The South Bay real estate market in February cooled as sales volume of all residential real estate in the South Bay decreased almost 20% on a month-over-month basis, and slightly decreased 1% on a year-over-year basis. The February inventory level increased to 1.9 months, up from 1.7 in January.
According to the Zillow Home Value Index, home values in Los Angeles County increased 8.4% over the last year, marking a straight fifth year of rising prices.
Evaluating Real Estate Investment
When considering purchasing an investment, the first thing people think of is cash flow. However, this is not the only way to consider real estate investments. After all, if you pay for a property completely upfront with 100% cash, then almost any rental property will generate positive cash flow, since it’s mainly a matter of paying for property taxes, insurance and some maintenance costs. But that doesn’t necessarily mean it’s a good investment.
One way to evaluate an investment property is to use the Capitalization Rate. The Cap Rate is the rate of return on a real estate investment property based on the income that the property is expected to generate. Here’s a simple way to calculate the Cap Rate:
- Calculate the yearly gross income of the investment property.
- Subtract the operating expenses associated with the property from the gross income; such as taxes, homeowner insurance, property management, HOA fees (if any), estimated utilities, etc.
- Divide the net income by the property’s purchase price.
One can use the cap rate to compare different investment properties and the calculation applies regardless of whether you decide to pay all cash or use a loan. The average cap rate in an area can also be useful in determining the market value of a particular property.
According to a recent HomeUnion study appearing in commercial real estate news source, GlobeSt, the highest cap rates tend to be located in the middle of the country. Memphis, Tennessee tops the list with an average cap rate of 7.3%. The lowest cap rates are along the west coast (plus New York City), with average cap rates of:
- 3.6% in Sacramento
- 3.6% in San Diego
- 3.2% in Los Angeles
- 3.0% in Orange County
- 2.7% in San Jose
- 2.7% in San Francisco
In California, single family residence (SFR) investors are wrestling with the lowest capitalization rates in the nation; however, it is important also to evaluate the total return on investment (ROI), which includes other considerations in purchasing an investment property, such as appreciation and any tax savings. For example, home prices in Hawthorne, CA increased by almost 57% over the past 5 years. When combined with the cash flow and potential tax savings over that same period, the total ROI of an investment property in Hawthorne could be much higher than a property in another city even though the cap rate is not as high.
Things to Know About Being a Landlord
Once you’ve found the right investment property, the other thing to consider is whether or not you are ready to be a landlord. Here’s a breakdown of the main aspects of being a landlord:
- Setting the rental price and marketing the property – this can be done by comparing rentals in the area on sites such as Zillow or craigslist, and also posting on such sites.
- Vetting prospective tenants – this is probably the most important aspect of being a landlord, as it will determine whether tenants have enough resources and reserves to pay the rent, as well as how your interactions will be in the future.
- Move in and move out checklist – in order to be clear on the condition of the property when the tenant moves in so you can minimize disputes when they move out.
- Periodic inspections – landlords are allowed to check the property as long as they give 24 hour advance notice, and this is something that one should definitely consider doing in order to keep the property well maintained and to avoid surprises at the end of a lease.
- Maintenance & Repairs – a landlord should have a clear maintenance policy and also a good network of licensed, bonded and fully insured contractors for any necessary repairs. It might make sense to purchase a home warranty on your investment properties as well.
- Issues with late rents and evictions – landlords should have a clear policy in place and be aware of local regulations and requirements in this regard.
For all of the above duties, it might be worth considering hiring a property manager to help you find tenants and maintain your property. This will typically cost anywhere from 5-10% of the monthly rent (and around 50% of the first month’s rent for finding a tenant), but this cost may be well worth it for the sake of peace of mind, especially if issues arise.
Being a landlord is not for everyone, and like every investment, there are associated risks and rewards. Still, if you have the resources to do so, it’s definitely something you may want to consider adding to your financial portfolio. Whether you’re considering purchasing, selling, or exchanging your investment property, or if you’re just at the starting process and thinking about buying your first home, I’d be happy to help you with your real estate goals.