likely to be families and therefore stay on average for a little more than two years (source: Zelman & Associates). Tenants in apartment buildings typically do not have kids living with them and often stay for a shorter period of time as compared to home renters. For example, in Las Vegas apartments, more than half of tenants typically turn over every year. Operating expenses for apartments include items such as utilities and common area maintenance, whereas for homes, all utilities are typically in the name of the tenant. Overall, operating expenses for homes and apartments are probably similar, per unit per year, in the range of $4,000-$5,000 when reserves for capital expenditures are taken into account. The yield for investors buying large apartment buildings may be a little lower today vs. the yield on homes in the same area, because there are more well-capitalized buyers trying to acquire apartment buildings, though this is changing. The biggest difference is potential appreciation. Apartments are valued based strictly on cash flow, and today values are very high relative to cash flow (partly because interest rates are so low). Single family homes can be valued based on cash flow but also based on the intrinsic value to a future owner-occupant. Today, there are few owner-occupant buyers for foreclosed homes in many markets, but if and when the economy improves, single family home values in these markets might appreciate more rapidly than apartment values.
Predicting housing prices is a very imprecise science and is influenced by many factors. The most important drivers include the condition of the overall economy, especially job growth and growth in household income. The U.S. economy has been in a very prolonged slump that has destroyed a substantial amount of household net worth and reduced household income for many families. As these factors improve and consumer confidence gets stronger, housing prices will rise.
Also, the supply of distressed inventory hitting the market (often referred to as “shadow inventory”) will be a big driver of future housing prices. The less distressed inventory that hits the market, the stronger housing prices should be in a given area.
Nobody knows how long prices will remain at current levels. At their current rate, banks will most likely need several more years to resolve the bulk of their delinquent loans. Most active single family investors expect that prices will move up substantially within one to two years. In some areas, prices have already moved up significantly. For example, homes in the Inland Empire area of Southern California that could be purchased for $80,000 in early 2011 might sell for $100,000 today. This represents a 25% increase in just 18 months.
First, let’s define how yields are calculated for single family investors. Suppose you purchase a home for $85,000 and spend $15,000 on renovations such as paint, flooring and updating the kitchen. Your total cost basis for this property is $100,000. A rule of thumb is that you should be able to rent out the property for a monthly rent of at least 1% of your cost ‚Äîin this case, $1,000 per month. If you achieve this rental income, your annual rent would be $12,000 (this is called the “gross potential rent”). Your actual rent collected may be a little less once you account for vacancy, occasional bad debt and the like. Let’s assume actual rent is $11,000 per year. Your operating expenses including property taxes, insurance, repair expenses and property management fees might be $5,000 per year. This would leave you with $11,000-$5,000=$6,000 per year in cash flow (“net operating income” or “NOI”), which represents a 6% yield on your cost basis of $100,000. In many markets today, for investors who purchase carefully and renovate cost effectively, these types of yields or “capitalization rates” are achievable and in some cases can be exceeded. This represents an unleveraged yield in which all of the investment is made in cash. Below we describe how yields change with the use of leverage.
They vary widely from one region to another, but usually fall within the range of $3,000 to $6,000 per house, per year for an entry-level home in a middle income area. Sometimes investors look at operating expenses as a percentage of collected rent, in which case a normal range is 35% to 45% (however, in very low income areas operating expenses can be a higher percentage of collected rent).
Investors would be wise to consider all the items that must be deducted from gross potential rent to determine net operating income (“NOI”). These items include the following:
Vacancy: The period in which there is no rent being collected.
Loss to Lease: Refers to tenants who are allowed to stay at below-market rent.
Concessions: Refers to promotions such as “one month free with a one year lease.”
Bad Debt: Losses from tenants who leave without paying their rent.
Total Collection Loss: This term is used by experienced operators to track the total difference between gross potential rent and actual collected rent; usually expressed as a percentage of gross potential rent.
Payroll: Wages for any employees who assist in maintaining and/or leasing properties.
Utilities: For example, water bills to keep lawns watered while property is vacant or other utilities such as electrical and gas that need to be paid on vacant properties.
Repairs & Maintenance: Includes fixing appliances, cleaning carpets, gardener, etc.
Marketing: Costs to advertise properties for rent. Many operators include the leasing fee paid to a property manager or realtor on this expense line.
G&A (not including property management): This might include the cost of office supplies, fuel or business meals.
