Tuesday, June 25, 2019

Ready to Buy the First Investment Property? Try a Single Family Residence

Now that you have been moving up the corporate ladder with more financial security and disposable incomes, your financial planner might suggest diversifying the asset allocation by adding an investment property to the mix.

Unlike your 401Ks, mutual funds and IRAs, owning an investment property generally requires hands-on management so it’s also a “lifestyle” investment. Many people later regret jumping into this area as it doesn’t suit their personality and/or lifestyle. It is therefore often suggested to test the water with a limited, one-off investment property, preferably a single family residence (SFR). 

My definition of the SFR comprises townhouses (HOA), condos and co-ops as well; for instance, the outer boroughs of NYC have more co-ops than condos so co-ops should also be part of the SFR complex, at least the investment SFR complex.

While a private SFR offers more flexibility in terms of ownership, it nonetheless requires more day-to-day management than condos or co-ops wherein the outside and common area maintenance (from cleaning to landscaping to maintenance of general amenities to routine repairs, building insurance, etc.) are taken care of by the Condo HOA/Co-op Board in exchange for a monthly Common Charge/Co-op Maintenance. Of course, the complex-wide cyclical renewals and improvements (like new roof, elevator, windows, etc.) are additionally assessed (atop the monthly fees), known as special assessments.

In this post, I will talk about some of the do’s and don’ts of buying and managing the first investment property for income (positive cash flow) and growth (in equity), not quick flipping or non-rental warehousing. Please seek advice from your financial planner regarding the financial/investment basics: change in asset allocation, credit, mortgage, PMI, etc. (again, this post does not attempt to offer financial or legal help/advice/counseling in any shape or form whatsoever).

   1. Cities/States Experiencing Population Growth are Better for Investment Properties than those Experiencing Negative Growth – Since we are talking about an investment property – not primary residence – one should take a longer-term view of the investment (i.e., consider the business cycle) before investing in towns/cities, even states, where the population growth has been negative in recent years. Although a small investor always prefers his/her own town/city for investment properties, the population growth variable should never be disregarded. For instance, the Sunbelt (where the real population growth has been for years) did much better than the major Midwest cities and states after the last recession. Case in point: While the Sunbelt cities like Las Vegas, Phoenix and Miami were the hardest-hit during the last recession, they came roaring back and made new highs in recent years because the smart money tends to chase those cities ahead of the others. 

   2. Primary Location is always the King, but Secondary Location factors are often as Valuable – While “location, location, location” is always the king in choosing a property, other geographic factors that positively impact values like enhancing water views, on-the-hill with majestic skyline/valley views, scenic tree-lined streets, across from major parks, proximity to houses of worship, etc. generally make properties significantly more valuable than those lacking such influencers. Likewise, the high-rise condos and co-ops with magnificent river or park-view (e.g., East/Hudson River or Central Park view in Manhattan) fetch significantly higher rents than their counterparts facing noisy arteries. No doubt, the properties with such enhancing views cost more to start with, but they tend to maintain much higher rental demands, thus lowering vacancy rates, improving cash flows, and returning above average capital appreciations.

   3. Understanding the local Demographic makeup/shift is the other key to Rental Success – If the local demographic is changing, with more and more small tech companies are moving in, it’s good to pay attention to that emerging trend and make the purchase accordingly. A smaller but efficient house or a 1BR condo in a complex with modern amenities located within an easy commute of the new tech hub will make more economic sense than a large house or a 3BR condo in a suburb away from the hub. Tech is generally 24/7 operation so the proximity is often more important than the size. Therefore, before deciding on the size and location of the property, one must thoroughly research and understand the demographic makeup and any on-going shift, including gentrification. For example, people who invested in Austin, TX about 20 years ago when the city started transforming into a major tech hub are reaping big benefits today. Property rental business, like any other business, requires vision and consistent strategy.    

   4. While Researching Rental Properties, Current Property Taxes require Serious Scrutiny – Since property assessment is prone to local laws and exemptions, the current taxes require reconstruction in line with the future owner’s status. For example, the current low taxes resulting from the available exemptions like low income, senior citizen’s etc. will certainly go up once a young owner with high income takes over and as the prior exemptions are withdrawn. Local laws like Prop. 13 in California could make a big difference in property taxes as well. Regardless of the exemptions or local statutes, most assessment rolls contain certain idiosyncrasies due to inefficiencies in automated valuation modeling, so it is imperative to hone in on the candidates with lower taxes that are un-impacted by the aforesaid factors. While the new home/condo owner can appeal any unreasonably higher taxes (relative to the comps), there is no guarantee that it would be reduced. Co-op owners cannot fight taxes at the individual level.  

