4.

PICKING THE BEST INVESTMENT FOR YOU

What constitutes “good” rental property? Can you simply pick a house, duplex, or apartment building and depend on supply and demand? Or do you need to consider more factors, both financial and market driven?

While it might seem that the study of supply and demand would be enough to decide whether the market can support another rental, you need to go beyond the initial study and discover more facts. You must also understand how the attributes of a particular property are going to affect rental value, as well as what type of tenant the property is likely to draw. A particular property, for example, may attract a specific type of tenant depending on its neighborhood location, the age and condition of the home, the square footage, and the amount of rent you charge.

SUPPLY AND DEMAND CYCLES IN REAL ESTATE

The real estate market—like all investment markets—experiences cycles in which the relative strength of demand varies as supply grows or shrinks. A basic economic reality is that the cycle is predictable, but its timing cannot be known specifically or in advance. This is the most interesting aspect of real estate economics, but it also creates the greatest uncertainty.

DIRECT CAUSES

There is no mystery to understanding the direct causes of changes in real estate values. If more people need and want housing than there are properties available, prices rise. The demand causes more building and development activity. As that activity continues, it finally causes overbuilding, which softens prices. The excess demand exceeds supply. This is the nature of the supply and demand market.

The specific forces and the timing of their interaction varies considerably. A cycle may take a year or two, if and when big changes occur within the area. For example, the liberalization of rules for new home construction could lead to higher building activity within a very short period of time. The direct causes of change in supply and demand for real estate—population changes, interest rate fluctuations, the availability of money supply for loans to buyers, changes in the tax rules concerning deductions for real estate ownership or investment, and availability of land—can be studied to predict the likely timing of real estate cycles. Even so, the overall uncertainty makes calling the peaks and valleys elusive even for the most experienced analyst.

INDIRECT INFLUENCES

Many forces are at work during the real estate cycle, many of which are not connected directly to real estate values or the market for rentals. Consider the seasonal effect of having a large college or university population in a city. In some areas, college students leave during the summer, but for the rest of the year, they may represent 25 percent or more of the total population. Other influences on real estate values and rental demand include crime statistics, traffic, and employment trends. If a large employer decides to relocate elsewhere, unemployment is going to rise; in some cases, people will leave the area to look for work elsewhere. The loss of a major employment base has a devastating effect on real estate values, as well as on demand for rental units. By the same argument, a new employer coming into an area creates strong demand for real estate, including rentals.

EXAMPLE 1: Seattle depends, to a degree, on large employers such as Boeing. In the 1970s, large-scale layoffs created a depression in real estate values. Although Seattle has since recovered and has become one of the fastest growing real estate markets, its vulnerability continues. The employment base has expanded, but Boeing remains one of the larger employers in the region. At the time of the layoffs, a commonly heard form of pessimism in the region was, “Will the last person to leave Seattle please turn off the lights.”

EXAMPLE 2: In the late 1980s, many employers in San Francisco moved out of the city in reaction to a newly passed payroll tax. The surrounding suburbs to the east and the north were better environments for corporations, so a large employee migration occurred. With the shift of the employment base from San Francisco to other areas in the East Bay and North Bay, property values in the suburbs rose dramatically between 1987 and 1989. The changes in value resulted from the sudden increase in demand for both commercial and residential property. Ironically, due to the shift in employment out of San Francisco, the net result was a decline in overall sales taxes, revenue from parking and transportation, and retail business. The net was a negative due to the punitive payroll tax.

Although the original payroll tax was replaced in 2012 with a gross receipts tax, the idea resurfaced in 2016. A 2016 article demonstrates that the government might not have learned history’s lessons, as this development could lead to a new migration out of the city with resulting effects on real estate:

San Francisco supervisors want to put a 1.5 percent payroll tax on November’s ballot that would hit San Francisco-based tech companies to help address the city’s housing shortage and chronic homelessness.

The tax would generate $120 million in revenue—calculated based on tech companies’ existing payroll expenses—that would be redirected to homelessness programs and anti-displacement initiatives, according to an estimate by the city’s comptroller.¹

THE LOCAL MARKET VS. NATIONAL AVERAGES

A lot of time and effort are put into studying national trends in real estate. Industry groups publish detailed statistics and the government tracks trends in prices of homes, inflation, and the average age of people buying their first homes. All of these statistics are interesting and useful, but they do not tell the story of what is going on in your town.