Insurance: Property insurance that provides protection in case of fire or other hazards.
Property Taxes: In California this is usually set at about 1.2% of purchase price, plus an annual increase.
Management Fee: Management companies charge 7-10% of collected rent to manage single family homes.
Capital Reserves: An amount set aside each year (as an accounting entry) so that there is enough cash available for occasional capital expenditures as required, such as to replace the roof or other large expenses every five to 15 years, etc.
Generally the yields are lowest in the most desirable locations and also have the highest priced homes. For example, if you purchase a foreclosed home in Beverly Hills, you might pay $1 million to acquire the home. To earn a 6% NOI on this investment you would need $60,000 per year in net cash flow. Your actual cash flow is likely to be more like $30,000. The reason is that, in the most desirable locations, even today, there will be fierce competition from families who want to purchase the home for themselves and those homeowners with the financial position to own in these areas will pay higher prices to live in desirable neighborhoods that offer great schools and other valuable benefits to those living in these neighborhoods.
On the other hand, in more distressed or less desirable areas such as Stockton, CA it may be possible to purchase a home for $50,000 and get a 10% or 12% NOI. However, the neighborhood may be crime-ridden and the tenant will probably not take good care of the house. In California, coastal markets generally feature low single-digit yields while inland markets feature mid or higher single-digit yields. In the best neighborhoods and for higher-end homes, even in inland markets, yields are much lower.
The highest-yielding investment homes are typically those in high crime areas. The yield is high because most real estate investors prefer not to invest in areas where they feel unsafe. Investors who are set up to manage properties in high crime areas might earn good returns, but home appreciation in these areas may be more modest than in safer and more desirable neighborhoods.
Using leverage‚Äîin other words, putting a loan on an investment property‚Äîtends to magnify returns. If a property appreciates, as long as interest rates are reasonable, leverage will greatly enhance returns. If a property drops in value, leverage will magnify the losses. Furthermore, leverage can either increase or decrease the “cash-on-cash” return of an investment. For example, suppose you own a house with a total cost of $100,000 and it generates $8,000 per year in net income (after accounting for all operating expenses). If you own the property free and clear, your cash-on-cash return is 8%. If you can get a $65,000 loan with 10 year maturity at an interest rate of 4.5%, with 30 year amortization, your cash-on-cash return will rise to almost 12%. However, if you had to pay an 8% interest rate, with the same 30 year amortization, your cash-on-cash return would drop to about 6%.
Below is a link to a useful spreadsheet for figuring out the monthly payment on a given loan (it is a little easier to use than a calculator):
Getting a loan for a rented investment home in today’s market is not easy. Fannie Mae does provide such loans, up to a maximum of 10 homes per investor, but to qualify the borrower needs to have strong cash flow. The process is more difficult than receiving a loan for one’s own primary residence. Some banks provide “balance sheet” loans on rented homes, particularly if the home has been rented for some time. A balance sheet loan is one which the lender will keep on its own balance sheet for the life of the loan, as opposed to loans which are sold soon after they have been originated. Some lenders required that rental homes have a “seasoned” income stream, meaning that they have been rented and generating positive cash flow for some minimum period of time. Finally, there are certain private money lenders who provide loans on rented homes; however their rates tend to be in the neighborhood of 8-10%, plus a 2% origination fee, making such financing costly. If bank financing is available, both the rate and the up-front fees are likely to be lower. Regardless of the lender, most loans for rental homes are limited to about 65% of the appraised value of a property.
Like owning apartments, owning leased homes features two significant tax advantages. First, the building can be depreciated so that a significant portion of net rental income is sheltered from taxation. Second, if and when a home is sold it qualifies for capital gains tax treatment rather than ordinary income treatment.
Commercial real estate such as shopping centers, office buildings and industrial buildings tend to feature a little more current cash flow than apartment buildings. One reason is that analysts expect apartment rents to rise more rapidly than rent for other property types. For example, shopping centers face ever increasing competition from online retailers, limiting growth in demand from “brick-and-mortar” stores. Also, investors prefer apartments because their income is perceived to be more stable. There is a perception that apartment vacancy issues can be resolved more easily than vacancy in other types of property. In general, there has been too much capital chasing a limited number of commercial real estate opportunities, resulting in high prices for commercial real estate, making single family investment more attractive, however this may change as capital pours into single family investment.
