Real estate is wonderful isn’t it? You get to buy a property with other people’s money at a dirt cheap interest rate. Your costs are largely fixed while rents keep on going up thanks to inflation. You get plenty of tax deductions. And you get to earn a $250,000/$500,000 tax free profit upon sale in America, depending on if you are single or married. No wonder why real estate is my favorite asset class for people under 40 years old.
But I haven’t done a good enough job over the past eight years telling you about the negatives of owning real estate. The main reason why is because I’ve been bullish on the asset class – coastal city real estate in particular. What a shame it would be to have convinced you out of buying years ago, like some doom and gloom sites who only focus on the negatives.
After a massive run up in property prices, my bullishness has turned neutral-to-slightly-negative. Supply is rising. Valuations are expensive. Rents are falling in places like NYC and SF (where I’m a landlord). While mortgage rates may finally tick up, although they’ve continued to remain low despite the Fed’s moves. Therefore, I’d like to share a reader’s horror story about being a landlord in the last down cycle. I’ve shared my own horror story, which sounds like a first class trip to Paris in comparison.
Taking A Vegas Gamble
$250K janitors. $9K/month direct deposit easy rental income. It all sounds so wonderful, but it applies to a tiny part of the US, metro areas with concentrations of educated professionals with very high incomes sipping lattes and driving their Priuses to the wine country on the weekends to stay in a nice B&B.
I moved from the Bay Area to Las Vegas in 2004. I thought I was so smart to sell my Bay Area townhouse for $425K, enabling me to buy a single story LV house here for $220K. Then I bought two rental townhomes, new construction for $200,000 each. Cash.
I didn’t see the point of borrowing money and paying interest if I could afford cash. I was going to be a happy landlord, collecting rents and capital gains on my investments. I would trade my one abode in the Bay for a nicer abode here, plus two rental streams. I had retired, early.
By 2007, the builder of the townhome complex had filed bankruptcy with 157 of 300 units empty, and all the other units which peaked at about $250K were being abandoned by people walking from their mortgages.
The banks would often leave them in limbo, vacant, and vagrant squatters would break in and live in some units (new construction, remember). As foreclosures were slowly processed, the going price to buy a unit similar to mine on the courthouse steps for cash was $50K.
All the units that had been purchased with financing were abandoned, there was no point to continue paying a mortgage for even $150K on a unit worth only $50K. The new purchasers at the foreclosure auctions were mostly absentee landlords, out of state, many from CA, but many Canadian, Australian etc. They simply wired money over and instructed realtors to buy some and get them rented.
The median income in this town was under $50K per household, and these people mostly bought a house. The tenant pool was much poorer. And vacancies were off the scale, so lots of property with hungry landlords needed income. Therefore, very poor quality tenants got great deals.
Realtors then told their out of state landlords that the best way to get a tenant who could pay and not have to be evicted would be to Section 8. Get a poor person with a government voucher to move in, and the government pays you 80% of the rent. You collect the remaining 20% from the tenant, except they usually do not pay. A landlord can evict, and lose his income stream, but most often landlords simply take the 80% payment from the government and write off the rest.
A New Owner In Town
When the builder filed for bankruptcy, the court ordered sale of the remaining 157 units were bought in bulk by an investor for $9M. That works out to about $60K per. They rent for approximately $1K per month, creating an astounding 20% gross rental yield.
That investor experienced high vacancy rates as well so they took in Section 8, and this new construction complex in a new and up and coming area quickly started looking like an inner city housing project. Crime, drugs, idle people milling around all day, sitting in their garages smoking pot, tons of kids everywhere. Domestic disputes. Continuous police presence, you name it. Have you seen The Wire?
The HOA fees started at $42/mo but over a couple years, and three managers later, they were raised to $145/mo. Common areas were destroyed by tenants. A swimming pool bathroom was lit on fire. Pool furniture was thrown into pool. An unsupervised toddler drowned in a pool while mom was passed out in a unit from drugs. Gangs of unsupervised thug kids terrorized residents for fun. The pool has been chained closed for five years due to lack of funds to open it plus the scepter of repeated vandalism. Water to external landscaping was turned off years ago to let the landscaping die, due to lack of money to pay for water.
