Big things are happening right now. If you haven’t read any of my background yet, I’ll give you the quick run-down: my family and I bought a 22-unit apartment building in Orange County, California in 2003. We managed the building ourselves from 2003 to 2010, which taught me a lot about how to handle tenant disputes, how to know when a tenant’s gone bad, and how to know if it’s time to fire the manager. The markets have done some crazy things since we bought in 2003, but lately, rents have been shooting upward, which has sent rental property values skyrocketing as well. Some of my family members think this is a good time to get out of the game, so we’re selling our apartment building. Eep!
Let me clarify something quickly: I don’t want to get out of the rental property game. It’s been a core part of my family’s strategy to increase our wealth and to pass it along to subsequent generations. In addition, it’s been a great learning tool for each generation to teach the next about how to manage property, and to instill the motivation to manage it and keep it growing. But for my mom and stepdad, who are pretty close to retirement age themselves, it didn’t make as much sense to stick with it.
History of Our Apartment Building: the Roller-Coaster Economy
When we bought in 2003, we paid virtually no money down to get the building. This was a mistake, in my opinion. If it weren’t for our unique situation, we wouldn’t have survived the first decade. Fortunately, my mom is very financially secure, and she was able to cover the cash flow shortfall.
From about 2005 to 2007, in the run-up to the housing crisis, more and more people became homeowners, and more apartments started going vacant. Then the foreclosures started in about 2007. You would think that the housing foreclosures would have caused apartments to fill up again, but a huge number of those folks didn’t go back to renting, they ended up moving in with relatives instead. Then the stock market and the economy in general crashed in 2007–08, and massive numbers of people became unemployed or underemployed. Our rents didn’t increase at all for years, and it became very difficult to keep the apartments full at the existing rental rates.
The one good thing that came out of the recession was that the interest rates fell. A lot. We refinanced in 2011, and got an even lower rate with a loan modification in early 2015. As the economy started to recover, rents recovered dramatically, and we finally had some positive cash flow after paying our newly-reduced mortgage payments.
The Current State of Affairs: This Building is a Gold Mine!
When the rents increased, the value of the building also increased substantially, because the value of the building is largely based on net operating income. The market price of the building has been further boosted by the influx of foreign investment money into Southern California real estate, and also by the very low interest rates, which have helped put massive mortgage loans within reach of more buyers. This is all good news for us.
In fact, if you look at what 20-50 unit apartment buildings in Southern California have been selling for in the past few months, your jaw might drop. I’m surprised that so many buyers are looking for apartment buildings in this market at these crazy prices. And not enough owners are selling, which is driving the market into a frenzy I’ve never seen before.
Why We’re Selling the Apartment Building
Property values are at record highs right now. They may continue at these levels, or they may drop back to more “normal” numbers and take a while to climb back up again. My mom and stepdad are in their 60s. If they decide to hang on to the building for now, they may not get another good crack at selling it for another 10 or 20 years.
The mortgage on the building won’t be paid off until 2041. That’s 26 years away. For us spring chickens (not really—I’m 36), waiting 26 years is not such a big deal. The mortgage will be paid off, and then the building will be producing some major cash flow. But for my mom and stepdad, the idea of owning a building and chipping away slowly at the mortgage for the next 26 years is not all that appealing. They might be dead before they get the big payoff. My mom would rather cash out now at these high prices and use the money to help her grandkids go to college. My stepdad would rather cash out now and downsize to a couple of single family homes nearby, with little to no mortgage so he can start enjoying more of the cash flow now.
My Plan for the Future
Now it looks like I’m going to take my share of the proceeds and strike out on my own. Unfortunately, we didn’t plan far enough ahead for me to do a 1031 exchange, so I will get hammered with a pretty big tax bill before I move on. On the plus side, I will be starting over with a new tax basis, so I will have more to depreciate in the coming years.
I’ve been looking at triplexes and fourplexes in the Orange County area. Those prices have gone up, too, but not quite as much as the larger buildings have. I’m weighing some options, and soon I will have to make some tough choices between getting a better deal on a building in a slightly less desirable area, or paying a little more to get a building in a slightly better area. On its face, it looks like it’s all about money, and so I should shoot for the better deal in the slightly less desirable area. But the buildings in better areas have virtually zero vacancies, which brings the numbers closer than they initially appear. The other important point is that better areas mean better tenants, which usually means more consistent rent payments and less drama (so long as you screen your tenants properly).
What would you do if you were in my shoes? Assume you were getting a good chunk of money, enough to have a sizeable down payment on a triplex or fourplex in your area. Would you invest now? Or wait for property values to drop and invest in something else in the meantime?