Challenges and Risks of Investing in Homes
In some markets, such as Ohio, Michigan and Indiana, where average home prices are much lower than coastal markets, it is very reasonable to purchase homes that provide substantial monthly cash flow as rentals. In other markets, such as Southern California, there is substantial competition for any property that might cash flow well as a rental. In June 2012, California had the highest foreclosure rate in the U.S. (1 out of every 288 homes received a foreclosure filing (source: http://www.realtytrac.com/trendcenter/trend.html)). Even so, there are dozens of bidders at California foreclosure sales, and when homes have been renovated, in many areas there are actually bidding wars among qualified buyers for these properties. The best properties for rental tend to be more standard homes that do not have many elements that could cause problems (e.g. pools), that were built more recently and meet the needs of a large pool of potential renters in your target price point. Many families like 3 and 4 bedrooms that have a minimum of 2 bathrooms and some private front or back yard space. While it is not always possible to find these elements in a rental property, it is important to think about the ongoing expenses and challenges with a particular property when you consider how it might fit into a rental portfolio.
For inexperienced investors, the list of possible issues includes: (1) paying too much for a property; (2) underestimating the cost of renovations or not completing the renovations in a satisfactory manner; (3) having trouble renting the property (though rental demand is strong in most areas for quality properties); (4) choosing a bad tenant; and (5) having poor systems and procedures for maintaining and managing the property. Paying too much for a property and/or going over budget on renovations will reduce returns substantially as these mistakes impact your upfront investment. On the other hand, choosing a tenant poorly will not only hamper returns but it could also absorb substantial amounts of time and may well lead to remorse on the part of the investor. In another area of this FAQ we address a scenario in which the owner could not evict a tenant for more than six months, in part because the tenant filed for bankruptcy protection. Having the experience to choose tenants well may be the strongest argument for investing passively with an expert rather than purchasing and leasing properties directly.
If an investor is not able to maintain their properties on a regular basis, this could lead to substantial problems that require large capital expenditures. These issues could involve problems with a furnace or air conditioner, roof issues, plumbing or electrical issues or other items that could be expensive to repair and make the property non-leasable while the repairs are being made.
The biggest challenge is the lack of economies of scale in managing a portfolio of rental properties. This is especially challenging when compared to investing in an apartment building. Owning 30 homes is a lot more cumbersome to manage than one 30-unit apartment building. Also, finding a competent and dependable property manager for single family homes is more difficult.
The risks include property-specific risks, market risks, legal risks and execution risks, among others.
Some examples include a cracked foundation, which can be very costly to repair; structural problems, especially on properties built on sloping ground; mold; roof problems; electrical problems; and problems with plumbing, water and sewer lines. Purchasing property without first inspecting it thoroughly increases the risk of unwelcome surprises and extra expenses, and therefore dictates a larger discount to projected retail value.
Market risk refers to the possibility of property values falling dramatically and/or the inability to find tenants to rent a property. Legal risks range from title problems (such as unanticipated liens affecting title to the property, including lawsuits that attach to the property) to legal problems evicting the prior owner and/or tenants. Execution risk includes issues such as theft of rent by the property manager to poor organizational systems resulting in inordinate delays in getting properties repaired and rented, as well as poor choice of tenant resulting in turnover and bad debt.
Homes that are left vacant frequently deteriorate quickly. Risks include moisture and mold, theft of appliances, HVAC units and even wiring, vandalism and squatting.
Market Conditions in 2012
While today’s housing prices make single family home investing quite attractive, there will be a long-term need for quality single family housing units. Many investors and operators that we work with have been managing rental portfolios in their markets for 10, 20 even 30 years. They purchase their properties at a good price and manage and maintain the properties in a way that attracts and retains quality tenants. They have been able to continue to produce yield through holding their portfolio. Some investors consider their rental portfolio a key part of the retirement assets and seek to create a long term income stream that can supplement their earnings after retirement. The good news is that single family home investing has been a good source of income and investment returns for many years and should continue to be a good opportunity for both passive and active investors for many years to come. The change in today’s investment environment is that there are new ways to gain exposure to this sector through professionally managed investment funds that provide similar returns to active management of a rental portfolio without the other issues referenced above.
Nobody can predict the future of home values accurately. That being said, in many hard-hit areas, some appreciation is likely, especially where employment and population is likely to rebound. U.S. home values have fallen dramatically from their peak in the mid 2000s, as shown on the chart below. As of late 2011, The Economist calculated that home values were 22% below their long-run average, when compared to average household income (source: http://www.economist.com/node/21540231). Given that the U.S. population is growing and the U.S. economy is still more dynamic than other developed economies, the U.S. housing market has a good chance of rising in the next five to ten years.
