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I'm a fan of rental property

Posted by Rona Fischman  June 24, 2009 03:09 PM

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The New York Times had an article about our triple-deckers this month. Besides quoting what Dennis Lehane thinks of them, Abby Goodnough quoted these statistics about foreclosure in this kind of housing:

In Boston, three-family homes represent 14 percent of the housing stock, but made up 21 percent of foreclosed property in 2008, according to the city’s Department of Neighborhood Development… Ms. [Evelyn] Friedman, [chief and director of the Boston’s Department of Neighborhood Development] believes the foreclosure rate on triple-deckers is even higher than the data indicate, because many were converted into condominiums in recent years. These are counted in a separate category that made up 48 percent of the city’s foreclosed properties last year.

I am a huge fan of owner-occupied multi-family housing. The Times’ reporter reiterates what I think:

Best of all, three-deckers put homeownership within reach of the working class. Buyers could live in one unit and rent out the others, assuring they could afford payments and upkeep for years to come.

For years, two- and three-family ownership has not been a viable option. As purchase prices increased far beyond rental rates, the owners of a two- or three-family home found themselves paying more to live in their properties that their tenants.

Quick math:
1996: A two-family house costs $200,000. The PITI mortgage cost is about $1550 a month (with 20 percent down payment of $40,000. 7 percent interest rate.) Rent for a two-bedroom unit is about $1200 a month. Owner is out-of-pocket $350 a month, plus expenses and upkeep. A three-family would give the owners a positive cash flow of $850 a month.

2006: If a two-family house sells for $600,000, the PITI mortgage cost is about $3350 a month (with 20 percent down payment of $120,000. 6 percent interest rate.) Rent for a two-bedroom unit is about $1400 a month. Owner is out-of-pocket $1950 a month, plus expenses and upkeep. Even if this was a three-family home, the owners would still be out-of-pocket $550 a month.

Is it any wonder that developers bought these properties and flipped them for condos? There was nothing to be gained by owning rental property of this type.

Multi-family housing prices are coming down now. When do they approach the “worth-it” level? Are we there yet?

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20 comments so far...
  1. I think they are already there in a lot of places. I sat around for the last 4-5 years, waiting for multi-families to become affordable. Just closed on a 2 family in Salem in April. Only put 3.5% down (intentionally), which is basically covered by my $8k first time home buyer's credit.

    The house is older but in great shape. Both units are 3 bedrooms, I rent out the first floor for $1200/month. My wife and I live on the second floor and our monthly payment is only $730/month when backing out the rental income.

    We doubled our living space and went from paying $1100 for a crappy 2 bedroom. No brainer

    Posted by fishmonger13 June 24, 09 04:02 PM
  1. The tax benefits of buying a primary home during times of high interest/low prices have been discussed. Some of that analysis changes for rentals as most of the purchase price will be deductible over time as depreciation. A bad time to buy a personal residence might be a better time to buy a rental. There are of course, many other considerations.
    A good rule of thumb for triple-deckers on small lots would be 90% of the purchase price assigned to the depreciable building, with 10% assigned to non-depreciable land.

    Posted by lama June 24, 09 04:36 PM
  1. I don't think we are there yet. There are many people buying foreclosed multi family properties with the expectation that there is a bigger sucker out there or that they can convert these two and three unit properties to condos if they dont find that sucker. in 1995 more than 50% of 1-9 unit owners reportes barely breaking even or loosing money on their rental properties. Witht he loose lending standards of recent years, I can guarantee that this number is significantly higher!

    Our day may come but for now the money stays in the bank.

    Posted by Devlin June 24, 09 04:42 PM
  1. Great points. As I have said before, prices need to come back in line with rents. That means cash on cash returns for landlords of at least 8-10%.

    EXAMPLE 1: Let's do a quick back of the envelope on Rona's first example. Rather than think about it as an owner occupied duplex, think about it as two rental units. (For purposes of evaluating the investment opportunity, the fact you intend to “rent” one of the units from yourself is irrelevant.) I will also include an explicit allowance for vacancy and maintenance.

    Gross rental income (2 units x $1200/mo): $2,400/mo
    Maintenance/vacancy reserve (20% gross): -$480/mo
    PITI: -$1,550/mo
    Net cash flow: $370/mo or $4,444/year
    Cash on cash return ($4,444 / $40,000 down payment): 11% per year

    This is a sensible investment. The numbers work.

