How LA Rent Control Affects Appreciation?

Question

Hi everyone. Hope You're all enjoying your weekend.

I've recently been looking at some Fourplexes here in the San Fernando valley and most of the cap rates are looking pretty low. I've seen 1 or 2 properties that even come close to the 50% and 2% rule and that's assuming all the expenses are actual (probably not).

It seems like the prices are inflated because of anticipated future appreciation? I'm not sure.

My question is, If rental property market values are calculated on the income they generate, and there is rent control, wouldn't that prevent the property from appreciating. What's with the low cap rates then?

Is there a variable I am missing? Please bear with me as I am just learning  :D  Thanks in advance!

Bryan Hancock · Answer

Rent control is anti capitalist and I hope we get some rulings one day that it is unconstitutional.  I would NEVER invest somewhere with rent control even if the property was well below market.  Others are fine with the government running their business and that is okay.

Bryan Hancock · Answer

Yeah...I guess I'm not smart (or lucky?) enough to know when something will appreciate.  One can make very educated bets, but this is still speculating.  Speculating in areas with rent control is all the more risky so the discount better be pretty steep!

I never have understood how people think that rent control is going to solve any problems.  We have Section 8 programs for the truly needy that don't attempt to defy the laws of economics.

I wouldn't invest anywhere with rent control.  It certainly will influence the appreciation potential.  Even worse...it is hard to know how much it will influence it because you never know how nutty the legislators will get about extorting more money from PRIVATE property owners.

Loc R. · Answer

My 2 cents.

My older sister got me into real estate investing.  Her first property was a triplex in Van Nuys.  She bought it near the bottom of the market in 1997.  3 units for $139,000.

To this day it is her biggest real estate investing mistake, in that the laws that LA has in place are SO tenant-friendly that even though it has been profitable for her, she could have done so much better by buying something in say, Pasadena (where there is no rent control, and where I bought my first multi-family dwelling).

On paper, I'm sure that her 1997 purchase looked so much better than my 2003 purchase.  But as time as goes on, I have been able to steadily increase my rents to keep up with the actual market.  My sister, OTOH, has been limited to 3% or whatever the CPI says inflation is.

Bryan Hancock · Answer

Jeff's post is correct from a financing standpoint.  I disagree that *value* should be based on comparables though.  Value should be based on an IRR calculation and the project should compete with other projects for the investment dollars giving your cash constraints.

Value and how the property is valued by lenders are two different things.  Capitalization rates apply equally to SFRs.  The trouble is that most SFRs rely on a huge reversion cash flow for the bulk of their return and are, by definition, largely speculative plays.  This is due to competing with owner-occupants for the bid prices as Jeff described.

Rent control is an effort by local folks to defy the economic laws.  Having the gov-mint monkey in my business is not my idea of a good investment.

Jeff S. · Answer

Your question has a false assumption in it, Mehran.  Not all rental property is valued on income.  If youâ€™re looking at 4-plexes, youâ€™re looking at residential, not commercial property.   This is applies nationwide, not just in LA.  In spite of your desire to use a cap rate, residential property is valued on comps not cash flow.   Since homeowners donâ€™t buy property for cash flow, but as a place to live, residential property is typically valued higher on a per unit basis than commercial even though you can only live in one of the four units at a time.

Iâ€™m not suggesting you donâ€™t consider cash flow when you invest -- on the contrary.  Just donâ€™t be surprised when you see the huge difference between residential and commercial properties per unit (i.e.  try calculating the cap rate for an SFR) . The cutoff by the way, is four units.  Five or more is commercial and you can often buy more commercial units for the same money as you would pay for a 4-plex.

Some people like to buy 4-plexes only since they are small, easy to maintain, and (in normal times) easily financed with residential loans.  Commercial on the other hand requires, well, commercial loans, which are primarily based on the propertyâ€™s income and not the surrounding comps, thus the source of your confusion.

I know many investors who buy older rent controlled property in LA.  Their tenant turnover is frequent enough to enable them to bring the majority of rents to market levels, enabling them to make money and keep their property value high.  Barring extremely unusual circumstances, no one who will give cash for keys since rent controlled tenants are a savvy lot and will ask for many thousands of dollars to move.  If you have enough units, the strategy is to wait them out.  Given a choice, owning a rent controlled building is not a strategy Iâ€™d use, but there are many apartment owners in the Los Angeles area and enough demand for the buildings to keep prices high.

Joseph M. · Answer

Yeah exactly, investors should look at cash flow first and appreciation second.

But, my point was it could make sense to purchase something that doesn't cash flow when the market is hot and you have the opportunity to actually sell it for more just based on appreciation.

But I don't see the point in buying something now that the market is declining or still.

While neither of these is a smart move, buying a property that doesn't cash flow and isn't appreciating (most likely for years to come) is a dumber move.

J Scott · Answer

Just to add to this...

The other major reason that parts of California see such high real estate prices is that certain markets are very constrained physically.  For example, Silicon Valley (northern California) is bordered by water and mountains on all sides -- without completely redo'ing the highway infrastructure to accommodate long-distance commuting, there is just no room for market expansion.

This means that the limited number of properties (supply) is pretty much fixed and as demand increases (there is still a lot of economic expansion in the area), the market values will increase.  Unless/until demand decreases -- as it has on a few occasions during economic downturns -- the property values are likely to stay very high.

But, based on the limited supply and increasing demand, I think it would be incorrect to say the values are artificially high; I believe they can remain that high long-term based on the supply conditions.

Account Closed · Answer

Hey Mehran,

I disagree with a few of the comments here, and I'm going to tell you my opinion about investing here in Los Angeles.

First of all if you plan to buy a small income property (like a fourplex) it would only make sense to buy something in an area close to you and that you're familiar with. Outsourcing management for such a property isn't cost effective and buying one in area you're not familiar with is risky.

The Valley is a great place to buy now. together with Long Beach it's the only place you can still find good deals in Los Angeles. Remember that California and Los Angeles are one of the fastest growing (population) areas in the country. For rentals this is one of the major facts you have to look at. When values are going to go up again your property is going to be worth a lot more and since people are going to have a harder time finding a place to live they're going to have to pay a lot more rent.

Regarding rent control. This is not always a bad thing. Might even be a great opportunity since the current value is under-market. I know many investors who took this opportunity and payed tenants to move out. They made a whole lot selling the property later when the income was at market value.

If you can't find a good deal on an income property you can also look at condos in the Vally - you can easily get a 9% return on condos. And when the market will go up the same will apply to those condos.

Good Luck!

Bryan Hancock · Answer

Perhaps...that can all change with the stroke of a pen though.  I would park your money elsewhere.  There are some locales that don't think of property owners as evil, money-hungry tyrants.

Account Closed · Answer

Yes Mehran, anything built after 78 isn't subject to rent control. Regardless, I would recommend investing in newer dwellings.

How LA Rent Control Affects Appreciation?

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