how to make sense out of buying a rental property in California

[Sara Mofrad]

hello. how are you ? my name is sara and I live in California. I am new to BP community. I am very interested on starting to but rental properties but my issue is that in any way that I see it seems that I am going to lose money if I but  property in CA(mainly looked in san diego and orange county).

for example a 2 bed room house is around 400K and above. even the foreclosures are around 370K and above. with the down payment the mortgage only by itself is going to be around 2100. without the HOA fees and other fees . the house can be rented out around 2400. and based on the 50% rule i am going to be way behind and going to loose money. no matter how I see it , it seems losing money .

can any one please give me ideas how to make sense out of buying a rental in California please ?

thank you very much 

[Dan H.]

first I am not a big fan of any of the rules (2%, 1%, 50%, etc).  Typically properties that do the best job of meeting these rules are in the worst neighborhoods and will not produce the profits they project.  

Next coastal So Cal does not produce the cash flow of many other locales however it is still possible to obtain positive cash flow properties (I have been presented 3 in the last month).  

So if it does not cash flow as well as other locales why would anyone purchase in So Cal?   How long have you lived in San Diego?   What has the price of real estate done in San Diego?   San Diego has a track record of long term appreciation going back more than 50 years (comprised of various short term cycles that have included some depreciation).  There is a correlation between property appreciation and rent appreciation.  What have you seen the rents do in the time you have lived in San Diego?  So the barely cash flow purchase today historically has a great chance of being a very good cash producer in a short period of time.  Add in prop 13 protection.

So assume you purchase that $400k unit non-owner occupied placing 20% down and that it is cash neutral at purchase.  You are $80k plus closing into the property but the lowest appreciation year in the last 5 years has been 8%.  Using that lowest appreciation number you property will have appreciated $32k after the first year (not bad on an $80k investment) but rents have also gone up so the cash neutral property is after 1 year cash positive.  Second year compounds on the first so if the property appreciates another 8% it will go up more that 32k.  The highest San Diego appreciation year in the last 5 years was over 20%.  At 20% appreciation that $400k property has appreciated $80k (same as your initial equity). 

I realize that past performance is not necessarily an indicator of future performance and I do not believe in trying to time the market.  I therefore do not claim to know where the market will be in 1 year or 5 years (so you must have the assets to weather a short-term depreciation cycle) but I am very confident 15 years from now that the San Diego RE market will have appreciated more than inflation and more than most other locals.  Why do I have this confidence?  Because San Diego has a over 50 year track record of doing so. This appreciation track record is factored into the cost of San Diego RE (as is the cost of land, cost of building, etc.). 

I believe appreciation has been shown to provide better ROI than cash flow but I believe you can be successful in either type of market. However I believe regardless of if the market is a cash flow market or appreciation market, your best (the beginning RE investor) opportunity for success is to invest local where you have some expertise and do not have to rely on other people as much. This also will allow you to learn about RE buy n hold.

When you are no longer a RE novice you will be better prepared to branch outside you local.  Better prepared equates to more likely to succeed.  

By the way I recommend any new RE investor at least look into a house hack using a small multiplex (duplex to quad). It would provide the best loan (owner occupied) with less down payment (especially if VA or FHA are options). It provides a good opportunity to learn a lot.

Good luck whatever you decide.