Stockton CA Multi-Family Bids Adieu to 1% Rule Properties

[Chris V.]

For the last few years Stockton CA buy-and-hold rental property used to be a virtual no-brainer. Now the market for conforming multi-family property is at a turning point, breaking through the floor dictated by the 1% rule. And that is very bad news for new investors looking for multi-family property. Here is why:

The Stockton cash-flow rental market has been my primary (even sole) focus for over three years now. This means I have been keeping a very close eye on, what I call, "conforming" multi-family rental pricing. By this I mean standard duplexes and triplexes build in the last two or three decades of the 21st century. Throw a dart at a map anywhere north of Hammer Lane and you are bound to hit one of these properties.

Having seen owned and rehabbed a good number of triplexes and duplexes that fall into this category I have really come to love this property "class". Why? Because I am lazy and unimaginative. And I know it:). Let me explain. These conforming multi-family properties are extremely predictable; everything is very "cookie cutter". If you've seen one, you've seen them all. Their homogeneous nature makes everything from estimating repair costs, guesstimating rents and even finding tenants, a lot easier. No need to reinvent the wheel.

Figure 1: North Stockton is Cookie Cutter Central:).

Also, being "newer" all building techniques used in their construction are standard and pretty "modern". This makes it straight forward to work, or have work done on these properties, even by less than expert craftsmen... Finally because these properties have always been rental properties. This means that while they are often badly maintained, at least they typically don't contain weird DIY modifications. What you actually mostly see is no upgrades at all:).

Combine the above with some basic, common sense knowledge about the different neighborhoods, or should I say blocks, this is Schizophrenic Stockton after all, estimating what you will be able to get in rent for these properties is also fairly predictable.

For all the above reasons these types of properties are definitely what I would recommend to new out-of-town investors looking to get their feet wet.

And that brings me to the bad news: The price point of this type of property is structurally starting to breach the 1% rule. Duplexes that will rent for around $900*2 ($1800) are being sold for over $200K. Triplexes that reasonably will not get more than $800*3 ($2400) are being offered for close to $300K.

Why is this such bad news? Owning a good number of these types of units I have discovered that because all properties are so similar, the 1% rule is dead on for this property type. Unless the building is inparticularly bad shape, needing immediate rehab; in a really bad location, or has rents that are even close to market, 1% of purchase price is about the minimum you need to gross to make the property a reasonable cash-flow investment at the current interest rates.

Without expounding too much on my (pretty standard) calculations, I want to point out that when calculating the profitability of a property I assume 100% financing at current rates. Now of course, the beginning investor will probably put 25% down. However, even if you do pay down (and I do recommend doing that), I feel your calculation should account for the opportunity cost that you incur by locking up those funds. Just think of it this way: you could have been doing something else with that cash. For example you could have paid down your mortgage or put the money in a Dow Jones Index fund etc. No money is every free.

What does this mean for the Stockton rental market? I think the days of abundant, no-brainer cash flow deals on the MLS have come to an end. Investors looking for cash flow will be tempted to look at old, non-conforming, functionally obsolete C and D class properties. However based on the low predictability and possible complications that these properties offer few would consider these good "starter" investments.

What I think we will also see more and more is money flowing into the market from Bay Area professionals with high paying jobs. I like to call these "dentist-investors":). This type of investor is looking mainly for tax deductions as opposed to short term cash flow. of which after all,they already have plenty:). Their hope is to have some paid-off properties by the time they retire. This allows them to slowly liquidate their portfolio or continue to collectrent without paying interest, when they are in a lower tax bracket.

Exactly because they are not looking for immediate cash flow. These investors are very hard to compete with on the open market. After all, if you need to cash-flow to sustain and grow your portfolio you don't have the luxury to wait 30 years until your mortgage is paid off...

Sowhat is my advice for new investors that are just now thinking of entering the Stockton market? Frankly, I don’t think there is any simple straightforward solution. If you know one, let me know too!:) So since I can’t tell you what to do I thought maybe I should close by telling you what *not* to do.

First of all, don’t pay a price because everyone else pays it. Analyze your deals very carefully from a cash flow perspective. If other conforming duplexes are selling for $230K this does not make a $210K duplex a great deal from a cash flow perspective!

Unless you want to speculate on equity growth, or you are one of the before mentioned extra-long-term-dentist-investors, I would not recommend breaking the 1% rule on conforming multi-family unless you have a very clear idea of how you will add value to the property to make it meet the 1%. Don’t give in to wishful thinking (“I’ll rehab real nice and raise the rent to $1,200 per side…”).

If you are thinking of adding value by rehabbing property, please realize that Stockton is a market with a very high price-elasticity. Unfortunately rent price seems to be way more important than quality for most tenants. Also consider that if you invest $10K and raise the rent by $100 you have not improved your gross rent multiplier at all. You just managed to increase your exposure with $10K while preventing yourself from putting that cash to use elsewhere.

