Stockton CA Multi-Family Bids Adieu to 1% Rule Properties

11 Replies

For the last few years Stockton CA buy-and-hold rental property used to be a virtual no-brainer. Now the market for conforming multi-family property is at a turning point, breaking through the floor dictated by the 1% rule. And that is very bad news for new investors looking for multi-family property. Here is why:

The Stockton cash-flow rental market has been my primary (even sole) focus for over three years now. This means I have been keeping a very close eye on, what I call, "conforming" multi-family rental pricing. By this I mean standard duplexes and triplexes build in the last two or three decades of the 21st century. Throw a dart at a map anywhere north of Hammer Lane and you are bound to hit one of these properties.

Having seen owned and rehabbed a good number of triplexes and duplexes that fall into this category I have really come to love this property "class". Why? Because I am lazy and unimaginative. And I know it:). Let me explain. These conforming multi-family properties are extremely predictable; everything is very "cookie cutter". If you've seen one, you've seen them all. Their homogeneous nature makes everything from estimating repair costs, guesstimating rents and even finding tenants, a lot easier. No need to reinvent the wheel.

Figure 1: North Stockton is Cookie Cutter Central:).

Also, being "newer" all building techniques used in their construction are standard and pretty "modern". This makes it straight forward to work, or have work done on these properties, even by less than expert craftsmen... Finally because these properties have always been rental properties. This means that while they are often badly maintained, at least they typically don't contain weird DIY modifications. What you actually mostly see is no upgrades at all:).

Combine the above with some basic, common sense knowledge about the different neighborhoods, or should I say blocks, this is Schizophrenic Stockton after all, estimating what you will be able to get in rent for these properties is also fairly predictable.

For all the above reasons these types of properties are definitely what I would recommend to new out-of-town investors looking to get their feet wet.

And that brings me to the bad news: The price point of this type of property is structurally starting to breach the 1% rule. Duplexes that will rent for around $900*2 ($1800) are being sold for over $200K. Triplexes that reasonably will not get more than $800*3 ($2400) are being offered for close to $300K.

Why is this such bad news? Owning a good number of these types of units I have discovered that because all properties are so similar, the 1% rule is dead on for this property type. Unless the building is inparticularly bad shape, needing immediate rehab; in a really bad location, or has rents that are even close to market, 1% of purchase price is about the minimum you need to gross to make the property a reasonable cash-flow investment at the current interest rates.

Without expounding too much on my (pretty standard) calculations, I want to point out that when calculating the profitability of a property I assume 100% financing at current rates. Now of course, the beginning investor will probably put 25% down. However, even if you do pay down (and I do recommend doing that), I feel your calculation should account for the opportunity cost that you incur by locking up those funds. Just think of it this way: you could have been doing something else with that cash. For example you could have paid down your mortgage or put the money in a Dow Jones Index fund etc. No money is every free.

What does this mean for the Stockton rental market? I think the days of abundant, no-brainer cash flow deals on the MLS have come to an end. Investors looking for cash flow will be tempted to look at old, non-conforming, functionally obsolete C and D class properties. However based on the low predictability and possible complications that these properties offer few would consider these good "starter" investments.

What I think we will also see more and more is money flowing into the market from Bay Area professionals with high paying jobs. I like to call these "dentist-investors":). This type of investor is looking mainly for tax deductions as opposed to short term cash flow. of which after all,they already have plenty:). Their hope is to have some paid-off properties by the time they retire. This allows them to slowly liquidate their portfolio or continue to collectrent without paying interest, when they are in a lower tax bracket.

Exactly because they are not looking for immediate cash flow. These investors are very hard to compete with on the open market. After all, if you need to cash-flow to sustain and grow your portfolio you don't have the luxury to wait 30 years until your mortgage is paid off...

Sowhat is my advice for new investors that are just now thinking of entering the Stockton market? Frankly, I don’t think there is any simple straightforward solution. If you know one, let me know too!:) So since I can’t tell you what to do I thought maybe I should close by telling you what *not* to do.