LOOK AROUND YOU

The real estate market in your region may be vastly different from the market in the next state or even in the next county. Considering the different economic and demographic factors that affect real estate values, a few miles can make a big difference. For example, if your area is suburban and within an easy commute to a large city, that proximity, when factored in, may translate into a healthy demand for housing. However, if your area is rural, and there are few employers within fifty to a hundred miles, property values are less likely to grow as strongly. Those relatively few miles can make a big difference in the strength of your market, for better or for worse.

Commuting distance to employment centers is only one of many factors that affect regional real estate values. Traffic rates, crime levels, the weather, and local amenities also influence not only today’s values, but how those values will change in coming months and years. If your property is located in or near a popular seaside resort, for example, that will favorably contribute to property values. But if the property is located in a hurricane zone, it could have the opposite effect. Therefore, a variety of different and potentially conflicting considerations have to be reviewed locally.

THINK LOCAL

National statistics may indicate that property values are rising at a desirable rate, consistently from year to year and above the inflation rate. Real estate values may even be beating stock market average returns. Even so, it does not mean that real estate in your area is going to perform in line with national averages. To really discover what is happening locally, you need to go to a local real estate broker, your banker, or Multiple Listing Service (MLS).

You also need to isolate employment statistics and housing trends for the specific area where you are thinking of buying property. This is a fairly complex matter if you live in a built-up region but far easier if your city is isolated. If you live in the Northeast, for example, your city or town may be part of a larger metropolitan area of a major city. However, in the Midwest and West, cities tend to be more separated, so local and regional statistics are more easily viewed in isolation.

A Tale of Three Regions: The corridor between New York City and Philadelphia is built up, and the entire area could be viewed as one massive bedroom community. Anyone living in the New Jersey corridor could reasonably work in Philadelphia, New York, or dozens of smaller cities within a hundred-mile radius. In that situation, how do you focus on housing and rental demand trends in your region? The region itself is so large that it consists of many different subregions. The solution is to study the last year or two in terms of housing prices, demand for rentals, and other related statistics (including population, services, traffic, crime, and amenities) and to isolate the area where you would consider investing in real estate.

If you live in Austin, Texas, you have an entirely different situation. The region is heavily populated and surrounded by many smaller cities. But compared to the New York and Philadelphia area, Austin is relatively isolated, so a regional market is more clearly defined. The fast growing suburban communities of Round Rock and Georgetown on the I-35 corridor to the north are good examples of how communities may grow up close to a larger metropolitan area, though the region is limited in terms of a likely real estate market.

A third possibility is that you live in an area such as Casper, Wyoming. This is a relatively small city with considerable distance to the next built-up area. The likely growth in prices and demand for real estate in this region is far different from that in the New-York-to-Philadelphia corridor or even the Austin region.

LOOK AT REGIONAL FACTORS

The point is that specific regional attributes—both economic and geographic—will affect the long-term growth prospects for real estate. A community located on an interstate and within thirty miles of a major city is going to experience far greater demand and growth than a community that’s farther removed from the economic activities that would bring further population growth to the region.

Even when a community is relatively isolated, real estate values may be high and rising because of a single large employer, a nearby recreational feature, or other causes. As a matter of assessing market risk, you need to decide how much of the local real estate value exists due to those special circumstances and what the risk is that the conditions could change. For example, Bentonville, Arkansas, has a total population of 35,000. Tyson Foods employs 23,000, and Wal-Mart employs 9,500 from the city and surroundings.²

INVESTIGATING THE LOCAL REAL ESTATE MARKET

The real estate market has two components: the prices of property and the demand for rentals. Property values, like all investments, go through predictable supply and demand cycles. Unlike stocks, the cycles for real estate tend to be longer. The phases of the cycles are not affected by day-to-day trading activity as stocks are, so in that respect, the real estate market is more easily understood. The market’s symptoms are easily recognized by studying the current market attributes.

