How do people make the numbers work in Southern CA?

18 Replies

We recently moved to Southern CA. I wanted to get an FHA loan, put 5% down and purchase a multi-family in Pasadena, CA.

I broke out my spreadsheets and WOW - I can't seem to make any scenario actually work, even to break even.   How do people make multi families in this market work?  I am not looking for a ton of cash flow from this property but, I keep coming up with negative numbers.  Now perhaps some of my assumptions are off:  

Variable cost assumptions 

  • I built it property management at 10% as even if we want to manage it the first 2 years, after that I would want to outsource this bit 
  • vacancy rate:  4% 
  • repairs and maintenance:  5% 
  • cap ex: 5% 
  • landscaping:  4.5%  (assuming that there will be some land maintenance)

Fixed costs assumptions 

  • property tax at 1.5% of initial cost 
  • insurance at roughly 3%  of rental income 

In terms of total price I used the FHA max numbers and also compared to current MLS listings. Mortgage would be FHA max minus 5% and closing costs.

I am not sure how anyone is buying these with negative cash flow?  Are people buying off market, foreclosures, negotiating down?  Or in order to make these break even you need a larger downpayment.  

Any insight would be greatly appreciated.  :)  

@michelle 

@Michelle Mapp

First of all welcome to bp!  Just know your question will inundated you with turn key marketers telling you to invest out of state so get ready.

To answer your question let me start by saying I don't own rentals I invest in rehabs so take my opinion as just an opinion. However I know quite a few investors and they do all of the above. Put a larger down payment, market to sellers via yellow letters, partner with others to buy bigger (more profitable) buildings.  

Good for you for running the numbers and starting to take action.  There's a wealth of knowledge on bp and plenty of people willing to help.

Good luck

Yeah, isn't So Cal investing fun?

If your using FHA then I'm going to assume you want to live in the vicinity of Pasadena. If you are also looking for a turn-key investment then I would consider opening up the area to surrounding cities.

La Crescenta, Montrose, Glendale, Burbank, Tujunga, and Sun Valley to the west, Alta Dena to the north, the cities along the 210 freeway to the east, and South Pasadena, Alhambra and areas of Los Angeles to the south. 

Alternatively, as others have suggested market to local properties owners in your target area or look for value add buying opportunities.

Finding qualifying FHA MF that offers cash flow isn't an easy process. When combined with a specific area you want to locate you need to have patience. And when something that could meet your financial needs does become available it needs to be viewed from the perspective of making the property work regardless of whether it does in its existing state.

@Michelle Mapp

 I live close by but I wouldn't buy in Pasadena, Glendale, Burbank etc... You will premium there simply because there's no rent control there. Also I don't see these areas as being "hot" both sales and rental market wise.

Right now I'm putting a deal together for one of my clients in North East LA...

It's $700K duplex. We should get it lower though. The listing agent made some mistakes and the property does not get adequate exposure. Lucky us! :) But assuming we can get it for $680K the PITI would be under $4300 and than (without any renovations) the rents will bring $4000/month. A lot of inexperienced people would think it's not a good deal but:

A) when you consider all tax deductions and depreciation the buyer will be still in plus. A lot.

B) if buyer does renovations this would bring the rents up to $5000

C) projected yearly appreciation for this area is 7% so it's like $47K extra equity (profit)

And it's not that hard to qualify for FHA assuming that renting one of the units will add minimum $2000/month as your qualifying income.

I would consider this a very attractive deal for decent up and coming area of Los Angeles.

I usually can find for my clients 2-3 interesting properties a month. Obviously depends on areas you're searching in. I  focus on NELA and mid city.

@Ewa Reza

Hi Ewa,

Burbank resident here and I agree REI in my area (and most surrounding) is tough sledding. Curious what you meant about these areas "not being hot markets".... do you mean not hot from the viewpoint of a potential investor?

Your duplex situation sounds like a nice deal. How much is your buyer having to front to close?

@Bryan Christopher

By "not hot" I mean I don't know anybody who is thinking about buying 2-4 units in these areas. And I know quite a few people :) The numbers just don't work. Also the rents are relatively stable comparing to other North East areas like atwater, cypress or glassell park where rents went up 30+% within last 2 years. 30% is my observation only. You could find a one bedroom apartment here at $1250/month 2 years ago. Now I see ads on craigslist between $1600-$1800. 

In LA and so cal the rent to value ratios are fractional compared to many other states.