Participants in the Market
The companies most likely to reach a scale that would allow for a public REIT offering include Waypoint, Colony American Homes (Colony Capital), Beazer Pre-Owned Homes (a joint venture of Beazer Homes and KKR), and American Residential Properties. Other players who have announced big plans for this strategy include Blackstone and Fundamental REO Access. The large players are attracted by low prices, attractively priced leverage and strong potential cash flow. Additionally, the large single family residential market allows these large investors to deploy large sums of capital. Some of these funds are seeking to invest more than $1 billion into this sector.
Most industry watchers believe there will be several public REITs devoted to owning rented single family homes by the end of 2013. There might be four to six public REITs in this area eventually. The most likely candidates to bring REIT’s focused on single family rentals include the large institutional investors listed above. It will likely be necessary for a company wanting to take a REIT public to have a minimum of 1,000 to 2,000 properties under management and perhaps even more. For small investors, if companies do become public REIT’s, this could create a very compelling and much shorter term exit option for smaller investors who may be able to sell their leased portfolios at a nice profit from their investment basis.
The single family rental business has diseconomies of scale. The biggest challenge for them will be to keep their costs low while trying to scale up substantially while still maintaining consistency and quality in their rental portfolio. If these larger investors end up paying too much on any level‚Äîacquisition, renovation or property management‚Äîand/or not getting high quality work done, their returns could suffer substantially. Additionally, most of the larger funds have historically focused their resources and capital on other real estate categories such as commercial or apartments. This shift into such a different investment category may prove challenging for such large funds.
Investing Passively vs. Managing Actively
In most cities there are local real estate operators who raise money from wealthy individuals to purchase income-producing properties. Some of these operators have set up programs to accept investors for single family rental strategies such as those described in this FAQ. A smaller number of groups have set up single family rental real estate private equity funds which differ from small syndications in that they typically have more formalized legal documentation (such as a complete private placement memorandum) and have more thorough reporting.
In considering a passive investment, a critical factor is the skill, dependability and integrity of the sponsor who will be actively building and managing the portfolio and handling investors’ funds. For a single family strategy, multiple capabilities are required including (a) a proven ability to purchase property at attractive prices from banks; (b) the ability to renovate homes cost-effectively; and (c) strong property management and accounting infrastructure.
Owning rental homes requires a commitment far beyond purchasing shares in a REIT or investing in a real estate fund. You might hire a property management firm to handle paying the bills and responding to tenant repair requests. However, it is not always easy to find good property managers willing to handle a few single family homes for years at a time. Alternately, you can manage the property yourself, but that requires a commitment of time for accounting, paying bills, arranging maintenance and leasing the property when necessary. If you are handy with household repairs and maintenance and you don’t mind spending time every month managing your property, or if you have a partner who is good in these areas, direct ownership might yield the best returns. If not, you might do better investing in a professionally-managed fund focusing on single family home rentals.
The best buys are typically made from the most motivated sellers, and the most motivated sellers of all are banks. They are under pressure from regulators to get troubled loans off their balance sheets. There are three main ways to purchase from banks: (1) at foreclosure auctions; (2) buying bank-owned properties listed by a local real estate agent; and (3) buying via a short sale.
A good guideline is to buy within an hour drive from your home or office. Otherwise, if and when you encounter problems, you will not be able to manage them easily nor will it be easy for you to visit and inspect your properties. Purchasing out-of-state properties as an active investor only makes sense if (a) you are investing on a scale that warrants regular flights and overnight stays, and (b) you have a very experienced, trustworthy partner or operator on the ground in the city where you are buying.
There is no single method that applies to all investors as it will depend on your investment objectives, holding periods and the type of investment that you are making. Some of the relevant factors to consider include: (1) Is there good rental demand and assuming there is, what kind of cash flow will you receive during the ownership period, using realistic expense projections, and including a reserve each year for capital expenditures? (2) Is the location desirable enough that you will be able to sell the property if and when you want to exit the investment (e.g. are there jobs nearby, are the schools acceptable, etc.); (3) Do you have the ability to manage the investment, given the location and your skills, or, do you have a solid partner or property manager available to do so?; (4) Are you purchasing the property at an attractive price, relative to recent sales of similar homes in the same neighborhood?; (5) Can you add significant value through renovations?; and (6) Do you believe that the local market is likely to rise in the coming years, given demographics, desirability of the location, and economic health of the area? If the answer to all of the six preceding questions is “yes” and your assumptions are correct then you will almost certainly make money with that investment. If the answer to most of the questions is “no,” then you are probably not going to be pleased with the results of your investment.