    EXAMPLE 2: Now let's look at the second example. Plug in the new numbers with the same assumptions and the annual cash flow is -$13,320 per year (-$1,110/mo), or -33% cash on cash. This is what's called a money pit. The only way you make a profit is by flipping the property to somebody else. This is an example of the “greater fool” method of investing. In other words, it's not an investment at all. It's pure speculation.

    Now to answer Rona's question. Prices are not even close to "worth it" levels. They need to come down at least another 30%. But don't take my word for it. Try the above calculations out for yourself. The nice thing about buying rental properties (or properties that can easily be rented) is that the market rent is more or less a known quantity. The calculations above require 5 minutes of time and a pocket calculator. As a buyer of any property, you would be crazy not to run a few "back of the envelope" calculations to see if the asking price makes financial sense. For a rental property, you should be able to earn a FAIR return on your investment. For me, that means something in the ballpark of 8-10% after financing, maintenance, and taxes. This is on par with returns for other risky asset classes, and is fair compensation for the considerable work involved with owning, managing, and maintaining property. Think about it... Why would anybody want to be a landlord if the return on the investment was negative? To me, demanding a fair return for working hard and putting my money at risk is just common sense.

    If you want to learn more, check out a great book by William Poorvu called "Real Estate Game". Bill is a Harvard professor and local Cambridge landlord/developer. He is exceptionally bright and articulate. Most of the examples he uses in his book are local, albeit from the late 1990's. I highly recommend.

    Good luck!

    Posted by Lance Stapleton June 24, 09 04:57 PM
  1. spot on Lance, multis for the most part have only been priced as condo-conversions, not buy and hold operator-type properties. We will however revert back to the point where they do have some investment merit.

    Posted by Hung Wang June 24, 09 05:47 PM
  1. Lance,

    Good post.

    You answered your own question...Why would anybody want to be a landlord if the return on the investment was negative?....The greater fool theory. (But you knew that.) And a lot of them got in the real estate investment business over the last several years.

    People bought thinking they will only be negative for a while or underestimated the expenses or had no business buying in the first place.

    And there is always someone who buys without considering the risks.

    Posted by JohnG June 24, 09 07:53 PM
  1. > Cash on cash return ($4,444 / $40,000 down payment): 11% per year
    > This is a sensible investment. The numbers work.

    I'll say. 11% per year with all expenses covered. If the place appreciates by $40k in the time you own it, tack on another 100% and if you pay down $40k of the mortgage, that's another 100%. You're not asking for much! Why would someone sell such a cash cow so cheap?

    Posted by JIM June 24, 09 08:50 PM
  1. In addition to Lance's cash analysis, you could look at it strictly from a profit perspective. Using an IRS Schedule E, list out the projected income and expenses for a minimum of 7 years.
    1. 2 months per year unoccupied
    2. worst case scenario maintenance
    3. repairs as scheduled
    4. include depreciation in your analysis, say 1/40th per year

    Look at every line item on the Schedule E. They are there for a reason. If you project any profit, divide it by the number of hours you will spend fixing, collecting, in court, etc. Forget about appreciation in any market, especially this one.
    Is it worth your time? You might make more money working at Home Depot, selling stuff to other weekend warrior landlords.

    Posted by lama June 24, 09 08:55 PM
  1. When will these greater fools run out of financing? I am amazed at some of the transactions. I know a few people banking on the greater fool theory. They buy a foreclosed multi and improve the curb appeal a little bit and go for a quick sale making anywhere from $20,000-$40,000 a deal. They know that they will eventually get stuck with one property when they run out of fools but thats ok with them. being stuck with one slightly underwater multi is ok with them.

    Posted by Devlin June 24, 09 10:56 PM
  1. or if you want to avoid high transaction costs, landlord headaches, leverage, etc.
    You could just buy these and over time become fabulously wealthy.