PROPERTY VALUES

Statistics kept by real estate brokerages or a local MLS can reveal the current condition of the market. If you approach an experienced real estate agent and ask the right questions, you can easily judge and compare the local market to others. You need to find out the average price of homes, the differences between average asking prices and average selling prices (i.e., the swing), the amount of time property stays on the market before it sells, and the housing stock (i.e., inventory) currently available. The key questions you need to ask to judge the market are summarized in Table 4-1.

TABLE 4-1: QUESTIONS FOR JUDGING CONDITIONS OF THE REAL ESTATE MARKET

Question	What it reveals
What is the average price of housing, both today and one year ago?	Rising property values are a positive sign for investment. Ideally, you want to get into the market at the end of a slow period and just before prices begin to rise. That is difficult to time correctly, so, as an alternative, it makes sense to buy into a rising market.
On average, what was the difference between asking prices and selling prices during the past year?	The so-called swing is a measurement of how soft the market is right now. If the swing is 5 percent or less, that indicates strong demand. If the swing is higher, it means that demand is on the decline. By comparing the swing during the past month or two to the same period last year, you get a sense of the direction in which the trend is moving.
How long are houses staying on the market, on average?	Are sales taking place within thirty to sixty days? If so, that means demand is very high. But if the time needed to sell is greater, then the signs are not as good. The longer it takes for property to sell, the weaker the demand.
What is the current inventory of homes for sale?	In a high-demand market, houses go up for sale and close very quickly. In a softer market, it takes more time. If your area has an inventory equal to three months’ demand or less, that is a positive sign. If current homes for sale are a full year’s supply, that is a negative indicator.
What level of building activity is under way locally?	Are a lot of homes and housing developments being constructed or planned? Or is current development at a standstill? If activity is high, it means that demand is there, too. But if no one is building homes in your town, that means the market is poor.

Local real estate brokers and agents can also tell you the direction in which the market is moving. As an astute investor, you will want to time your decision to begin investing in real estate so that demand will be high. That drives up prices and makes the investment value of your property positive—at least from the aspect of market value and potential growth.

DEMAND FOR RENTALS

The second area you need to evaluate is demand for rental housing. This information is also easily discovered by checking with local property management companies. Housing values that are on the rise is a positive sign for investment. Ideally, you want to get into the market at the end of a slow period and just before prices begin to rise. That is difficult to time correctly, so, as an alternative, it makes sense to buy into a rising market.

The identification of a specific neighborhood is important because rents may be significantly different in various parts of town. A residential area characterized by single-family, mostly owner-occupied homes will tend to carry a higher level of rent, whereas older homes in declining areas will naturally rent for far less per month. The more you understand the character of each neighborhood and the local economic forces at work, the better you will be able to decide where you want to buy rental property.

Table 4-2 lists the important questions you should ask to compare neighborhoods and judge overall demand for rentals in your city or town.

TABLE 4-2. QUESTIONS FOR JUDGING CONDITIONS OF THE RENTAL MARKET

Question	What it reveals
What are the latest vacancy rates (overall and by neighborhood)?	Vacancy is the most reliable indicator of market demand and thus of investment risk or opportunity. In high-demand markets, expect to see very low vacancies, under 5 percent. Compare annual changes in vacancy, and be aware of seasonal changes.
What is the average rent for each type of rental unit?	This analysis includes size of the property, number of bedrooms, and location. It will vary by whether you’re looking at single-unit houses, duplexes or triplexes, or apartment complexes. The trend is also revealing. Find out how today’s average rent compares to rents for the same type of rental six months and twelve months ago.
What level of construction of new rentals is under way or planned?	If a lot of new rental units are being built in your area, it could change demand—especially if the building trend outpaces demand. If demand is consistently higher than supply and no construction is taking place, then the market is strong—a good sign for you as an investor.

DETERMINING WHETHER THE INVESTMENT MAKES SENSE

In theory, demand is a simple concept. The greater the demand, the higher prices go, and if demand weakens, prices will level out and eventually fall. This economic theory, in practice, can be elusive and hard to identify.

As a real estate investor, you have to contend with two primary forms of demand: for properties and for rental units. While they are similar and tend to move together, they are not necessarily the same. You may find that in your region, demand is strong for property but weak for rentals. If your town has more owner-occupied properties than rentals, for example, it is possible to experience strong growth in market value but fairly low rents and rental demand.

