Shopping for East Bay Rental Property? How to Decide What to Buy [Part II]Colin Wiel
March 21, 2017
Class A. Class B. Single family. Multifamily. Turnkey properties. Value-add opportunities. Primary market. Secondary market. Tertiary market? Gut rehabs. Mixed-use. Student housing. Housing for young professionals. Rent controlled. Non-rent controlled.
When it comes to investing in East Bay real estate, there are so many different types of properties you can buy. So how do you narrow it down and decide what to buy?
In Part I of a multi-installment series on real estate investing, we shared the guiding principles that help us determine where to buy rental property. In Part II of this series, we explore a few key considerations that help guide us when evaluating what types of rental property to buy.
Condition of the Property
How much renovation work are you willing to take on? This differs for every investor. Some investors have construction and rehab experience, or are willing to manage the multiple contractors that are needed when taking on a major renovation project. Buying an older, outdated or otherwise “rough” property can make a lot of sense for those with a lot of experience or access to capital. As successful flippers know, one can realize a lot of financial upside by purchasing an underutilized asset, renovating it and then holding onto it for a period of time.
But renovating a property isn’t for everyone. If you have less experience, less capital, or are less interested in being a hands-on investor, buying a newer property makes a lot of sense. Newer properties – or properties that are older but have been newly-renovated (particularly with new heating systems, electrical and plumbing) – require less frequent repair and maintenance. You might pay more for these properties on the front end, but new properties also tend to command higher rents. For these reasons, we believe buying a fully renovated asset is still a great investment; you just won’t get the additional juice from adding value through renovation.
Fortunately, the East Bay is a mixed-bag when it comes to age and condition of properties. Many of the homes were built in the early 1900s. The craftsmanship on these properties is usually fantastic: the properties are structurally sound, and tend to feature unique details that you don’t find with new construction. Some of these properties have been scooped up by investors who renovated and flipped them, a welcome addition to the brand new units popping up throughout the East Bay.
Avoid the Diamond in the Rough
This may sound counter-intuitive, but hear me out: in my experience, you don’t want to buy the nicest property in an up-and-coming neighborhood. Instead, my investment approach is to look for the worst building in a great, stable community. People are always willing to pay up to live in an awesome neighborhood (e.g., good schools, well maintained parks, access to transit, restaurants and shops). It’s easier to improve a single property than to improve an entire neighborhood, so we prefer to invest in value-add opportunities in high-demand areas instead of vice versa.
Single Family vs. Multifamily
There are certainly advantages to both types of real estate. Single family homes can be a great investment because when it’s time to sell, you have a broad range of buyers, from institutional investors looking to add to their portfolios to owner-occupants willing to spend more for their “dream home” than would be justified on a cap rate basis alone. The price point of a single family can also be an advantage, for investors with a limited amount of capital. Single family homes are usually easier to finance, and if it’s someone’s first purchase they might be able to qualify for as little as 3.5% down. Multifamily properties are usually more expensive, and lenders usually want buyers to put down at least 30% if the property won’t be owner-occupied. Investing in a single family is a great option for those who don’t have a huge chunk of money to put down at the outset.
That said, I’m biased towards multifamily properties. Although they require a larger upfront investment, they tend to be less risky. If one tenant moves out or stops paying rent, you still have the cash flow coming in from the other units to balance expenses. The repair and maintenance costs tend to be more predictable, and when large capital expenditures do arise (like a new roof), the costs are lower on a per unit basis.
Rent Control vs. Non Rent Control
Most buildings in America are not rent controlled. Investing in non-rent controlled buildings has generally proven to be great investment strategy. The ability to raise rents with the market allows for substantial increase in cash flow and appreciation during periods of increasing rents.
That said, investing in rent controlled buildings is a strategy that we like a lot. The cash flow is more reliable due to lower vacancy rates, along with less sensitivity to declines in market rents. If a resident in a rent controlled unit is paying 30% below market rent, and market rents go down by 10%, they are unlikely to move out or ask for a lower rent. Furthermore, there is upside for the owner when residents move out and units reset to market rates, which is guaranteed to happen eventually (although it may be a very long time).
What to look for specifically in rent controlled buildings is a big topic, which I’ll cover in a future article.
Ability to Produce Cash Flow
Buying rental property is an investment, so you want to be sure this investment is generating meaningful cash flow. There are a few instances where investors might be willing to forego cash flow in the short term, such as buying a rent-controlled property with dramatically sub-market rents, or buying a fixer-upper that will need substantial investment. Otherwise, investors should look to buy properties at a reasonably high cap rate. In other words, you want to be taking some money off the table each month. At a minimum, you should be covering the cost of your debt (including amortization of the mortgage). In the current tight market, we target East Bay properties that have at least a 5-7% cap rate. In a down market, I’d look for properties with a 7-10% cap rate (or more).
So many investors focus on where to buy rental property that they often forget to put thought into what types of rental property to buy. We hope that Part I and Part II of this investors’ series has left you feeling well-equipped to make smart, informed decisions as you look to purchase your next East Bay rental property.