Looking for Value in the Income Property Market

Last year, we began looking to purchase a piece of income property with a partner. Our search started with the 5+ unit category because this is traditionally where you find the best cash flow.

After scouring the market for 6 months, we came across very little inventory, and even less attractive deals. If the Real Estate market was so bad, where were all of the good deals? If you read my last newsletter entitled “The Tail of Two Cities”, it states that more desirable markets were less affected because risky financing was more widely used in only the marginal areas.

A similar scenario applies to the income property market. Lenders never made risky loans in the 5+ unit market. Purchasing a large building has ALWAYS required a large down payment, usually 35%+. In addition to a large down payment, lenders require the rental income, after ALL expenses, to more than cover the loan payments. So with conservative underwriting, and well healed investors, these owners have not been desperate to sell or would face foreclosure.

So where were all the great deals? I thought I would follow my nose, and sniff for the scent of foreclosures. To find foreclosures just look where lenders made stupid loans.

Unlike large apartment loans, 2-4 unit financing is underwritten much like single family loans. There were loan programs for everyone, even the indigent. This would be a good place to start.

So after exhausting our choices in the 5+ market, I decided to look at the 2- 4 unit market, and what I found was the complete opposite. Lots of foreclosures, with prices having corrected aggressively. I found the best performing 2-4 properties were 3 & 4 unit properties that had more square footage. Two unit properties often get priced more like single family homes, because they may be owner occupied. So in looking for good cash flow in the 2-4 unit market I restricted my search to 3 & 4 unit properties.

After a full day of looking at thirty smaller properties, I concluded that 3 & 4 unit properties cash flowed as well as the 5+ unit properties. To boot, there were lots choices, unlike the limited inventory for 5+ units, and 3 & 4 unit properties are easier to finance.

It appeared to be that smaller units were cash flowing as well as bigger buildings. This was something I had never seen in 20 years of Real Estate. This shouldn’t be! Think of the 5+ unit market as the arena where the big boys play, where investors expect good cash flow. Investors must put down 30% or 40%, but in exchange, they get a quantity discount.

What was happening here? Relative values were not in line with historical norms. So I did some digging, and this is what I found.

Determining Value

First I had to decide how I was going to value a large number of properties for comparison. Income property is valued based upon the income method. Unfortunately, income data is difficult to obtain and is often unreliable. Advertised rents can be below market if an owner hasn’t raised them or they can be above market “pie in the sky” wishful thinking. Additionally, some units are owner occupied or vacant and show no income.

If I were to quickly review hundreds of buildings, using income data would be out of the question. But I could use a buildings total square footage, which is loosely related to a buildings income. I say loosely because rents can range from $1 per sqft in the least desirable neighborhoods to $2 per sqft in some of the most desirable areas. While income figures are NOT reliable on the MLS, building sqft is reliable because it is obtained directly from the tax assessor data, and auto populated into the MLS printout, so an agent can’t screw it up.

What the Results show.

The chart on the previous page shows 3 & 4 unit properties starting to correct right when the credit crunch hit in the 3rd quarter of 2007, at the same time that home prices started tanking. If 3 & 4 unit properties sold for $270 per sqft and now are priced at $150 per sqft this represents a whopping 45 percent correction. Not surprisingly, since January of 2007 there were 75 foreclosures or short pays that sold in this 3 & 4 unit category.

The 5+ unit market is a different world and has performed much differently. While the 3 & 4 unit market has been ravaged by foreclosures and short pays, there hasn’t been one 5+ unit property that was a distressed sale. So while 3 & 4 unit prices started dropping, 5+ unit prices held there value, for a while. Then 9 months later, 5+ apartment prices started to correct. They were pressured by the 3 & 4 unit property prices. If 5+ unit properties peaked at around $200 per sqft and now sell for $150 – $160 per sqft, this represents only a 20 – 25% correction.

Sales Volume and what this says about the market.

The number of 3-4 unit sales has been brisk, rising nicely back up from the depths of the credit crunch to respectable levels. Banks have set aggressive list prices to move these properties. With a 45% correction in this category and good deals to be found, buyers are stepping in aggressively to purchase. I have seen some astoundingly good deals in this category, and evidently other buyers see the same opportunity.

The number of sales for 5+ units on the other hand is very weak. Owners of 5+ apartment properties aren’t interested in selling at the price that banks are liquidating 3 & 4 unit properties. In the second half of 2008, there were a total of only 14 sales in all of Long Beach for 5+ unit apartments. Since risky financing in this category wasn’t allowed, most owners of these properties are not in trouble, and the properties cash flow well enough that they can weather the current storm. Only sellers that really want to sell, or have to sell, will decide to compete.

What it means.

Knowing that 3-4 unit properties have usually sold for more per sqft than 5+ unit properties, means something has to give. With 5+ units only several quarters into a decline it is likely that these might drop some more from their current levels. However, it is likely that the volume of 5+ units will stay low as most of these owners don’t have to sell, and will prefer to have the cash flow. Better deals may be found in the 3 & 4 unit category and might also have more opportunity to bounce back, once foreclosures are cleared out.

However, I think it is likely that both markets will bounce back, because my rough calculations indicate both of these markets are undervalued.

Replacement Cost Says it’s time to buy.

There are several ways to appraise properties. Single family homes are priced by comparable sales, income properties are priced based upon their income. Another method of valuation is replacement cost. Replacement cost is determined by adding the cost of the structure plus the cost of the land.

Construction costs in Los Angeles have been around $200 to $300+ per sqft. when the market was hot. With the market slow down maybe building costs are more at the lower end. To be ultra conservative, I will say you can now build for $175 per sqft. But this is for new construction, so maybe we should value an older apartment for less. Maybe it is only worth $150 per sqft, which is what income property is selling for. But I have not yet included the land. Land costs in Los Angeles might be anywhere from $200,000 to $500,000 for a typical lot.

If income properties are selling for just the building’s replacement cost, not including land, they are significantly undervalued.

Is it time to buy?

When I look at this question, I ask myself “What could go wrong moving forward?” We could certainly have a prolonged recession, or even an depression. In this case, rents will come down, construction costs will come down, and we might be best to wait because prices may continue to come down.

Realistically what is likely to happen, is that eventually we will come out of this recession. Maybe it even takes 3 more years. But there are three things I think are fairly certain. First, no builder in their right mind will build rental units right now. Why would they if buildings are selling for less than production costs? Two, Los Angeles has continued to grow and will likely do so in the future. So additional supply should be non existent and demand, while temporarily weak should continue to grow. And finally, my personal hunch is that inflation will be on the horizon, in which case owing hard assets is better than holding cash. But even if I am wrong, if the building makes money and cash flows, then who cares about appreciation? Appreciation is just the icing on the cake.

Regarding inflation, I have read a lot of economic books in my lifetime, and one thing seems certain. Never in the history of fiat money (paper money) has a civilization not debased their currency if it wasn’t tied to gold (and then they still try). It appears that our government has cranked up the printing presses, and this will likely lead to inflation. Property owners benefit during times of inflation by keeping the government from reaching into their pocketbooks and stealing their money. And if leverage is used, returns are even further enhanced because today dollars are paid back with less valuable tomorrow dollars.

While things might go wrong, the greatest wealth in Real Estate is created during bad times. Most importantly, I am personally putting my money where my mouth is.

In the next article, I have included a quick primer on how we evaluate rental property.