THE MONEY SUPPLY

A third form of demand involves the money supply. Depending on prevailing interest rates and the supply of money available to lenders, it may be difficult at times to find attractive mortgage rates, or it may be easier at other times, when economic conditions change. These varying conditions will also affect the level of closing costs you will have to pay to obtain a mortgage loan. In a healthy market, it is fairly easy for borrowers with good credit to find lenders for rental properties, even if they already own real estate. In tighter markets, the rules that a lender applies (or that are imposed by the secondary market) may be more difficult to meet.

Money, like all commodities, becomes available in cycles. The Federal Reserve controls the money supply by determining how much it will lend to banks and other commercial lenders. It raises or lowers interest rates to control economic growth. These economic factors, while beyond the scope of this book, have a direct impact on all financing of real estate investment. Few people can afford to purchase housing outright, so real estate investing is largely done through borrowed money. This leverage—as it is called among investors—can work both for and against you as an individual.

INTEREST RATES

As the money supply changes, so does the going rate for mortgages. Chances are that as a real estate investor, you will end up financing some of your properties with variable rate mortgages. The interest rate (thus, the monthly payment) on these obligations is adjusted periodically as interest rates rise or fall. The higher the going rate overall, the more your variable rate mortgage payments will climb.

Variable rate mortgages are limited in two ways. They contain both an annual and a lifetime “cap,” or maximum. For example, you may agree to a variable rate mortgage and a current rate of 6 percent. The annual cap is set at 2 percent, and the lifetime cap on the rate is 14 percent. This means that the lender can never increase your rate more than 2 percent per year, and the loan’s interest rate can never rise above 14 percent, no matter what market rates are doing at the time. The prevailing interest rate exists within a range. The better your credit, the shorter the mortgage repayment term, and the higher your down payment, the lower your rate will be. And by the same argument, the worse your credit, the longer your repayment term, and the lower your down payment, the higher your interest rate will be. The range of rates reflects current market interest rate levels, which are adjusted periodically by the Federal Reserve. So, in terms of the market for real estate, you need to be aware of the money supply and its influence on the availability of credit.

The changes in this market can be seen in varying promotions by lenders. When money is plentiful, lenders compete for your business, offering no closing costs, low points, and fast approval. When money is not available in large quantities, lenders do not seek out mortgage loans and will not encourage you to submit an application. But the money supply is fluid and ever changing. A low point on the economic cycle will soon edge upward, and next year’s conditions will look different. Changes may be gradual and take many years, or they can also happen rapidly, within a matter of months.

THE FEASIBILITY QUESTION

How do you decide whether to proceed when the three types of demand—for properties, rentals, and money—are inconsistent? It comes back to the question of feasibility. What is the monthly payment on a property? This figure has to be based on the price you expect to pay, the amount of down payment you can afford, and the interest rate you will be charged. If you compare this payment to the probable level of rent you expect to receive, you can quickly address the question of feasibility. If you can’t get the numbers to work out, it means that timing is poor. You need to look for investments in a different area, wait for interest rates to fall, or wait for rents to rise due to increased rental unit demand.

MARKET CONDITIONS THAT MAY CHANGE

Although any one of these factors could make the difference between achieving positive cash flow and falling short, it is likely that two or more factors will change over time. Interest rates may fall, and, at the same time, average rent levels may rise. So your monthly payment would be lower, and you would receive higher income each month. Interest rates are not a small part of this question. The difference of 1 percent on a thirty-year $100,000 loan is about $68.00 per month. For example, monthly payments on a $100,000 loan at 6.5 percent are $632.07. At 7.5 percent, that payment rises to $699.22, an increase of $67.15 per month. If the interest rate then goes up to 8.5 percent, payment grows to $768.92, or an increase of $69.70. Based on the average of about $68 per month, the difference comes out to more than $24,000 in total payments. If you wait out the market and average rates fall by 1 percent, you would save $68 per month through lower payments. If average rents also rose by $100 per month between now and the time rates change, the total positive difference on cash flow would be $168 per month. That could make the difference for you.