Whatever you do, remember that in a tougher market you make or break your investment when you buy it…

Anyway; those were some of my thoughts musings and opinions on Stockton investing. Let me know yours! Also if you have any questions regarding Stockton multi-family feel free to ask, I’d be happy to help!

[Chris V.]

Originally posted by @Kenneth Reimer:

@Chris V. Great post Chris, very insightful. It seems like you really know your target market, very impressive. Seeing as you think the "no-brainer cash flow deals" are done for, where do you think the Stockton market, as well as the greater Northern California market is headed?

Do you think we will see a decompression of cap rates?

Kenneth R. Reimer

 Hi Kenneth - I think eventually we will see a correction, but when in the big question. Macro economics are very hard to predict, anyone that can do that with any accuracy would probably have more profitable things to do with their time than to mess around with Stockton CA small multi-family property like I am:).

That being said, I can speculate a bit. I'll use the 18 year cycle theory.

The theory is that the real estate market goes through phases. Phases I - IV start after a property market recession like we had in 2006.

Phase I Recovery - Vacancies are slowly starting to go down, not much new construction going on. Everyone is really carefull.

Phase II Expansion - Vacancies are really starting to get filled, new construction is starting to ramp up. Money becomes more available and is being poured back into the market. People are starting to get optimistic and go on bigger pockets to get in on the action. Because it's the thing to do. *IMO this is where we are right now*

Phase III Hyper Supply - Everyone gets in on the deal.  Real estate investing is awesome! Grandma cashes out her retirement savings to get in on the action. Build it and they will come! We are all going to be rich, Yippee!! Vacancy is quietly on the rise but no one is paying attention ! There is still demand, but this demand it driven by speculation, not by fundamentals. This is where the real trouble starts, inventory is starting to build up. Most builders and developers are aware what is going on but who wants to leave the party early? After all, if you would cash out now your friends and investors might think you are a total p*ssy! Meow.

Phase IV Recession - The emperor turns out not to wear any clothes. There is no real denying anymore that all these new units being added to the market have little or no real demand. The Fed raises the interest rates in an attempt to hit the breaks. At these new "crazy" rates planned new developments no longer make sense because their caps would be too low. So no new projects. Projects that were already underway make the problem worse, but the units are never filled. The market is over-saturated and even by now even grandma knows to pull what is left of her savings out and to stick it in some bonds or something. Construction is one of the BIG engines of the economy and with that grinding to a halt other related sectors are affected. Fear does its job and people stick their checkbook deeper into their pockets and start recycling their cans. Sears threatens to go out of business. This is the recession phase. 

This pattern has been going on since John D. Rockefeller roamed the earth. Only difference being that back then Sears used to be called Roebuck. Or whatever; what do I know, I am not an archaeologist. 

Lets cut back to the cycle. Supposedly this real estate boom-bust cycle has on average peaked every 18 or 19 years or so. *On Average*. Those two words right there are the problem to answering your question. It reminds me of that joke of the statistician who drowned in a river that was on average 3 feet deep. Not very funny, but you get the picture.

Back to the 1800's these where the internals between the peaks of the construction cycle:

20

15

21

17

16

47

6

8

20    -This was the peak of 2006 which 

So to speculate on your question. We are 10 years into the cycle now. I think we are towards the end of phase II. The fist sign of trouble will be when you'll see Grandma and Joe the Plumber are investing in REIT's. And people buying Stockton property for twice the 1% rule value because everyone else is doing it. Then when you see the interest rates being jerked up it will be too late to make a graceful exit.

So the problem is that there is a lot of money that can be made in phase III. Lets say that phase lasts 3 years. Who wants to wait out that dance and sit on their cash waiting for the other shoe to drop while there is so much money to be made speculating on equity. However what are we going to do after cashing in $$$$$ in equity? That is right, reinvest it to try and do it again!  Always hoping that when the music stops we will have a chair. And we are sure we will, because we are smarter than everyone else. Right?:)

Personally I have the feeling that by the end of 2016 we will be firmly in phase III. I can't see how that phase could possibly last longer than a year or 2 to 3. But then again, I have been wrong before. In fact, I suck at predicting stuff. I miss-predicted, the internet, Obama, Smart Phones, Trump and the mega millions numbers. The internet if full with people that are more convinced fo their predictive abilities, but they seem to never agree. Which makes their analyses as worthless as mine.

Therefore the only thing I can recommend is to try and invest based on cash flow. Play it save and do not buy property that does not cash flow or that is financed in a vulnerable way like adjustable rate mortgages etc. If the S. hits the F. rents might go down a bit because competitors buy properties at a way better cap rate and can afford to rent them out for less, but I would not predict rent to drop extreme. Build in some safety and padding in your numbers and you should be alright. If it is not a deal, don't buy it. If you have to sock up your money until after the next collapse. Just realize that it will be hard to get a loan during that period. Think strategic and don't allow all the "success stories" to distract you from the fundamentals.  After all, they don't call real estate a "giant get-rich-slow-scheme" for nothing:)

Figure: Behold the cliff. Too bad zillow does not have 100 years worth of data or else you would see quite the mountain landscape.