First of all, don’t pay a price because everyone else pays it. Analyze your deals very carefully from a cash flow perspective. If other conforming duplexes are selling for $230K this does not make a $210K duplex a great deal from a cash flow perspective!

Unless you want to speculate on equity growth, or you are one of the before mentioned extra-long-term-dentist-investors, I would not recommend breaking the 1% rule on conforming multi-family unless you have a very clear idea of how you will add value to the property to make it meet the 1%. Don’t give in to wishful thinking (“I’ll rehab real nice and raise the rent to $1,200 per side…”).

If you are thinking of adding value by rehabbing property, please realize that Stockton is a market with a very high price-elasticity. Unfortunately rent price seems to be way more important than quality for most tenants. Also consider that if you invest $10K and raise the rent by $100 you have not improved your gross rent multiplier at all. You just managed to increase your exposure with $10K while preventing yourself from putting that cash to use elsewhere.

Whatever you do, remember that in a tougher market you make or break your investment when you buy it…

Anyway; those were some of my thoughts musings and opinions on Stockton investing. Let me know yours! Also if you have any questions regarding Stockton multi-family feel free to ask, I’d be happy to help!

Updated over 2 years ago

UPDATE: For those of you who are interested in seeing some actual Stockton, CA duplex / triplex numbers (not guesstimates) I have created a post showing my actual per unit numbers. You'll Find it here: https://www.biggerpockets.com/forums/627/topics/336409-stockton-deal-analyses-estimating-costs?page=1#p2158289

Thats great insight on the animal of Stockton multi family.  The numbers for reasonable positive cash have been disappearing.

I have been in Stockton for ten years and would not encourage to buy at this time. We have had huge appreciation in the last 3-4 years. I did say huge right? 

For example in 2012 I purchased a sfh for $250k. In just 3 short years I sold it for over $400k. Not a bad return. And I used it as my primary residence so I saved on the capital gains. 

So now I am looking at commercial multi family in the area because the bank doesn't pay me to hold my money and the 1-4plex idea doesn't make sense. I think the bank sent me peanuts. 

@Chris V. Great post! I live near a large concentration of these cookie cutter Duplexes and Triplexes. I have found it difficult to find deals due to reasons you stated. 

@Chris V. Great post Chris, very insightful. It seems like you really know your target market, very impressive. Seeing as you think the "no-brainer cash flow deals" are done for, where do you think the Stockton market, as well as the greater Northern California market is headed?

Do you think we will see a decompression of cap rates?

Kenneth R. Reimer

Originally posted by @Ben Perkin :

Thats great insight on the animal of Stockton multi family.  The numbers for reasonable positive cash have been disappearing.

I have been in Stockton for ten years and would not encourage to buy at this time. We have had huge appreciation in the last 3-4 years. I did say huge right? 

For example in 2012 I purchased a sfh for $250k. In just 3 short years I sold it for over $400k. Not a bad return. And I used it as my primary residence so I saved on the capital gains. 

So now I am looking at commercial multi family in the area because the bank doesn't pay me to hold my money and the 1-4plex idea doesn't make sense. I think the bank sent me peanuts. 

 Yes, over the last 3 years the market has gotten to a point where cashflow is hard to find. Nice job of your house, and using it at primary to prevent the capital gains:))). I want to probably buy two more Stockton multi-family properties before things start to get really crazy, and then I was planning on looking at large multi family as well. Locally I have not seen a lot that make sense when you apply the 50% or 60% rule. I might finally have to bite the bullet and start investing out of state:((((

Originally posted by @Kenneth Reimer :

@Chris V. Great post Chris, very insightful. It seems like you really know your target market, very impressive. Seeing as you think the "no-brainer cash flow deals" are done for, where do you think the Stockton market, as well as the greater Northern California market is headed?

Do you think we will see a decompression of cap rates?

Kenneth R. Reimer

 Hi Kenneth - I think eventually we will see a correction, but when in the big question. Macro economics are very hard to predict, anyone that can do that with any accuracy would probably have more profitable things to do with their time than to mess around with Stockton CA small multi-family property like I am:).

