Could Your Rental Property Investment Be Hurting You Financially?
By Mercedes Shaffer l Published in AOA Magazine
With an everchanging legal and economic landscape, it might be time to rethink your real estate investment strategy. If you’ve been in the apartment business for a while, you know that it’s usually more profitable to own a 4-plex than it is to own four rental homes. The income tends to be a lot better relative to the price, and the upkeep is easier and more cost-effective. However, recent changes in state and local laws that limit a property owner’s ability to run their own multifamily rental properties has made it much more difficult to maintain a gainful business. In the face of this new reality, it makes sense to reevaluate your strategy.
Exemption From Rent Control
Because of statewide rent control laws, one recent advantage to single family rental homes and condos is that they are typically exempt from these laws, and thereby give a housing provider the ability to keep rents at market value. If you own a single-family rental home, so long as you don’t hold title as a corporation, LLC or as a REIT, your rental home and condo are exempt from AB 1482, which caps rents at 5% + CPI for all multifamily real estate in California. Some cities, such as Santa Ana, have even more stringent rent control laws that cap rents at 80% of the precent change in CPI, with a maximum allowable annual rent increase of 3% for multifamily rentals.
These past few years have seen rent prices increasing between 10-25%, so owners of single-family rental homes have the advantage of being able to raise the rent according to current market conditions rather than be forced to go below market by state rent control laws.
Since 2020, It’s worth noting, “emergency” rules are in place in reaction to COVID-19 that do not allow housing providers to raise the rent more than 10% on any rental property, and some areas such as LA county are forbidden to raise rent at all until one year after the state of emergency is declared over. This is an unfair restriction that singles out the housing provider industry, but that’s for another article. Once the pandemic is deemed to be over, these restrictions are to be lifted and we will return to having no rent caps on homes or condos.
ROI on Upgrades
With multifamily properties, the rent caps make it virtually prohibitive to be able to afford to maintain the property much less update it from time-to-time. In decades past, renovating a multifamily property could make financial sense. You upgrade the property, charge higher rents to recoup the investment, and in doing so add value to a whole neighborhood, and provide a better place for renters to live. Under the new laws, you can’t keep multifamily rent on pace with market anyway, so why invest in upgrades or renovations. The lethal combination of government-imposed rent restrictions during a time of high inflation and steeply rising costs for appliances and building materials -- makes it so that upgrades are NOT likely to yield an ROI.
On the other hand, with single-family rental homes you are often more likely to realize a return on upgrades and improvements because you can adjust the rent to reflect the value of the property. This makes it financially feasible to keep the home well maintained and updated while the tenant is living in it.
In addition, once you’ve made the upgrades and added value to the home, you can turn around and sell it for a profit, and if the tenant is on a month-to-month lease, now you have an even broader pool of buyers because the home appeals to both investors and owner-occupied buyers, which will surely create high demand and a bidding war so that the home sells for maximum value.
Now you can take your profits, do another tax-deferred 1031 exchange and purchase another fixer-upper home and continue to grow your wealth while providing excellent rental housing for those who are in need.
Growing Demand for Rental Homes
Due to the shortage of affordable housing, there is a growing number of people for whom purchasing a house is out of reach. Our country has approximately 80 million Millennials who are at the prime age for buying their first home. The Millennials represent the largest home-buying population in history, yet most Millennials are choosing to rent instead of own a home. One of the reasons is because home ownership has become so expensive. Another important reason is that polls indicate that they prefer to spend their money on experiences such as travel, recreation and leisure activities rather than being anchored by home ownership. While they aren’t ready to own a home, many are high earning professionals who want to live in a house rather than an apartment, and the types of jobs these professionals have allow them to work from home, so having plenty of space and a nice home environment is important to them and they are willing to pay more for it.
Similarly, the Baby Boomer generation, the second largest demographic alive today, right behind the Millennials, are taking advantage of this hot seller’s market, cashing out of their homes and using the equity to enjoy travel and leisure experiences too. Due to Prop 19, since the tax basis no longer carries over to the heirs once the parents are deceased, (unless the child moves into the house as their primary home, and even then there is a limit of up to one million dollars above the current assessed value) parents are not as incentivized to leave their home to their kids as part of their legacy so they prefer to downsize, rent, and maintain a flexible lifestyle.
Home Values and Unrestricted Rental Rates Have Flipped The Business Case
Homes have been appreciating between 10-25% annually over the past two years. In Costa Mesa homes appreciated 24% in the last quarter of 2021 compared to the last quarter of 2020 and in Anaheim they appreciated 27%. While home prices are based on whatever the market will bear, multifamily properties derive much of their value from their rental income.
As a real estate investor, it’s important to look at both the income and the appreciation of a property, and if the market continues in this direction, over time, homes will likely appreciate at a faster rate than multifamily properties and command higher rents. With this growing need for rental homes and recent rises in rental prices, it may make financial sense to change out of multifamily rental property and into single-family homes and condos -- or own a little of each to diversify your real estate investments.
Vote! Housing providers are being singled out unfairly and it’s crippling the industry.
With so much change over the past two years, it’s good to re-evaluate your real estate investments in light of the new legal and financial realities. What worked so well 10 years ago may not work in today’s market. There is no one-size-fits-all approach to real estate investing and it’s a dynamic market that’s always changing, and as a real estate investor, you have to always be evolving too.
If you would like a free investment property financial analysis, or to learn more about rental properties in Orange County, I can be reached by phone or text at 714.330.9999, by email at InvestingInTheOC@gmail.com or visit my website at www.InvestingInTheOC.com. Mercedes Shaffer is a real estate agent with Pacific Sotheby's International Realty and specializes in helping clients to create an optimal investment strategy through buying and selling investment real estate and 1031 Exchanges. DRE 02114448.