Today we field a great question from one of our RentPosters in California. It’s a great opportunity to discuss the ins and outs of condo investments, the current real estate market, and the future of the U.S. economy. Read closely, you will not want to miss this one, as we review the economic forecast for the coming decade.
“J” from California writes:
Tony, I am a very conservative investor, but elected to retire early at 48, about 3 years ago, and put a majority of my portfolio into real estate rentals. I own 4 homes in Ohio and 1 (and a quarter) in California. With the down market, they are likely worth about 1.1 or 1.2 million right now. I also have about 300k in mutual funds and 50k or so of cash. I own all of them out right…
My dilemma is that there are some very good deals right now in CA for rental properties, specifically a condo that was once valued at over $300k is now bank owned and offered at 196k. If I could purchase this for 175k, would it be a good move, given the opportunity cost of not having that money in my mutual funds? The gross return and net return after renting it out would be about 11% and 8%, respectively.
I would appreciate your thoughts!
Answer, Tony Salloum: Hey, J. Thanks for the question.
I don’t like condos as revenue generating investments; your situation is no exception. Here is why:
- Poor Return – after it’s all said and done, the HOA fees chew too far into your pre-tax return. Just guessing here, but I expect the monthly HOAs to be around $250. Additionally, I’ll assume the property tax rate is around 1.25% of appraised value. In this case, your property taxes amount to $184/mo. Tack on another $30 for property insurance, and you are left with $1147 in monthly pre-income tax revenue. I’ll try to help the numbers out a little bit and assume you are in a 20% tax bracket, so after some math, you are left with about $11,000/year money in your pocket, nearly a 6.3% annual return. Keep in mind, I only gave you some favorable assumptions, so this number could be lower.
- Risky – 6.3% doesn’t seem so bad, but you must also deal with the headache of keeping the condo rented, handling any maintenance requests along the way. Hiring a property manager could cost you close to another $1,900 per year, so your bottom line might take too great of a hit by doing anything other than managing the property yourself. The reason condo’s are risky is because one year of vacancy could cripple your return, as HOA fees exaggerate the loss. Larger dwellings, like houses, are more readily divided up into rent per bedroom, so you may be able to fill the house partially, lessening the risk of loss. Condos are usually all or none, so you could be on the hook for $500+ per month, without any revenue to counteract your expenses. Also, I’m assuming that you intend to pay with cash, and you never like to see all cash investments bear such a negative cash flow potential. There is a second reason all-cash condo purchases should typically be avoided….
- Poor Liquidity – it’s never easy to secure a condo buyer, as investors are typically required to place a minimum 20% down payment on condos, and with HOA fees tearing into the return, the only potential buyers are residential purchasers, who also typically face stricter financing requirements. At the end of the day, it’s just not easy to buy a condo, meaning it will not be very easy to sell.
- Liability – finally, and this may not apply to your state, but condo associations can be jointly and severally liable for the financial defaults of its members. This means when Jim in condo #109, down the hall from your investment property, can’t make mortgage, the bank might turn to the association to collect those payments. That means you and all the other condo owners in the Home Owners Association could be on the hook for old Jimbo’s follies.
As you can probably tell, I’m against the condo. The in-pocket return is not great, and condos can be a terribly illiquid investment vehicles. Let’s talk about why liquidity matters today…
Consider the U.S.’s recessed economy, and note that U.S. dependence on foreign imports is weakening the dollar, despite the free fall of domestic prices. You may wonder how the dollar could be weakening when investment products are significantly less expensive than before??!!?? The fact that the dollar has resisted deflation, despite decreased consumption, investment, and prices should alert you that the Federal Reserve has lost control of liquidity in this country, as there are nearly no more federal funds left to buy. This means the Fed has pumped money out to its limit, leaving itself little room to gauge the resurgence of the federal funds rate. Think of the Federal Reserves Open Market Committee as a child who has pulled back so far on a sling shot that it lost strength in its hand, unable to hold back the rubber band any longer. As the Reserve’s hand finally gives out, the interest rate projectile shoots off, with mother nature as its only obstacle. The market place is now free to trade up the cost of borrowed funds, without any Reserve Board Referees keeping borrowers and lenders in check.
Think of it simply: people have less money now, and the money still hanging around has lost value. Alas, Americans need even more money than before to re-establish their pre-recession lifestyles. SO, there is a looming, massive demand for borrowed money. If you ain’t got it and you need it; borrow it! It’s the American way. Unfortunately, nobody can stop what’s coming next. As soon as the secondary market for debt securities shows some new life, America will see a borrowing frenzy, sling-shotting the interest rate upwards, while American’s scramble for financial re-establishment in the wake of depressionary-inflation (and I made up a word, but still pulled off an oxymoron).
So what can we take away from this?
Expect interest rates to climb dramatically in the coming few years, and don’t forget about your old friend George Washington, whose greenback image, once ebullient, draws ever closer to a fateful grimace. Inflation and high interest rates are next on our economic menu. You are a young retiree, so your money needs to last. Knowing this, I cannot advise you to buy the California Condo, as it locks you in to a low-yield, illiquid investment vehicle, and you will be kicking yourself in 4 years when you could be earning 12-15% on your money, stuck with an illiquid hunk of condo that on it’s best day can’t bring you more than 7%. If you think you will make up the difference in the enhanced value of the condo, think again. Investors wont consider buying condos, with many other, higher-yield investments available, and personal homebuyers can’t afford to buy condos (can’t get the financing to work out). There is a dwindling market of condo buyers, and you will be hard-pressed to muster up any capital gains with so few interested and capable buyers out there.
J, if I were you, I would keep the homes you have now, keep the $50,000 in cash (or money market), but I would take $100,000 out of the mutual funds, and invest in an array of long term commodities. This way, you will have monthly income from the homes, secured in a growing renters market (fewer vacancy fears); you will also take advantage of the upcoming surge in money circulation by keeping some money in mutual funds (I’m assuming they are all well diversified funds, and still have some equity securities mixed in), and you will protect yourself against what should prove to be a very peculiar, but powerful form of inflation. I say peculiar because money circulation will be driven away from the real estate market, and into small business, so don’t expect a restoration of home values to accompany the inflationary storm. There will no longer be a consumer emphasis driving real estate circulation; many real assets will fall into long-term investment portfolios.
After 3-4 years, you should reassess your portfolio, and I expect a wise move in these future years will be to shift your cash out of mutual funds (assuming an auspicious tax season), and into long-term fixed income securities, such as preferred securities with favorable tax treatment, municipal bonds, and high-grade corporate bonds (NOT bonds coming from the financial market). Stay away from financials all together over the next decade. And 10 years from today, get that money out of commodities, and grab more quality, conservative, fixed income securities. I’m always a sucker for muni-bonds.
Your income-property revenue, along with your clean-money interest collections should carry you through your golden years, allowing you to enjoy your retirement. And remember, DON’T BUY THAT CONDO!!!!!!!
About the Author
Tony Salloum is the Chief Financial Officer for RentPost. The company provides software and consulting services for property managers, property investors and owners, and even tenants. Tony also frequents the RentPost blog with Real Estate advice, and he welcomes you to visit RentPost to explore how one company has used online software and customer relations to maximize profit for property managers and investors, automating business activities for property managers, and providing the internet savvy renting generation with the online tools to handle rent without the fuss. Also, check out the RentPost Blog for more advice articles and RentPost updates. Take the RentPost Tour.