That being said, I can speculate a bit. I'll use the 18 year cycle theory.

The theory is that the real estate market goes through phases. Phases I - IV start after a property market recession like we had in 2006.

Phase I Recovery - Vacancies are slowly starting to go down, not much new construction going on. Everyone is really carefull.

Phase II Expansion - Vacancies are really starting to get filled, new construction is starting to ramp up. Money becomes more available and is being poured back into the market. People are starting to get optimistic and go on bigger pockets to get in on the action. Because it's the thing to do. *IMO this is where we are right now*

Phase III Hyper Supply - Everyone gets in on the deal.  Real estate investing is awesome! Grandma cashes out her retirement savings to get in on the action. Build it and they will come! We are all going to be rich, Yippee!! Vacancy is quietly on the rise but no one is paying attention because: Everything is AWESOME! There is still demand, but this demand it driven by speculation, not by fundamentals. This is where the real trouble starts, inventory is starting to build up. Most builders and developers are aware what is going on but who wants to leave the party early? After all, if you would cash out now your friends and investors might think you are a total p*ssy! Meow.

Phase IV Recession - The emperor turns out not to wear any clothes. There is no real denying anymore that all these new units being added to the market have little or no real demand. The Fed raises the interest rates in an attempt to hit the breaks. At these new "crazy" rates planned new developments no longer make sense because their caps would be too low. So no new projects. Projects that were already underway make the problem worse, but the units are never filled. The market is over-saturated and even by now even grandma knows to pull what is left of her savings out and to stick it in some bonds or something. Construction is one of the BIG engines of the economy and with that grinding to a halt other related sectors are affected. Fear does its job and people stick their checkbook deeper into their pockets and start recycling their cans. Sears threatens to go out of business. This is the recession phase. 

This pattern has been going on since John D. Rockefeller roamed the earth. Only difference being that back then Sears used to be called Roebuck. Or whatever; what do I know, I am not an archaeologist. 

Lets cut back to the cycle. Supposedly this real estate boom-bust cycle has on average peaked every 18 or 19 years or so. *On Average*. Those two words right there are the problem to answering your question. It reminds me of that joke of the statistician who drowned in a river that was on average 3 feet deep. Not very funny, but you get the picture.

Back to the 1800's these where the internals between the peaks of the construction cycle:

20

15

21

17

16

47

6

8

20    -This was the peak of 2006 which 

So to speculate on your question. We are 10 years into the cycle now. I think we are towards the end of phase II. The fist sign of trouble will be when you'll see Grandma and Joe the Plumber are investing in REIT's. And people buying Stockton property for twice the 1% rule value because everyone else is doing it. Then when you see the interest rates being jerked up it will be too late to make a graceful exit.

So the problem is that there is a lot of money that can be made in phase III. Lets say that phase lasts 3 years. Who wants to wait out that dance and sit on their cash waiting for the other shoe to drop while there is so much money to be made speculating on equity. However what are we going to do after cashing in $$$$$ in equity? That is right, reinvest it to try and do it again!  Always hoping that when the music stops we will have a chair. And we are sure we will, because we are smarter than everyone else. Right?:)

Personally I have the feeling that by the end of 2016 we will be firmly in phase III. I can't see how that phase could possibly last longer than a year or 2 to 3. But then again, I have been wrong before. In fact, I suck at predicting stuff. I miss-predicted, the internet, Obama, Smart Phones, Trump and the mega millions numbers. The internet if full with people that are more convinced fo their predictive abilities, but they seem to never agree. Which makes their analyses as worthless as mine.