   5. Lifestyle Upgrades are Impractical for Rental Properties – Lifestyle upgrades are fine for primary residences but are totally impractical for the generic rental market. Since the first investment property is more of a test case, it is advisable to stay as generic (in line with the local competition) as possible, attracting renters who comprise the body of the bell curve (the more homogeneous middle 68%), rather than the outer ends of the curve and the outliers. As such, adding fancy upgrades like smart appliances, plush carpeting and remote-controlled blinds to an average property may produce negative rental returns. Instead, it is better to price it right by shunning unproductive upgrades and frills. By the same token, if the appliances and systems (plumbing, central air conditioning, etc.) are out of the manufacturer’s warranty, buying service warranties from a national vendor is extremely prudent, to avoid having to deal with expensive outages, especially central air conditioning and plumbing.

   6. Range of Amenities in the Complex helps Attract and Retain Tenants – People who invest in rental condos and co-ops know how important amenities are in attracting and retaining quality tenants. The “retention” of quality tenants is one of the primary metrics of rental success. Renewal of leases not only makes the rent roll stronger and more predictable, but it also saves renovation costs as the tenant turnover eases. Of course, one must understand the local demographics to invest in a certain complex. Tech demographics usually require a different set of amenities than the more normally distributed demographics. Gym, pool, tennis/racquet ball courts and business services are generally more important to attract tech professionals while the family-oriented amenities are more conducive for distributed demographics.        

   7. Before Buying Investment Condos or Co-ops, it’s good to know the Rental and Pet Policies – Almost all established condos and co-ops have rental and pet policies in place. The vast majority of them will not allow any short-term (month to month, Airbnb, etc.) leasing; instead, they will require 7-month to annual leases. Many co-op boards have more stringent rental policies, requiring pre-qual followed by face-to-face interviews (could be time-consuming). Many established condo complexes institute a 20% rental threshold, meaning only up to 20% of the total units could be rented out at any given time, often forcing a long waiting list, depending on the attractiveness of the complex. A big percent of condo and co-op boards – outside of the major cities – maintains a 2-pet (cats and dogs) policy with size and weight restrictions. Like the pet-friendly motels and hotels, some complexes do charge a monthly pet fee, tagging on to the common charges. Increasingly more and more homeowners insurances are prohibiting certain aggressive breeds.

   8. Understanding the Financials of HOA/Co-op Corp., Monthly Charges and Renewal Cycles – Before investing in a condo or co-op future owners must thoroughly investigate the financial management, especially the general reserve of the HOA/Co-op corporation. A good reserve will help the board manage the next recession better than those walking on thin ice. If a wave of defaults hits, the rest would be on the hooks. Good tenants avoid poorly run facilities as well, causing above average vacancies. Special assessments coupled with higher vacancies make absent owners jitterier than the resident owners. All-inclusive monthly charge (including pass-through utilities/items like gas, electric, water, cable, internet, etc.) forces owners to bump up rents, often dampening rental attractions. Every 25-30 years, complexes (even houses) hit a renewal/replacement cycle, necessitating back-to-back expensive special assessments, so the future owners must study the existing (generally the responsibility of the seller) and the prior special assessments, thus understanding what could still be in store for them. It’s generally prudent to buy into a complex that has gone through a series of major renewals and replacements.

   9. Locating Qualified Tenants is not easy for the First-time Investors – Last but not least, locating the right tenant is not an easy job either. First-time investors would be better off using a qualified rental outfit that would vet and select the right tenant after checking for income, credit, references, past rental history, etc. Moreover, their ad copy is more professional and the placement of the vacancy ad on the MLS, Zillow and other rental sites helps promote and accentuate the entire process (including the online document signing, etc.).  In some major markets, eviction is a long-drawn judicial process, during which the tenants live free while the owner’s monthly expenses generally go up by way of added legal costs and court filing fees. Locating qualified tenants is therefore one area new investors must practice prudent risk management. Good rental agencies help reduce risks.

   Good Luck!

   Sid Som, MBA, MIM
   President, Homequant, Inc.

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