Buying a condo brings special issues. For example, if many owners in a condo association are not paying their monthly association dues, then the association may not have sufficient funds to maintain common areas such as roofs, elevators, mechanical systems such as HVAC and landscaping. Also, obtaining financing for an investment condominium may be harder than for a single family home, and reselling a condo may be more difficult because the pool of condo buyers is limited.
Foreclosure sales can offer bargains for all-cash buyers who are able to make quick decisions with limited information about what they are buying. They offer a legitimate way for investors to put money to work into single family homes and purchase single family properties at discounts to their fair value. Unfortunately, these auctions have become very popular precisely because they are an “easy” way for large investors to accumulate properties. Prices at foreclosure sales on average have moved closer and closer to fair market value recently in many markets and many savvy investors no longer feel they are being compensated for the risk involved in buying a house that may have an occupant who must be evicted, or without the benefit of full information about the condition of the property (since it is usually impossible to inspect the interior of homes sold in foreclosure sales prior to the sale).
REO properties have already been through the foreclosure process. In non-judicial states like California, the bank was the high bidder at the foreclosure sale and took title to the property. Typically, the prior owner has left the property after the foreclosure has been completed. Sometimes REO properties have been repainted and otherwise fixed up by the bank that now owns the REO, and on other occasions they are sold in their “as-is” condition, which may be very poor.
REO homes are listed with local REO agents who tend to have experience managing the sale of these types of properties. As actively listed properties, these properties can be inspected to determine their condition, which is an advantage relative to buying homes at foreclosure sales. However, because these homes are publicly listed in the local MLS, there can be quite a bit of competition for each property and many of the buyers seeking these properties will be cash buyers that can close in a very short period (10 to 21 days).
In a short sale, the buyer purchases the home from the existing occupant, but the purchase price is less than the amount owed to the lender. Therefore, both the owner and the lender need to approve the sale. Short sales offer the best opportunity for buyers, but they are the hardest to orchestrate and often take months to conclude. Thus, short sales are not very practical if you are seeking to purchase properties at a specific time.
Short sale pricing has started to converge much closer to REO pricing in many markets, especially in judicial foreclosure states such as Florida, Illinois, New York and Pennsylvania. To understand why short sales are frequently priced attractively, consider that in the first quarter of 2012, the average U.S. foreclosure took 370 days to process (source: RealtyTrac), but in some markets this process exceeded 500 days. When purchasing an REO, the bank has already incurred the huge cost of a foreclosure, which includes holding a non-income generating asset for more than a year, and the cost of evicting the occupant. In the case of a short sale, the bank can avoid the foreclosure process, significantly reduce their holding periods when they receive no payments on their loans and they can avoid the costs of fixing up the property and potentially evicting the tenant through a long and costly foreclosure process. Additionally, several large mortgage services such as Bank of America and Wells Fargo entered into a national settlement with 49 state attorneys general. This settlement requires these large services to provide funds for borrowers to avoid foreclosure and some of these funds will be used to complete short sale transactions.
Different investors take different approaches as it relates to renovations. Of course the condition and “bones” of the home upon purchase may dictate significant renovations or virtually none at all. We prefer to invest in a home upfront, to bring the property up-to-date and make it attractive for our tenants. We feel this attracts a higher-quality tenant who will pay a little more in rent and, just as importantly, will take better care of the property and stay longer. A typical range of renovation for an entry-level rental home is $5,000 to $20,000. Most homes will benefit from even simple cosmetic improvements such as new paint, new carpet and new appliances. The homes will need to be fully functional to support most tenants so this may require updates and fixes to items such as electrical and plumbing.
Major capital investments such as repairing or replacing the roof and plumbing will inevitably be required, especially for older homes. When these repairs are needed, the cost can easily be $5,000 to $10,000 or more. Assuming one $5,000 capital expenditure every 10 years, an owner might budget a “capital reserve” of $500 per year, in addition to the cost of routine repairs and maintenance (which may be another $1,000 or so per year). A common mistake made by novice landlords is to underestimate their expenses by ignoring these capital reserves. A property might operate with expenses of just $3,000 per year for several years in a row, but if in the fifth year a $10,000 one-time expense is incurred, the real operating costs over the five year period would have been closer to $5,000 per year.