DEALING WITH FUTURE RISK

Just as today’s conditions can improve, a healthy situation can deteriorate. How can you deal with these risks? First, if you are able to finance a real estate investment with a fixed-rate mortgage loan, that freezes your payment level over thirty years—and this is a considerable advantage when you also estimate the possible rise in market rents over the same period. The higher average rents move, the better your cash flow. Second, even if you go with a variable-rate mortgage, the increase in interest is fixed in two ways. A lender can raise the variable rate only by a limited amount each year (and remember, if rates go down, so will your variable rate). In addition, by contract, the variable rate can go up only so far. The annual cap, along with the lifetime cap, protects you from indefinite increases in the interest rate on a variable-rate loan.

You can also mitigate risks by ensuring that the elements that contribute to rental demand are not limited. If there is only one major employer in your town, you are at risk. If you buy a rental property, and the employer lays off the whole workforce, many people will leave, you will have higher vacancies, and your property value will fall. You should seek out markets with a more varied employment base—with not only several employers but diversified industries as well. Then, even if one employer closes its doors and leaves, it will not have an across-the-board effect on the whole rental and real estate market.

Look for factors other than local employment that also contribute to property values. A year-round tourist attraction, for example, tends to keep property values high. Proximity to a large city (meaning easy access and a short commute) may be a strong factor that adds to demand in the market, today and in the future as well. Suburban communities that are within fifty miles of major cities are often among the best investment markets. Their housing prices have not grown as rapidly as those within the cities themselves in many cases, but values rise strongly each year. This is the best possible situation in terms of both property value and rental demand.

TIMING YOUR DECISION TO THE SUPPLY AND DEMAND CYCLE

Just as the economic concept of demand is easily understood but more difficult to apply, so is the timing of your decision. The supply and demand cycle is fairly simple to grasp but more difficult to recognize from month to month.

In all investments, there is a tendency for false indicators to throw off your estimates. In the stock market, the primary price movement (of a stock or an index) may reverse and appear to head in the opposite direction, only to stop and retreat back the other way. These false starts can occur time and again. A major change in direction is more easily recognized in hindsight, which tends to be perfect. When you are at a specific point in a supply and demand cycle, it is quite difficult to identify the direction or the timing.

THINK LONG TERM

Even if you are confident about the position of the cycle, it is far more difficult to know how long it is going to take for the cycle to move in a specific direction. Every cycle sets its own pace and may speed up or slow down without warning. Many factors are at play, including the variable of behavior among sellers and buyers at any given time. You cannot approach real estate in the same way that stock market speculators and day traders do, trying to time decisions to maximize profits and moving in and out of positions frequently. Real estate is far less liquid than stocks, and it also does not trade through auction as stocks do. As a result, real estate has to be treated as a long-term investment. This doesn’t mean it cannot be traded from year to year. However, you cannot depend on fast changes in the market. It happens, but it would not be prudent to invest in real estate while depending on fast changes.

EXAMPLE: An investor bid on a house in a market where prices had grown quickly. The intention was to rent the house out, even though market rents were not adequate to cover the monthly mortgage payment. In fact, rents fell about $400 short of the mortgage payment. The investor reasoned that prices had been climbing rapidly and were going to continue outpacing the negative cash flow each month. The only problem with this approach was that the market did not continue expanding. In fact, prices leveled off and then fell. Although this change in direction was temporary, the slowdown lasted nearly two years. The investor could not afford to keep paying the difference between rental income and mortgage payments each month and had to sell the house at a loss.

DON’T SPECULATE ON RENTAL REAL ESTATE

In the previous example, the investor made the mistake of speculating in rental real estate. This investor was willing to absorb negative cash flow for a few months on the theory that price growth would outpace it and make it possible to sell at a profit a few months later. Speculating in this way makes no sense because you cannot control timing, temporary changes in a supply and demand cycle’s direction, or the prices of property. If you transact too often, profits will be absorbed or even exceeded by closing costs. Real estate is not a viable market for speculation, unless you have an exceptional understanding of the market, a healthy reserve of cash, and the willingness to live with higher than average market risk.

PICKING THE BEST REAL ESTATE RENTALS

Aside from the investigation into the demand for housing, rental rates, and market value, you also should be aware that the “best” value often depends on where the house is located and the type of house itself. As an income-generating asset, a specific house will vary in value based on its size and condition, specific neighborhood location, appearance, and age.