Landlords experienced continuous turnover and breaking of leases. No one would live there, except people who had no other choice. Lowest credit quality applicants, Section 8’s whose past history caused other landlords to turn them down but desperate landlords would take them here. Gang symbols were spray painted on buildings and fixtures.
Here’s What Happened To My Rentals
I have owned these rentals since 2005. Today my $200K purchases have returned to about $130K in current value from a low of $100K. I have evicted twice, and repeated repairs and turnovers.
The latest blow is that it turns out the HOA was managed for many years by a local community manager who didn’t have a license. The reserve study shows it should have $1.6M in reserves, but has about $200K instead. A $900K construction defect lawsuit was won against the builder’s insurance co, which should have provided some relief, but all that money was ‘spent.’ Legally spent, by overcharging by managers, contractors and other helpers. The State Dept of RE has ordered audits, fined the HOA, and has a case pending against the board president who it turns out started a pest control company then and made sure to get a $6K contract for his little company from the HOA. All the absentee out of state landlords pay their dues and really have no idea what is going on.
I suspect soon I will get a letter saying a new manager or receiver has been appointed. He’ll turn around and tell us the HOA is woefully underfunded and special assessments of an extra $1K a month are now required to keep the HOA afloat.
Profiles Of My Tenants
My tenant applicants have been: DJ, prostitutes (legal), exotic dancer, cab driver, etc. Here are the financials for one example: he earns $1700/mo and has $700/mo car payment. No thank you.
Another application was for roommates, three young people each with incomes of $1000/mo (McDonald’s) who wanted to pool their resources to rent for $1000/mo. Big question is how do you afford this if one of you moves out? Uh. No idea. When I pointed out that move in cost would be one month rent plus one month as deposit, and each of the three would need $660 cash they realized they couldn’t afford to move in.
These are not isolated examples, this is reality. This is the tenant pool in this market. They simply do not have the income.
My own home that I bought in 2004 for $220K is again worth roughly $220K today. At the bottom it was worth $100K and many around were foreclosed. At that time I bought two more, at $100K, and so clearly I have a gain there, which offsets my losses on the townhome disasters.
My point is this happy landlord dream with continuous work, toilet repairs and many other repairs (yes I do it all myself) has earned me perhaps a break even on capital, and perhaps a rental yield of 5%. And the break even required gains on the townhomes I bought in 2012 to offset the ones I bought in 2004/5.
It all sounds so wonderful in blog land. So happy, effortless. I gather that many of the people who have discovered the joys of this investing have never seen a crash or downturn. Or a destroyed unit. Evictions. Tenants threatening your life by calling in the middle of the night firing guns to scare you, because you filed to start eviction and they have no money to pay.
Maybe it will never happen in La La Land. But maybe it will, and you’ll question why on Earth you tied up so much of your capital and your life to an extremely illiquid asset. If you want real estate exposure, consider buying a REIT or diversifying into real estate crowdfunding instead. Your sanity will thank you in the future.
Buyer Always Beware
I hope this reader’s story gives you a clear idea of what could go wrong when the real estate cycle turns south. Here’s a property owner who paid cash for three properties in 2004 and had to buy two more properties in 2012 just to break even 13 years later! What’s worse is the amount of stress and heartache he had to go through to manage the properties. If he had to stretch to buy all those properties with a mortgage, I’m pretty sure his entire retirement nest egg would have been wiped out.
If you’re close to retirement or in retirement, the last thing you want to do is spend your free time worrying about your assets. I’d much rather go on an around the world cruise and earn income 100% passively. Sure it sounds like the reader could have hired a property manager, but if you’re already bleeding cash, you aren’t as amenable to bleeding even more cash.
The longer you are an investor, the higher the chance you will experience bad times. It’s easy to feel good about your investments after such a prolonged bull run. Just know that when the storm hits, the floor drops out as the herd gets scared. At that time, you’ll wish you had a tremendous amount of liquidity like the investor who bought 157 units for a mere $9M with a 20% yield (BURL in effect!).
* Invest in real estate pain-free: If you don’t have the downpayment to buy a property, don’t want to tie up liquidity in physical real estate, and shudder at having to deal with tenant and maintenance issues, take a look at RealtyShares, one of the largest real estate crowdsourcing companies today. Real estate crowdsourcing also allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 4% in San Francisco, but over 10% in the Midwest and South. Earn income passively and let someone else deal with the hassle.
* Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a 2.375% 5/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.