Therefore the only thing I can recommend is to try and invest based on cash flow. Play it save and do not buy property that does not cash flow or that is financed in a vulnerable way like adjustable rate mortgages etc. If the S. hits the F. rents might go down a bit because competitors buy properties at a way better cap rate and can afford to rent them out for less, but I would not predict rent to drop extreme. Build in some safety and padding in your numbers and you should be alright. If it is not a deal, don't buy it. If you have to sock up your money until after the next collapse. Just realize that it will be hard to get a loan during that period. Think strategic and don't allow all the "success stories" to distract you from the fundamentals.  After all, they don't call real estate a "giant get-rich-slow-scheme" for nothing:)

Figure: Behold the cliff. Too bad zillow does not have 100 years worth of data or else you would see quite the mountain landscape.

@Chris V. That was one hell of an answer, wish I could vote for it over and over. Thank you!

I can see where you're coming from thinking we're approaching Phase III. As I'm very new to real estate, I haven't even see multiple phases, let alone multiple cycles. So, is it uncommon to see sub 4% cap rates? The rates I'm seeing make it hard for me to believe that people put so much time and effort into a property to get out 5% (assuming unleveraged).  Maybe they're gambling on appreciation? 

The way I see it, I'm going to continue building liquidity so that when I do see a valley building itself back up, I can get in on a positive cash flow deal, and know that there is a good chance for appreciation, the cherry on top. 

I mean, what justifies 5% returns on unleveraged property with all that work when bonds are producing 3%? I guess leverage is really the name of the game these days, but it just seems like real assets are awfully expensive right now. 

I've seen properties, specifically in the bay area, trying to artificially pump up NOI, with things such as trash valet services. People are paying 30 dollars a month to have someone take their trash out when they live 30 feet from the dumpster! A dollar a foot seems pricey to me! That signals to me that the fundamental value add deals are drying up and investors are trying to squeeze everything they can out of the assets before dumping them and sitting on cash until a correction comes about.

Lastly, I think my view is skewed since I started paying attention to the market during the recession. My "normal" is people losing their shirts on properties and financial products they had no business being in. I keep getting nervous that people are still buying when things seem hot. I always think back to Warren Buffet's fearful/greedy saying. I want to wait until we get to distressed times when people are trying to unload assets at fire sale prices but I go back and forth in my mind as to whether we'll see that in the next five to ten years, or if we will only see pullbacks and small corrections.

Any advice you have on my thoughts would be very helpful, and I appreciate your detailed response, you know your stuff!

Kenneth R. Reimer

@Chris V. there are lots of ideas out there, but that is what makes life fun. Keep on thinking and life will turn out well for you or fun anyways.

Thanks

Originally posted by @Kenneth Reimer :

@Chris V. That was one hell of an answer, wish I could vote for it over and over. Thank you!

Any advice you have on my thoughts would be very helpful, and I appreciate your detailed response, you know your stuff!

Kenneth R. Reimer

 Hi Kenneth - You were asking why people are continuing to buy while they could also put their money in the market? While it would be easy to brush it off by saying people are idiots that are buying into the appreciation hype, there are other more valid reasons too. 

Example 1: A dental surgeon who makes about $400K per year buys a property. I am not a tax professional so I'll oversimplify and probably be wrong on some details:) but you'll get the gist. So I buy a rental property for $400,000. I sink another $100,000 into the property in repairs etc. I (have someone else, not me!) rent the property out for 27 years. I break even every month generate no cash flow at all.  

The fictitous dentist and his fictitious trophy wife and I retire to some tax friendly state or country. Now  they sell it for $500,000. Some might argue that that was a really bad deal right? However the dentist might argue that he was able to take a write off of 1/27.5th of the value of the property per year for every year he owned the property. That is $14,500 that he did not have to pay tax on while he made a boat load of money. On top of that he got to deduct all the repairs (or investments) he made in the property and he got all that back in the sale. That is another $100K that he did not have to pay tax on while he was still working and in a high tax bracket. Now he is retired and his taxes are in a way lower bracket and he slowly liquidates his portfolio. Maybe he even does some owner financing where he will get interest income from the buyer until the note is paid off. And, remember, he did little or NO WORK during all this time. Now you might say that the only bad part of this deal is that he had to spend 27 years looking down other peoples pie holes.:)

Example 2: A very high income earner from the Bay Area, say a lawyer buys rental properties with money that he was not going to spend anyway. He has all the advantages the dentist had. On top of that he is counting on a low but steady appreciation of the property. If you can afford to think in 20 or 30 year terms it is hard to go very wrong with an asset that on average appreciates, and an income stream (rent) that you can compensate for inflation (raise).