MATCHING HOUSES TO TENANTS

Tenants look for houses that match their income (translating to what they can afford) and can accommodate the size of their family. They are attracted to houses that are near work and that fit their specific lifestyle and desires. Each house will appeal to a specific type of tenant. A house in an upscale neighborhood with manicured lawns, fresh paint, and modern appliances and design is likely to appeal to a middle-class working couple with children. A small, rustic cabin out in the woods that’s away from traffic patterns will be more appealing to independent-minded, single, younger people, probably without children. Many tenants cannot afford to buy property on their own, but they want a yard where their children can play; they would like to get a dog or a cat, so they want a house rather than an apartment; and if they have several children, they want a larger house with more bedrooms.

AGE AND CONDITION

A house with a lot of deferred maintenance is going to be more expensive to keep in shape. It will also be more difficult to get top rents if the house is outdated, poorly insulated, poorly located, or in need of painting, yard maintenance, new flooring, and other work. One bit of wisdom advises that you should “buy the worst house on a good block.” This means that a poorly maintained house that needs cosmetic improvements is likely to increase in value more rapidly than its neighbors. This assumes that you get a discount in the price due to its condition. In comparison, buying a well-maintained house in a declining neighborhood is a poor investment; it will not hold its value well against other houses if the overall trend in that area is negative. So factors such as local employment, traffic patterns, crime statistics, and demographics all affect investment value of property.

CONFORMITY

Generally speaking, you should invest in properties that are similar to other properties in the same neighborhood. Nonconforming properties tend not to appreciate as well as the typical house. For example, if a neighborhood consists primarily of three-bedroom, two-bath, double-car-garage houses on a quarter acre, that is the standard. The typical house meeting that definition might cost $145,000, for example. If you find a house in such a neighborhood with five bedrooms, four baths, no garage, on one-half acre, and it is selling for $200,000, it is a nonconforming house in every respect (lot size, layout, and price). That nonconforming house, even while offering more in the way of features, is likely to be a poor investment. It will not appreciate at the same rate as other, conforming houses, and as a result, it would be a difficult house to resell. It may also be difficult to rent out due to your need to charge higher-than-average rents given the price.

Conformity is more than just a concept. It defines investment value in the same way that rental income levels affect appraisal value. The higher the potential income, the higher the property will appraise, based on the income method. However, you would lose points for the nonconformity of a house. Even if an appraiser were to base the estimated value on finding similar houses, a downward adjustment would be made to conforming houses in the same or similar neighborhood, which would make it very difficult to justify a higher purchase price—and, ultimately, the level of selling price you would want to realize later on. Not only is price a problem; nonconforming houses are understandably also more difficult to resell.

NEIGHBORHOODS

You cannot avoid references to location in a discussion of value. The location of your investment property determines, more than anything else, what today’s value will be and how well that value will grow in the future.

Even a difference of one block can significantly affect long-term value. If a house is located on an exceptionally busy street, it is highly visible but will not grow in value as well as an identical house only one block away from the arterial. A house in an older, established neighborhood will be far more valuable than a newer house in a less desirable area.

“Less desirable” does not refer to anything as obvious as the neighborhood’s crime statistics, proximity to noise or traffic, or any other tangible characteristics of an area. Desirability of a neighborhood is a reflection of where people want to live. For a variety of reasons (some of which are intangible), a specific neighborhood will have greater status than another. For example, an older section of town where many old-time residents live may be close to a neighborhood coffeehouse, pub, or grocery store. By comparison, more modern neighborhoods may not have the same “feel” to them. In many small towns and small to medium-size cities, this intangible effect can be witnessed time and again. Why is one neighborhood more desirable than another? There are as many answers as there are neighborhoods. As a real estate investor, you can recognize these variations in desirability only by living in the area long enough to be aware of them. You will probably never be able to understand all the reasons for that difference in desirability.

COST VS. RENTAL VALUE

Another way to define what constitutes the “best” investment is through a comparison of cost and rental value. Clearly, the most desirable rental investment is one that costs as little as possible but yields the highest demand among renters.

