The California property Roller Coaster

 The California Real Estate Market is quite the roller coaster.  In the 70's it was flat, in the 80's it spiked, in the 90's it fell, in the earlier half of this decade it shot through the roof, and now it appears flat again.  This up and down performance has many analysts, investors and economists scratching their head, and postulating about what the upcoming year will do for California real estate.  All the advice of which is for not, because no one truly knows.  However California isn't as hard to read as all of that.

First understand the history.

In the 70's real estate was flat because interest rates were extremely high.
In the 80's huge investment in technology and aerospace brought lots of jobs to California
In the 80's the interest rates came way down as well.
In the 90's aerospace jobs and tech jobs hit a wall, and left California
In the late 90's tech investment again surged
In early 2000 the interest rates came further down
In mid 2000 the internet bubble burst, with many people looking for new investments
Property values rose tremendously through this period
Investors started using the 1031 exchange programs to "buy up"
Interest rates continued to decline
Jobs were returning to the state in droves
Interest rates started to creep up
Affordability dissappeared
The average home was over $500,000
"Creative Financing" became popular
Interest only financing & longer term mortgages grew in popularity as well.

Now with that, let's look at the realities of California's market -
The average home is over $500,000.
In most urbanized areas that figure is closer to $800,000.
In order to afford that mortgage, household income needs to be roughly $172k.
The average household income in California is roughly $75k.
With that salary, the average household can afford roughly a $350k home.

In order to command a rent of $2000 (what the average household could afford), an investor would have to put roughly $150,000 down on the average home, and $450,000 on the average home in an urbanized area.

So what has happened?
- With high prices and salaries not keeping pace, there has been a huge slow down in purchasing homes. 
- Investors have moved further and further away from urban areas in order for their deals to pencil out. 
- 1031 exchanges have driven up the prices of everything from homes to office complexes. 
- People are holding off on buying homes. 
- Sellers are either oblivious to the realities of the market, or panicing to get rid of their homes. 
- Builders are half built on many projects that may not get the expected return when plans were submitted. 
- Land values have shot through the roof, making new construction a difficult proposition.

Add all of that to the fact that this is the traditionally slow time of the year for real estate, and there is a lot of speculation that this market is finished, and that investment is not a possibility.  This however couldn't be farther from the truth.  You need to know where to look for investment opportunities.

Flipping
Not a highly likely prospect unless you can get the property well under market & also down encounter tenancy deposit not protected situation.  Depending on the situation of the seller, this may be possible.  Most sellers have a great deal of equity in their properties, but haven't kept them up to date.  They typically don't want to take the time to upgrade the property, and an investor familiar with conducting these projects could make a great deal of profit by constructing the right deal.  One word of caution, in California with average prices being over $500,000, real estate commissions are likely to start at around $25,000, so build that into your budget.

Foreclosures & Pre-Foreclosures
This is a real opportunity for many investors.  Look for the people who over extended themselves through Adjustable Rate Mortgages, 100% + financing, and the like who may have some equity in the property, but are facing a baloon payment.  They will need help, and there is room there to move on the property.

Distressed Properties
This is a real opportunity because now that buyers have the ability to be choosy, properties that have equity but don't have modern amenities can be bought up at a profit for the seller and a bigger profit for the rehabber.

Condo Conversions
Make sure that you have a good attorney to help with this, and make sure you work well with the city on this issue, because plenty of people have screwed these deals up.  However if you can pick up an apartment complex, and carve them into separate ownership units, you can see a property you probably picked up for $150k a unit turn into $250k or more a unit when resold.  Again, get a good attorney on this, and even better contractors.

Short Sales
Bone up on these deals.  This will likely be a good opportunity for investment in California, many foreclosures will be settled before the court date, and working with a bank is a great way to be involved in the process.  There are plenty of formulas and advice out there for how to figure this process out.  Learning this process will help the investor a great deal.

Types of investments are also something to consider.  Here are some thoughts on the types of investments out there, and how to engage them in an investment strategy for California.

Condos
These homes will be great investments for a couple of reasons -
1) They are still relatively affordable, and attainable to the young professionals starting out.
2) These units are still easy to rent as they are similar to apartment complexes, but typically with a little better tenant mix.
3) Just as young professionals are trying to get into the market, baby boomers will likely look to condos as an opportunity to downsize.
Condos can be a good place to find potential growth to rental and property values.  The cautions an investor needs to address in these deals are -
- The Association Fees.  Some are low, some are insane.  Since this is not a tax-deductable expense, don't buy into a property with higher fees.
- The roofs.  Many condos were built in the 80's when shake roofs were still legal.  This is a huge potential expense that owners need to be prepared to incur.
- The area.  Make sure it is close to a city center for the most appeal to renters and buyers.

Single Family Homes (Resale)
Excellent opportunities.  Rents are likely to go up over the next few years due to the high cost of ownership.  Buyers are starting to panic because of their carrying costs, and the appearance of the market.  If you have enough available cash to make these exchanges work out, you will do well in these markets over time.

Single Family Homes (New Build)
The publically traded builders will likely unload properties in the upcoming month.  We've seen it in other markets, builders trying to get product off of their books for reporting, so they offer great discounts, incentives and upgrades.  Currently many are not offering them as they are trying to squeeze out the last few investment dollars possible.  However they will need to start those offers this upcoming month.  Keep an eye open for those opportunities

Smaller Apartment Buildings (Less than 4 units)
This depends on your risk tollerance, and how much you can invest.  Splitting a duplex into 2 for sale units can be very tricky with a lot of legal attention, which will cut into your profits.  So you have to look for holding value and rent potential.

Holding value will be a long term strategy here.  Prices are relatively high compared to the cap rates.  However if you can get the right deal, that is commanding low rents, could be cheaply rehabbed, and is in a good location.  You are looking at a potential gold mine.  Here's an example -

4 unit complex of 3 2x2 units and an owner's 3x2 unit.  Rents on the 2x2's being approximately $1000, and the 3x2 getting $1250.  This would be a little under market in most areas.  If you are in a good area, you could probably get closer to $1250 on the 2x2s and almost $1700 on the 3x2.  Add on to that the estimates that rents will increase between 7 and 10% each year for the next 3 to 5 years, and you could see some real upside on those rents.

Your acquisition cost is probably around $200,000 a unit.  So your 4 plex is going to run around $800,000 under these conditions.  With rent coming in at $4250, you are looking at a per month loss of $750 - $1000.  Once you raise the rents to market rates, you are looking at a $1200 a month positive cash flow.  A conservative estimate would put your rental income in 5 years at roughly double the current rates.  Cash flowing more than $3,000 a month positive cash flow.  And this is assuming conventional financing, and conservative rent growths of only 5%.

Medium Sized Apartment Buildings (5 to 15 units)
Make sure you have a good property management company.  However buildings of these sizes have fewer vacancy rates to contend with, and as such may be a more suitable investment.  Rents tend to be closer to market on these properties, so the upside potential isn't as great.  Still the estimated rent growth over the next few years makes these properties an attractive investment.

These property estimates show what the smaller investor should be looking at as potentials in California.  Even though our rollercoaster appears to be cresting, that crest is only in property values, not potential rents, or rehab possibilities.  The California investor needs to shift from a focus on the growth of the properties to a focus on the growth of the property's cash flow.  And that is where the opportunity is in California.