Buying Condos as Rentals.
Buying Condos as Rentals
All too often, real estate investors, even successful experienced ones, make decisions based on past performance of an already owned rental property or on success during recent years. One of the few certainties regarding investing is that the market can take away your gains as fast as it can give them. As a real estate investor, it is important to treat every purchase decision independently and to perform adequate due diligence before making a purchase.
Real estate investors often decide that the best type of rental property for them is condos. Reasons for this preference include:
- Single unit properties can be sold to owner occupants,
- Lack of external maintenance responsibility makes condos more attractive than single-family homes,
- Good condo communities provide numerous amenities that are attractive to potential tenants and future buyers, and
- Condos are considered to be a hot market.
We will examine some relevant issues to consider when you perform your due diligence, including some issues that are often overlooked.
Rental Restrictions
The CC&Rs of some developments regulate rental of units, even to the prohibition of rental. Even when rental is not outright prohibited the number
and severity of restrictions must be considered. Restrictions other than outright prohibition include requiring Association Board approval of tenants.
The importance of this issue depends on the details. If a tenant must be approved by a formal meeting of the board, it could mean a delay of many days,
even weeks. Since this is something that must be disclosed to potential applicants this might eliminate a significant percentage of your potential pool
of applicants. A Board approval requirement also creates opportunity for fair housing violation claims because of Board actions.
For the owner occupant purchaser prohibition and even less severe restrictions regarding renting can be a positive. Many buyers consider owner occupants to be superior to tenants. Lenders and even the government appear to agree. Financing is more difficult to obtain and more costly when a significant percentage of units are tenant occupied.
Severity of other possible restrictions can also create serious problems if the selected tenant refuses to proceed with signing the lease agreement. The applicants should be required to read the documentation prior to signing because your lease should contain clauses whereby the tenants agree to abide by all documentation and reimburse the landlord for any fines resulting from tenants’ violations and agree that repeated violations (with the number stated) is cause for termination.
Accordingly, investors should read the condo documentation before considering any other issues and immediately terminate consideration of the development if the restrictions are unacceptable – obviously, particularly when renting is prohibited.
Have a Plan
One should never invest in anything without having an adequate plan. The plan must be consistent with the investor’s goals, financial qualifications, knowledge of the type of investment being considered, and risk tolerance. Planning carefully will help an investor place his capital in the most productive way toward realizing goals.
Goals can vary from quick profits to long term growth. Whether you are a short-term investor, perhaps even planning to flip a property for almost instant profit or you are a “growth” investor who plans to hold the property as a rental for many years, the rental numbers still have to make sense for resale value. Short-term investors must buy far enough below market to make enough profit to warrant the wish being taken.
Long-term growth investors should usually focus on the capitalization rate of the property as well as expected future rents and expenses. A growth investor must consider how the rental property will be managed. Will he be basically a passive investor who, upon close of escrow, turns full operation of the rental property to a property management company or will he fully manage the property? Being a passive investor requires the investor to find a competent experienced manager and means that the extra cost of management must be considered. The extra cost includes not only the fee paid to the manager but also the extra cost of maintenance that would usually be performed by the owner-operator. One must also consider that the cost of the maintenance contracted out by a manager is often higher than when the owner personally finds the contractor.
An investor’s financial qualifications will limit the types of investments as well as the risks he should take. This is so for both the amount of cash that will
be initially be invested and the amount of negative cash flow the investor can support. Everyone can tolerate different levels of risk and everyone reacts
differently when it become evident that the risk was greater than that which the investor should have taken.
Purchase Price
An “old” real estate investing proverb says: you make money in real estate by what you pay for it, not what you sell it for. The price of a condo is the next thing that you should consider. Of course, an investor must perform a financial analysis to be sure that the cash flow after paying the mortgage and all operating expenses and expected reserve for capital improvements is acceptable considering his financial resources and income tax situation.
It is important to avoid inflated prices. If the condo is in a hot neighborhood or in a heated market it is even more important that care be exercised because it is very possible that you’re buying at the high point of “value.” This is often a greater problem when buying units in new projects.
For new projects it is particularly important that buyers thoroughly understand the fees that will be assessed by the HOA. Inadequate budgeting projections, whether intentional in order to increase sales or due to incompetence, can significantly increase the cost of operation, reducing the “real” gain upon ultimate sale. You must remember that developers spend many thousands of dollars on marketing and promoting a new product.
Is the initial marketing budget being provided to potential buyers realistic or is it underestimated to keep monthly fees low in order to facilitate sales? Will there be a need to significantly increase fees or have special assessments for future capital expenditures as the property ages because of grossly inadequate
reserves? Don’t fall prey to developer greed. No matter what the hype for the project, don’t be fooled into overpaying.
While fee and budget issues must also be considered when purchasing in existing communities, one has the ability to analyze financial records from previous years for resale units. Required availability of adequate financial information for several past years should be included in the purchase offer, with buyer approval being a contingency.
Location
As for all real estate, location is a primary issue in value for condos. The purchase price should definitely depend on the location because the rents that can charged and the eventual resale price will depend on the development’s location and on the neighborhood around it.
The condo does not usually make the neighborhood; the neighborhood usually makes the condo. This doesn’t mean that the neighborhood has to be modern, refined, or meet any other strict requirement. It does, however, mean that the neighborhood must have a stable foundation for rental and resale. When all is said and done, the project should feel like a community.
New Project Issues
Hot markets often attract amateur developers who want to get in on the action. However, many times products by such developers have inadequate planning, have poor designs, and/or build poor quality. It is usually best to buy from (1) a local developer and (2) a developer who has a portfolio of successful products of similar type and size in the local market.
Buyers of new construction often have significant choices regarding numerous components. It is very easy for a buyer to spend too much on upgrades. Developers make money on each upgrade, so they will make it easy to select upgrades and provide many incentives to do so.
When considering upgrades you should think of what the average tenant for the type of unit being purchased in the particular development where located would need in order to sign a lease. Do not look at the decisions as if you were going to live in it yourself for many years. When buying for rental it is best to stay with middle of the road components such as light fixtures, fans, appliances, flooring, cabinets, and countertops. Do not choose unusual colors and patterns.
While overly upgrading to your tastes may not stop the average qualified rental applicant from signing a lease, it will not likely result in rents enough higher to justify the costs. Furthermore, just as for being the largest and most elaborate home in a single-family subdivision, being an overly upgraded unit in a condo development will usually not get you a lot more net profit upon future resale. For both rental and resale value, you want to appeal to the masses. Overly upgrading can actually decrease your buyer pool if the costs of high-price upgrades are to be recaptured upon resale.
Even if the price is right and the developer appears to be great you will still need to have sufficient knowledge and spend adequate time analyzing the location, size of the project, layouts, designer, amenities, and HOA documentation. Of course, you should consider all the same issues when buying resale condo units.