How do people make the numbers work in Southern CA?

[Michelle Mapp]

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.  :)  

[Allan Glass]

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!