    For his new work, Siegel searched through the Standard & Poor's 500 Index to find patterns among the winners and losers. "I was frankly shocked that Philip Morris would be the number-one stock," Siegel said. "I would just never have guessed that. I would have said, 'Maybe IBM.'" From 1925 through the end of 2003, tobacco company Philip Morris, now called Altria Group, delivered a 17% average annual return, assuming all dividends were reinvested in the company's shares. That beat the average stock by 7.3 percentage points a year. A $1,000 investment in Philip Morris in 1925 would now be worth more than a quarter of a billion dollars.
    Similarly, consider a choice available to an investor in 1950 who could have put money into the most cutting-edge company of the day, computer maker IBM, or the numbingly ordinary Standard Oil of New Jersey. Even today, most investors would assume IBM was the best bet. Indeed, according to the most widely watched measures of growth, IBM was the winner over the next 53 years, dramatically outstripping Standard Oil in per-share growth of revenue, dividends and earnings.

    But Standard Oil shareholders did better, with average annual returns of 14.42% versus 13.83% for IBM. That half-point difference, compounded over 53 years, put the oil-company shareholders ahead by more than 25%. A $1,000 investment in Standard Oil would have grown to $1.26 million, compared to less than $1 million for an equal investment in IBM.
    Siegel found similar results again and again. Since 1950, the top-performing companies were National Dairy Products (now Kraft Foods), returning 15.47% a year; R.J. Reynolds Tobacco, 15.16%; Standard Oil of New Jersey (now ExxonMobil), 14.42%; and Coca-Cola, 14.33%. A $4,000 investment in the top four would have grown to $6.29 million, versus $1.11 million for a similar investment in the stock market as a whole.
    XOM, PM, PEP, PG, JNJ, you don't have to kill yourself being a landlord (I've been there).

    Posted by Hung Wang June 25, 09 05:29 AM
  1. I want to know where the 2-family selling for 600k is, that is only getting 1400/mo for a 2br rental.

    Posted by buffetwatcher June 25, 09 08:00 AM
  1. Right now in most decent areas in and around Boston the rental income for a 2 to 3 family unit do not justify the asking price. And whern you start looking at some of the more affluent towns it becomes a no brainer. A decent multi family home that does not need a significant amount of work or isn't located on the "wrong side of the tracks" will cost north of $600K to $700 in better neighborhoods . Take into account a very saturated rental market and it just does not make sense to purchase income housing in the near future. Unless somone is a contractor with significant time on their hands to do improvements, or has the ability to put down a massive downpayment, the return on a multi family as an investment or supplimental income for living in one does not make owning one of these properties a good investment or choice of residence right now.

    Posted by Joe June 25, 09 08:43 AM
  1. I bought my three-family in 2000 for $220,000. The almost identical three-family next door sold in 2004 for $566,500. The owners could not make a go of it (couldn't get the rents to support the debt) and sold it at a loss in 2008 for $410,000. I still think that's too much for the rents in the area. I'm very lucky I bought when I did. I can afford to keep my rents attractive and still have a nice positive cash flow.

    When I was looking to buy, I read two things that helped me. One was that the expected rents should be able to pay for the property (theoretically, of course) in 7 years. I came very close to that. The other was that people who buy three-family homes are generally happier with their purchases than those who buy two-family homes. I think that is because you will rarely have both units vacant at the same time, so you always have some income from the property, and you can take your time to find good tenants.

    But being a landlord *is* a job. But I look at it as a second job I don't have to go to every day, and that I can sometimes do in my pajamas.

    Posted by Susan June 25, 09 09:19 AM
  1. I think a lot of the "is it worth it" question comes down to buying an investment property for the cash flow (which is what I tried to do), rather than praying for appreciation that is a pipedream, or hoping to convert to condos. Bottom line is you have to get your hands dirty in my situation

    Posted by fishmonger13 June 25, 09 09:31 AM
  1. JIM (#7): You are correct. I didn't make this entirely clear in my comment, but the numbers in Rona's first example are not just good, they are very good. As I have said before, a rough price target for rental properties is usually somewhere around 100-150x gross monthly rent. The ratio for this property is 83x ($200,000/$2,400) so as an investor I'd be very interested. Unless there is something obviously wrong, it's a slam-dunk. Deals like that very rare these days, and have been for the past 10-15 years. But they were all over the place during the last downturn and I predict they will be back again before too long.

    The bigger point I was trying to make is that people should at least run some simple numbers and apply common sense before buying. As Rona shows in her second example (which I suspect is a real property, while the first example was made-up for illustration purposes) the prices these past few years have been utterly ridiculous and completely unjustifiable based on fundamentals. Even with very optimistic assumptions, the numbers don't work. Period.