There is a tendency to think that high demand for property and associated growth in property values translates to a strong rental market. An in-depth analysis reveals that the two markets are quite independent and may even operate in opposition to each other. It is true that a large transient population (e.g., students or tourism workers) can create a seasonal fluctuation in rental demand. There may be nothing available in the summer months and high vacancies during the winter. From the investment point of view, this is an unhealthy condition. Ideally, there should be a year-round demand for housing to ensure that you can make your cash flow goals.

In cities with large college populations, this is possible when the school has courses throughout the year. In cities with a high dependence on tourism, the colder months may be lean economically and across all job sectors. So a robust summer economy might be depressed in the off-season. As an investor, these seemingly subtle differences can spell cash flow disaster if you are not aware of the potential problems beforehand.

THE ADVANTAGES OF MULTIPLE-UNIT HOUSING

When real estate investors face the difficulty of cash flow in single-family housing (the most popular form of investment real estate), one solution may be found by investing in multiple-unit housing instead. This does not limit your choices to detached houses or ten-unit apartment buildings. There is a lot to choose from in between.

TWO CAN BE BETTER THAN ONE

The duplex—an attached two-unit property—is a far better choice for many markets than the single-family detached home. There are several reasons:

The duplex appeals to many people who want a house. Tenants who seek a detached house often have children. They want to have the sense of living in a house, not an apartment. They may want to grow a garden or enjoy the yard in other ways, such as having a playground for their children or for pets. However, many families cannot afford the rent on an entire house, so the duplex is an attractive compromise. The duplex or triplex is also popular for student housing; it is nicer than an apartment but far less expensive than an entire house.

Many attractive attributes are found in the duplex. The duplex often has many of the attributes found in rental homes—a garage and storage space, a yard, a single-family living space, and more of a family-oriented neighborhood. The duplex, if located in a predominantly single-family area, is far more desirable from the tenant’s point of view than apartment living but far more affordable than renting a house. Utility costs also tend to be lower. The ability of tenants to attain the sense of being in a house, but at a price closer to that of an apartment, explains why these units are so popular. In many areas, apartment units and houses are plentiful but available duplex units are rare. So, from your point of view, the desirability of the duplex unit makes these safer investments.

Duplex living is a step up from apartment living. Many tenants consider the duplex a significant step up from apartment living. This is especially the case when the duplex is designed to look like a house or is actually a conversion from a onetime single-family residence into two or more self-contained units. It’s important to remember that the majority of tenants want to own a house at some point in the future. Most people with families don’t want to live in an apartment complex any longer than necessary, and a duplex is definitely an improvement over the typical apartment unit. Many tenants who can afford to graduate from an apartment to a duplex see it as a step closer to home ownership. The maintenance cost of a duplex is virtually the same as that for a house. For you as landlord, the maintenance concerns and costs of a duplex are the same as for a detached house. They include yard work, utilities, systems upkeep, and outside (roof, siding, paint) maintenance.

The efficiency of combined utility costs and yard maintenance makes it easier to meet cash flow. Landlords normally pay for garbage pickup and often for water, while tenants pay the remainder. As far as yard maintenance goes, one potential problem with the duplex is the question of which tenant is responsible for it. Expecting two tenants to share the responsibility is asking for trouble; the responsibility has to be specified in the lease for one or the other if you expect to have it done efficiently. As an alternative, you can hire an outside landscaping service and pass on the cost to each tenant.

There are insurance and tax savings. You need to insure your investment property against the possibility of fire and other catastrophic losses. As with utilities, insurance costs for a duplex are going to be lower—as a percentage of the rents you collect—than for a house. Insurance rates are based on the market value of the property, so a duplex that is about the same market price as a house will cost about the same to insure—even when rental income is far greater.

The taxes on a duplex are going to be approximately the same as those on a single-family house or perhaps a little more. But if you compare the annual property tax bill as a percentage of annual rents, you will discover that duplex taxes tend to be far lower overall. For example, let’s say that you own a single-family house that you rent out for $700 per month, which is $8,400 per year. Annual property taxes are $900, which is 10.7 percent of annual rents. Or let’s say you own a duplex and each unit rents out for $450 per month. Your annual income is $10,800. If property taxes on the duplex are $1,000 per year, that represents 9.3 percent of rents.

