Investors

Investing in Single Family Homes

Craig Acord

There are a number of reasons why investing in single-family homes has become more attractive:

  • Home prices are rising substantially.
  • Given current house values, there exists a good chance for homes to appreciate over time.
  • The underlying home ownership equation has undergone a fundamental change in the U.S., substantially increasing rental demand. Some experts project many households will lose their homes due to foreclosure of delinquency in the next five years, driving even further rental demand.
  • New construction levels in the U.S are on the rise and at prices that exceed what medium households can afford.
  • 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.

Economics of Single Family Homes

You should consider the market when looking at various opportunities

According to a 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). An 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.

Capital appreciation likely for long-term investors

Some factors are likely to drive prices higher for entry-level homes in many areas. First, inventory levels are dropping and second, demand from both investors and end users has strengthened. This combination has led to the stabilization of housing prices in a number of markets. I expect this trend to continue.

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. If an investor can purchase a home for half of the 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.

In many hard-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. 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.

Home prices expected to rise

Predicting housing prices 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 and also know as shadow inventory hitting the market 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.

Operating costs of a single-family home

They vary widely from one region to another, but usually fall within the range of $2,000 to $8,000 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 25% to 40% 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.
  • Concessions: Promotions such as “one month free with a one year lease.”
  • Bad Debt: Losses from tenants who leave without paying their rent.
  • Property Manangement: Maintaining and/or leasing properties.
  • Utilities: Water bills to keep lawns watered while the property is vacant or other utilities such as electrical and gas that need to be paid on vacant properties.
  • Repairs & Maintenance: Repairing appliances, cleaning carpets, landscaping, etc.
  • Marketing: Costs to advertise properties for rent.
  • Insurance: Property insurance that provides protection in case of fire or other hazards.
  • Property Taxes: Approximately .8% to 1.5% of purchase price, plus an annual increase.
  • Management Fee: Management companies charge 6-15% 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.

Using leverage

Using leverage‚ meaning putting a loan on an investment property‚ it tends to amplify returns. If a property appreciates, as long as interest rates are reasonable, leverage will greatly enhance returns. Getting a loan for a rented investment home in today’s market is not easy. Fannie Mae does provide such loans, 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. Finally, there are certain private money lenders who provide loans on rented homes; however, their rates tend to be in the neighborhood of 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.

Tax treatment of investing in single family homes

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.

Most investors of single family homes hold the investment for many years

Today’s housing prices make single family home investing quite attractive. Many investors have been managing rental portfolios 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.

Purchasing a home at favorable prices

Best buys are typically made from the most ambitious sellers, and the most inspired 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:

  • Foreclosure auctions;
  • Buying bank-owned properties listed by a local real estate agent; or
  • Buying via a short sale.

Where to buy

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:

  • Investing on a scale that warrants regular flights and overnight stays
  • You have a very experienced, trustworthy partner such as Pyramis Company in San Antonio, Texas.

Is that home a good investment

There is no single method as it will depend on your objectives, holding periods and the type of investment that you are making. Some of the relevant factors to consider include:

  • 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?
  • Is the location desirable enough that you will be able to sell the property if and when you want to exit the investment.
  • Do you have the ability to manage the investment, given the location and your skills, or, do you have a property manager such as Pyramis Company available to do so?
  • Are you purchasing the property at an good price, relative to recent sales of similar homes in the same neighborhood?
  • Can you add significant value through renovations?
  • Do you believe that the local market is likely to rise in the coming years, given demographics, the 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.

Investing in a condo as a rental

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.

Advantages and disadvantages of buying at foreclosure sales

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. 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.

Buying bank-owned homes that are listed on the Multiple Listing Service (“MLS”)

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).

Pros and cons of buying a short sale

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.

Renovating a home after it’s purchased

Different investors take different approaches as it relates to renovations. The condition of the home upon purchase may dictate significant renovations or virtually none at all. You should bring the property up-to-date and make it attractive for tenants. 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 $2,000 to $15,000. Most homes will benefit from even simple cosmetic improvements such as new paint, new carpet and new appliances.

Number of rental houses in the neighborhood

Some neighborhoods are transitioning from owner-occupied neighborhoods to rental neighborhoods. 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.

Advantages and disadvantages of active versus passive investing

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 property manager such as Pyramis Company in San Antonio, Texas. 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 property. 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 property management firm 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 to realize investment returns that were unachievable on your own.

Fees that property managers charge are justified

In selecting a property manager to consider there track record in order to determine whether or not they have 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 a professional, such as the Pyramis Company, may very well justify their fees.