If you're lucky you'll get .5% monthly rent to price ratio and in highly contested areas its not unusual to get .25-.35% in terms of monthly gross rents relative to asking sales price.

example: 2300 2 bed room rent to purchase price of 625,000 = .368% RV ratio

In my experience you'll probably need a min of around .6-.7% RV ratio to break even with your maintenance, debt service, property management, etc. Thats not considering cap Ex, margin of error, and your cash flow profit either.

If you're buying with FHA you may even need a higher RV ratio since you're financing nearly 100% of the sales price plus you've got .8 to .85% annual MIP.

I am not saying its impossible to get a cash flow deal but, it will probably have to be a self sourced off market deal rather than a publicly listed property.

I get RE investors who buy negative cash flow deals as a loan officer who buy based on anticipated market appreciation all the time. It just depends on what criteria you're looking to achieve. Its apparent they have different intentions other than cash flow.

I hope that helps.

Hi @Michelle Mapp

Southern California is a mature market, Particularly the cities that have national or international notoriety (Beverly Hills, Pasadena, West LA, Santa Monica, etc...).

Mature markets attract all types of investors, which can sometimes make deals unattainable or non-performing for some groups.  Your value problem is that you are competing with "wealth" investors as a "cash flow" investor.

Here's what I mean.  Some real estate investors have reached a point where they no longer need additional cash flow; whether from their primary jobs, or from their investments, they have amassed enough wealth to live off the monthly income they generate.  Many not only make enough to cover their expenses, they have additional money which accumulates allowing them to further invest.

For these investors, additional monthly cash flow is not their goal.  They often seek three things:  1) stable / mature markets to invest in 2) the prospect or probability of asset appreciation (where real wealth is generated) and 3) passive losses to offset the excess income they already generate.

Just like an investor seeking cash flow will find it difficult to compete on price with a buyer who intends to live in the property they are buying, a cash flow investor will find it difficult to compete on price with a wealth investor who is less concerned with income and deems short term cash flow losses acceptable.

In Los Angeles, Pasadena included, you are competing on both ends.  First, Pasadena is a desirable and expensive are to live.  For some who wish to live in the city a single family home is unattainable; but a duplex that generates some income may be just enough to lower the mortgage payments to allow them entry to the market.  Investors needing cash flow will find it difficult to compete on price with this buyer.

Second, nicer areas, again Pasadena included, would be considered a stable and more importantly an appreciating market by wealth investors, this means it would be attractive to carry a property for several years, even at a loss, to realize the appreciation on exit.  Again, cash flow investors will find it difficult to compete with these investors on price.

So... what do you do?

You'll typically have two options as a cash flow investor.  Go to softer, less mature markets, or find something dilapidated that you can buy and renovate into positive cash flow. I'll address the latter first.

The competition you face on dilapidated properties stems from the fact that they are often desirable to owner/users. This means there are many "Flippers" who will buy those properties at a price that allows them to renovate and add value, but leaves them in a financial position where they do not cash flow after renovation. To make matters worse, they buy with cash or hard money loans, meaning they can close in 5-15 days vs. the 30-45 days you'll need for an FHA loan. Again the cash flow investor loses here on price, typically to the tune of 10-15%.

This leaves you with the opportunity to buy in either the "emerging" markets of a mature overall market (Southern California) or to go elsewhere.  Elsewhere would cover any market where you don't see much appreciation and the have an abundance of renters vs. owners.  These markets repel wealth investors and the have little to no competition among owner/users.

I hope this helps.

Best of luck,

A

PS: there are markets in Los Angeles where you can compete, don't give up!

Three things to consider:

1. Pls do not price "predicted appreciation" into your deals. This is a recipe for disaster; anyone who claims he can accurately predict appreciation is lying to you. Multifam is about trying to pay a reasonable price for a stable cashflow. If you invest in improving areas, you will very likely see appreciation in excess of inflation over a sufficiently long time horizon. But you should not count on it to make your deals work, because prices can go down as well as up.

2. You have to price in the implied rent on the unit you will occupy. In other words, if you're buying a 4plex with four 2 bed / 1 bath units, three are rented for $1,500 and you are planning to live in the fourth, you have to put an implied $1,500 rent for your unit into your number, too. Why? Well, you are receiving the benefit of housing worth $1,5000, so you need to take that into account in your return calculations.

3. For FHA deals, you can live with a much lower cash-on-cash return than you can with conventional deals. The reasoning is as follows: Your loan will be large relative to the purchase price (as much as 96.5%); therefore, you will be retiring a sizeable amount of principal with each payment, relative to your (small) downpayment. So, if you can get a deal to break even, you're doing ok.