In this comparison, the duplex investment produces a lower tax burden. Because rents are higher, the property taxes are less of a burden. While you’re paying more for taxes on the duplex, taxes are a smaller percentage of rent income.

Potential rental income for the duplex may be considerably higher than for a house. The most appealing point of comparison is in rental income. Even if one unit goes vacant, you continue receiving rent on the other. Rent levels vary by area, of course, but you may discover that the total rent you will receive from a duplex will be far greater than you could receive on a single-family house in the same neighborhood. For example, while a four-bedroom house may rent for $900, you may be able to rent two duplex units, each with two bedrooms, for $600 apiece, for a total of $1,200 per month. If the duplex costs the same as a comparably sized house, your cash flow in the duplex will be much higher. In addition, the lower unit rent of $600 opens your units to a far wider market, reducing the risk of vacancies.

Of course, before investing in multiunit housing, it is wise to compare current market rates first, just to make sure that the rents are better. But if your area is typical, you will have better overall cash flow with duplexes in almost every instance. The economy is even more improved with a triplex or four-unit building.

Investment value may be better in duplex units. Single-family houses used as rentals tend to have a resale value about the same as owner-occupied housing. It is likely, in fact, that when you decide to sell your rental house, the buyer will be someone who intends to live in the house and use it as a primary residence.

Many first-time home buyers are attracted to the duplex for this very reason. The affordability of home ownership is made easier when the new owner can recoup half of the mortgage cost by renting out the second unit. This also provides tax benefits and partial deductions of insurance and utilities—all advantageous for tax purposes.

APPRAISING MARKET VALUE

Multiple-unit rental property may have greater market value, especially in cities or towns with high rental demand and with strong property values. If you own a duplex or triplex, which is clearly rental property as opposed to primary residence property, it may be appraised on the income basis. The higher your rental income per month, the more likely that your duplex property will increase in value. Potential buyers—other landlords—seek properties with positive cash flow, and multiple-unit housing is the most desirable among residential properties.

APPRAISING APARTMENT BUILDINGS

When you consider buying an apartment building as an investment, you must be aware of how the actual cost of the property compares to rental income. The gross rent multiplier (GRM) is used by appraisers for apartment buildings and is a useful comparative tool. The sales price is divided by monthly rents to arrive at GRM. For example, let’s say you are thinking of buying a property with an asking price of $410,000. Rents for all units add up to $3,000 per month. GRM is calculated as follows:

$410,000 ÷ $3,000 = 136.67

Appraisers compute GRM for several similar properties and then calculate the average. From this calculation, they next set market value under the income method. So, if the average GRM in your area were 131.36, the appraiser would calculate a thirty-unit building’s market value at $394,800 (131.6 × $3,000). Based on the appraiser’s report, you would conclude that $410,000 is too much to pay, and you could make an offer of $394,800.

DEFINING YOUR SPECIFIC REAL ESTATE MARKET

No one formula works in every market. Generalized valuation and demand factors cannot be applied to define the real estate market in your region. We all hear statistics about national housing prices rising or beating inflation, but that is a collective trend representing the net outcome for all regions. Some areas of the country have exceptionally strong real estate markets, whereas other areas are quite depressed. Some areas have seen real estate prices accelerate so quickly that it is difficult to enter the market as a landlord and create positive cash flow. Other areas have very affordable properties but little or no demand for rental units. So it is all a mix.

Evaluate all of the conditions in your area. Remember, all real estate is local, and you cannot rely on the national averages to decide whether you are in a good real estate market. It is so local, in fact, that you cannot even depend on statistics from the next town to define real estate values where you live. You need to look at the specific facts where you plan to buy: the prices of property, the demand for rental units, the employment statistics and number of local employers, the typical age of residents (especially if heavily represented by college students or retired people, for example), the different neighborhood characteristics, and the crime levels and trends.

No one approach is going to work for everyone. Every region and city or town has different economic and demand features. Your personal risk tolerance and financial position further affect the type of property you will end up buying. Just as different stockholders will be drawn to one strategy or another in stock selection—varying by risk and growth potential, for example—different people will view real estate properties in varying degrees. The risk factors, added to your financial limitations and commitment level, will determine which properties will work best for you.