    ATTENTION REALTORS: If you know of deals priced at 100-150x actual gross rents then let me know. My checkbook is ready.

    Posted by Lance Stapleton June 25, 09 09:34 AM
  1. Hi everyone. Good discussion. Thank you. I hope this clears things up a little.
    There's a number you are all ignoring: 2006.
    My example was total fabrication based on norms three years ago, which was about peak. Now those $600,000 two-family homes are more like $500,000. We are not there yet, but we are getting closer, especially with three-famly homes. ( I'm an optimist, not a fool.)
    What are prices for rent and sales of these prices doing near you? I am seeing some three-family homes that could work. What cap rate would you tolerate for a multi-family house investment? Is break-even with repairs enough for an owner occupier?

    Posted by Rona June 25, 09 10:39 AM
  1. Susan (#13): Sounds like you made a great investment. I like that 7-year payoff rule. Stated in different terms, it implies a price-to-rent multiple of 84x... And as I said above (#15), anything less than 100x in this interest rate environment is usually a slam-dunk deal. Nice job!

    Posted by Lance Stapleton June 25, 09 10:59 AM
  1. Lance, your posts are great. They leave me with nothing to say except I agree. And 150x is a bit rich, no, especially in Massachusetts? Being a landlord here is much harder than most places. I learned something - didn't know about Poorvus book, and will order it.

    Jim - being a landlord is work. People expect to get paid for work. I doubt you work for free. And assuming a 40k increase in price is a big assumption this day and age. You might get a 40k loss - far more likely. So you should earn something for that risk, or why not just put your money in treasuries?

    Posted by charles June 25, 09 11:49 AM
  1. To clarify the 100-150x guideline for gross rent multiplier (GRM) discussed above...

    First, GRM is a very crude method but it can be useful for very quickly sizing up a potential investment opportunity. Multiply monthly rent by 100 and you get what is usually a “favorable” purchase price. Then add half again that amount to get your “high” purchase price. You can do the math in your head and it takes about 3 seconds. Compare this range with the asking price. Ideally, it will be toward the low end of the range, or better yet below the range entirely (like Susan's example above).

    Second, the range of GRM values is broad. There is obviously a lot of wiggle room in the estimate. That is where subjective factors come into play. Generally speaking, I would not be inclined to buy near the high end of the range. But I admit, there may be plausible justification for doing so in certain cases. With very optimistic setup assumptions (financing, assumed vacancy, maintenance, etc.) I was able to just barely make a hypothetical property cash flow positive at 150x. Likewise, with a GRM of 100x it's pretty hard not to get positive cash flow unless something is seriously wrong. When interest rates rise (and they will), the GRM range for attractive investment opportunities will move lower. So will prices. Be realistic about your assumptions. They make a big difference.

    Lastly, GRM can be used as a rough barometer for the level of housing prices. Historically, average GRM based on the entire residential housing stock and government estimates of imputed rent has fallen roughly within the range discussed above. In 2007 (near the market peak), GRM for Boston was 227x. How far do prices have to fall to restore a normal relationship with rents? Do the math... At least 35-55%. This is one of the major pillars underlying my prediction for further price declines.

    Fun stuff...

    Posted by Lance Stapleton June 25, 09 02:12 PM
  1. Great discussion. I'm in one of the outer neighborhoods of Boston where 2 and 3 family houses are priced anywhere from 350,000 - 700,000 which is quite a range. This range seems to reflect location, with certain locations being considered "more desirable" than others, and condition. The lower end properties might work financially but they are in such deplorable condition that it wouldn't be worth it. You'd have to put in 200,000 just to get these places in decent shape to be rented for $1400/month which is pretty much the top of the market for a 2br/1ba apartment in this neighborhood. I haven't seen anything that you could call a "turnkey" multifamily for sale here. So I don't think we are "there" yet in terms of how low the prices need to go before it makes sense to buy and rent out a multifamily house.

    Incidentally, why is this discussion not equally relevant to single family prices? I know the issue of whether rent/price ratios are critically out of whack in the single family market has received much discussion on this blog. Single families and multi-families (and condo-ized multifamilies) are interspersed in the same neighborhoods and can't be considered entirely independent of one another.

    Posted by catb June 26, 09 02:56 PM
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Scott Van Voorhis is a freelance writer who specializes in real estate and business issues.

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