Suppose you buy a home for $100,000 and it appreciates by 2.5% per year, or $2,500 per year. If your down payment is $40,000, the $2,500 of appreciation per year represents more than a 6% increase in equity per year. This is likely as much as the net cash flow after debt service. However, appreciation is speculative while income is much more predictable. Therefore, savvy investors often premise their investment on the income only, leaving appreciation as “icing on the cake.”
There is no simple answer to this question. Some neighborhoods are transitioning from owner-occupied neighborhoods to rental neighborhoods. For example, most homes sold by banks in Phoenix and Las Vegas today are purchased by investors who rent them out. A neighborhood transitioning from owner-occupied to rental homes might feature a rising crime rate, lower pride of ownership and/or lower prospects for future home value appreciation. However, if the alternative is a large number of homes that are in foreclosure or otherwise “underwater” then a transition from owners who expect to be foreclosed upon to investors with the means to take care of their investment homes may be beneficial.
The tenant must be notified that he or she is delinquent and given a period in which to bring rent current. If rent is not paid then an unlawful detainer action must be filed and eventually the tenant must be evicted, by a sheriff if necessary. Some states such as California are very tenant-friendly while other states such as Texas are more landlord-friendly in case of failure by the tenant to pay rent. In California tenants may be able to delay eviction by weeks or even months, if they know the system, file for bankruptcy and/or file a series of motions delaying the eviction process.
Before investing in any real estate directly, you should identify an experienced real estate lawyer whose hourly rate you can afford if you need to retain their services in the future. If a tenant files for bankruptcy, the owner and owner’s counsel need to monitor the process, submit filings and make court appearances as needed until the tenant can be evicted. The owner will not be reimbursed for any of these expenses, which highlights the importance of choosing tenants carefully.
Investing in non-performing loans is a very specialized strategy that can yield strong returns for expert investors. Investors purchase loans at a discount to par value and then negotiate with the borrower/occupant. Possible outcomes include restructuring the loan with a lower loan amount and/or monthly payment; foreclosing on the home, renovating and selling it; performing a deed-in-lieu of foreclosure; and/or renting the home back to the borrower. Usually non-performing loans are sold in pools rather than individually. Therefore the buyer needs to be able to handle multiple loans and borrower negotiations simultaneously, and frequently also navigate diverse state-by-state real estate laws. This strategy is not recommended for inexperienced investors. For example, in New York state it takes more than 1,000 days on average to foreclose on a home (source: RealtyTrac; see http://money.cnn.com/2012/04/13/real_estate/foreclosures/index.htm).
The best resource is to meet local investors who already own and operate single family homes. They can provide the most realistic input on rental demand, operating costs and any challenges unique to a particular area. Clubs exist in many areas where investors can meet each other. Local realtors who specialize in selling homes to investors are another good source of information. The www.arixacapital.com website also provides a lot of updated information on investing in single family homes.
Being a successful active investor in single family rentals requires expertise in selecting profitable investments, renovating properties cost effectively, and an on-going time commitment to managing the properties. On the other hand, a successful passive investment strategy necessitates selecting a good manager (or partner), as well as a close look at the fees involved. With active investing, finding profitable rental properties can be a rewarding endeavor, but by the same token you should be confident in your ability to find the right deals. Paying too much for a house is the easiest way to lose money. In order to be a successful buyer of rental homes you will have to be able to accurately assess the value and condition of a home, estimate a realistic range for the costs of renovation, understand how to create a pro forma operating budget, and be knowledgeable about the local rental market. If you do not have the expertise or inclination to invest on your own, hiring a fund manager or finding a partner can be an excellent alternative. By leveraging the expertise of a professional you can not only save yourself time and effort, but you may also be able realize investment returns that were unachievable on your own.
In selecting a manager consider his or her track record in order to determine whether or not he has a history of delivering value for investors. If you are working with someone who has the ability to find properties at a significant discount, and/or is adept at adding value through cost effective renovations, then the returns achieved by working with professional may very well justify their fees. Additionally, consider that the risk profile of a fund that owns dozens of properties is superior to personally owning a small number of properties. This is an added benefit of the fund structure and should also be taken into consideration when assessing fees.