Example 3: Joe the Plumber has a low paying job but owns his house outright. He gets a HELOC on his house and buys an investment property using the HELOC as a down payment. This is the leverage angle. Getting $400 per month of cash flow for a for a property you paid $100,000 for sounds like a really bad deal. However if the $100,000 was 75% mortgage and 25% HELOC loand and the debt service is calculated in your cost, along with conservative strong reserves it does not sound so bad anymore right? (I am leaving EXPOSURE out of this in a futile attempt at brevity). But think about it; The Plumber gets the deductions that the dentist got, the equity growth and inflation proofing that the Lawyer got and on top of that he gets some cash flow. More if he does more of the work himself, he is a handy plumber after all... In 30 Years Joe will own the appreciated property free and clear. All that time he will have been able to deduct his mortgage interest and a lot of other expense. Maybe he can even CASH OUT REFI the overvalue from the rental along the way and use it as a down payment for another one... And again and again. He has 30 years time after all... Meanwhile he keeps a modest cash flow going.

Anyway, all these are example of situations where the purchaser to some extent benefits from properties that, from my straight "growth oriented / cash flow angle" are TOTAL SH*T. And this does not even cover the speculative idiots from paragraph 1!:) :)))

@Chris V. Thanks for your detailed assessment of the Stockton market. Great analysis and great sense of humor too! Makes the reading fun. 

What other CA and out-of-state metro areas are you looking at for possible investing and why? What data/info do you look at when considering where to buy real estate? 

I've been compiling data on major metro areas including price-to-rent ratio, job growth and S-T and L-T home value trends. Although I'm not a lawyer or a dentist (love your examples), I am a Bay Area investor (high tech HR guy and dad) looking for good multi-unit cash flow opportunities within a couple hours of the Bay Area. A friend of mine bought a Stockton property about 10 years ago (maybe 12 units?) and he has been smiling ever since. 

Thanks again for sharing your insight.

Thanks for the quality post. Wonderful insights from all.

@Ethan Cooke

Here's what kind of numbers you can expect for the average 2-4 unit multifamily property in San Joaquin County (of which 75% are in Stockton):

List Price: $295k
Cost Per Unit: $114k
25% Down: $74k
Gross Monthly Rents: ~$2,000
Gross Annual Rents: ~$24,00
PITI Mortgage @ 5% Interest: $1,585
GRM: 12.18
1% Test: 0.72%
Gross Annual Yield: 8.65%

If you cherry-pick the 30 best performing properties, the numbers look more like this:

List Price: $261k
Cost Per Unit: $89k
25% Down: $65k
Gross Monthly Rents: ~$2,100
Gross Annual Rents: ~$26,000
PITI Mortgage @ 5% Interest: $1,400
GRM: 10.13
1% Test: 0.84%
Gross Annual Yield: 10.03%

As it currently stands, there are only 3 properties in all of San Joaquin County that surpass the 1% Test, all of which are in Stockton.

If I were you, I would strongly consider Sacramento as a much better alternative to Stockton or the rest of the Central Valley. I've written about the market pretty extensively in the Sacramento Forums, but this post I wrote here pretty much sums it up:

https://www.biggerpockets.com/forums/621/topics/396725-millennial-migration-to-sacramento-2017---here-comes-the-rush

Here's the highlight reel:

I'm currently working with a least a dozen other Bay Area investors with the exact same investing goals, from all the large brand-name tech companies that the area is known for. The Bay Area is too expensive, and Sacramento is a short shot up I-80 and offers properties at half the price. 

Plus when you combine 7.2% appreciation and 18.5% rent growth over the next two years there's probably only a handful of markets in the nation that can compete with that. And why invest several states away when you can get those kind of returns so close to home?

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