I am totally an amateur here, however all this talk of appreciation and break even while paying down principal would indicate you need a very good W-2 job to cover unexpected expenses (or a lot of capital available). We were looking in the San Diego market for a personal home to live in for a few years until we moved on. The only way the numbers worked was if you figured in an estimated appreciation. For us, that seemed like a potential recipe for huge losses. Whenever we found distressed properties there would be several cash offers close to ARV. We have elected to see if that markets cools and look elsewhere for investing while we wait.

@Michelle Mapp Another possible way to bump up your initial cash flow is through converting one or more doors to vacation rentals. It is a different animal and other regulations/liabilities may apply. Let's say you wanted to purchase a run of the mill Studio City property. As a normal rental it is monthly negative and as a vaca rental it produces 17k a month. This would be according to mashvisor last time I checked. Results may vary and new regulations might prohibit. I think if you have a 5 units+ building you might have more options built in by law. This varies by city. Good luck with your search!

Mr Glass summed it up very well.   There are markets where newbie's with limited resources can play but the nicer areas of Southern CA are not it.    It is a little bit like saying you want to start playing golf and then being upset about the green fees at Pebble Beach.   The Shanghai Index dropping 8.5% yesterday isn't going to make getting property in SF, LA or Manhattan any cheaper in the short term as you see that money fleeing to safer harbors... with those RE markets viewed as safe by international investors. 

You can invest in Southern CA with limited cash on hand but you need to become more familiar with cities like Banning and San Jacinto than you are with Pasadena or Beverly Hills. 

@Allan Glass  I found this thread from my keyword alerts and you answered many questions I had about Southern California markets and strategies. Fantastic stuff, I really appreciate your response!

Listen to @Allan Glass .  That's well written and spot on.

It's tough because BiggerPockets and the REI crowd in general values encouragement and optimism. The reality, though, is that stable and desirable mature markets like these are structurally detrimental to folks trying to use FHA / owner-financed / house-hack approaches popular amongst those just getting started. Especially right now.

Maybe it's a good use of your time to keep plugging away - persistence and luck are both important to success.  But, think about the best use of your time; it's easier to succeed when you're setup to succeed.

Thanks @Justin R. for the vote of support. 

I don't want to give anyone the impression cash flow investing is not possible in LA, just very difficult as they'll be competing with buyers who can typically pay more. It's nearly Impossible if they are hoping something will fall into their lap off the MLS.

Hope you all find success. 

A

Thanks everyone for your replies as this has been very helpful and really contributed to some deeper discussions on strategy. I may be trying to solve too many issues/goals with one property and one financing approach. I was trying to 1) buy into something for us to live in 2) secure a 2nd rental property (we have one in No VA) and 3) set up one unit as a vacation rental (I have numerous reasons). I was hoping to break even with basic rentals, then up cash flow with the vacation rental and we would live there for the 1-2 years then turn our unit into a rental. I was going FHA basically just to be able to afford more.

We are now rethinking our approach and looking at separating out some of our own housing needs (you don't get to move laterally in house when moving from northern Baltimore County to  Southern CA :))  and our investment options.  

Not giving up on the idea but rethinking how it might work and how to prioritize which we do first.  This also frees up location.  We want to live within a particular  geographic boundary but that doesn't mean we need to invest here completely.  

@Matt R.  yes, we were hoping to have at least one vacation/short term rental as Pasadena in particular has really high short term occupancy rates and some high peak seasons.   I also need to have a place for family and friends who are visiting.  However, I have seen some articles about people pushing to limit vacation rentals in town along the lines of Santa Barbara so I didn't want to base my calculations on something that appears to be a little more volatile.  So, I was using basic rental rates for my initial calcs.  

@Allan Glass  Thanks!  This helped explain a lot - including the horrible rental market in Pasadena.  We are currently renting and basically what I am learning is that many landlords are cutting it so close they have no money for basic upgrades or repairs.   I personally don't want to be in that situation.  

@Moses Kagan I completely agree that for me I can not include appreciation into the mix at this stage.  I have experienced selling in a depreciating market despite good schools, lovely environs... and it was not fun.  Not that LA will be depreciating but still its not something I want to risk at this stage of the game.  

Thanks again.  

Unfortunately you aren't likely to find cash flow around here! :( People buying them either don't know how to run numbers, are banking more on the appreciation potential than cash flow, or bought the properties decades ago which is the only reason they can cash flow on them. 

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