SF Apartment : September 2017

MIGHTY SMALL

Old House, New Tricks

by Kilby Stenkamp

With few exceptions, residential property constructed before 1979 is subject to rent control in San Francisco—unless of course the property has been condo converted. For 2-4-unit properties, rent control can be a real challenge as rent increases and tenant evictions are regulated. Smaller properties have less turnover, and per-door costs are often the same or more to operate than larger properties. It’s a tough balance to maintain a 2-4-unit building, considering cash flow. New technology, from smart meters to internet-based products, have the potential to dramatically change the way we live, but do these upgrades make sense in 2-4-unit properties?

Buildings with 2-4 units comprise a significant part of our housing stock and are dominated by Victorians and Edwardians. Building owners of 2-4-unit properties understand the economics of them. For example, the roof on a 4-unit building could cost the same as a roof on a 15-unit building. Recently, I visited a 4-unit property on the south side of town. It was built just before 1979, had great bones, parking, views, and decks. All the boxes were checked. There was only one problem: four long-term tenants, mostly in their 60s, and so will probably remain in the property for at least another 20 years. Because of the low income, and recent maintenance expenses, the owner is coming out-of-pocket to operate the property. Even with annual increases, the low rents do not cover taxes, insurance, and maintenance on the building. He wants to sell the property as is, but he will take a significant hit in potential value. There is no immediate upside potential for an investor, even with pass-through improvements: based on the tenants’ age range and income, they could claim hardship. For an owner-user, a buy-out or eviction would not be easy.

The owner has a few of choices: 1) sell the property as is and leave money on the table, 2) attempt to negotiate tenant buy-outs, or 3) evoke an Ellis Act eviction. The owner didn’t like the idea of selling at the current value, based on a gross rent multiplier formula. At the same time, tenant buy-outs could be costly, or the tenants may reject buy-outs altogether. The last option is an Ellis Act eviction, which would cost time and money. If the owner chooses to go the Ellis route, then the tenants, while paying rent, will be there at least another 12 to 18 months. In addition, there are attorneys fees and relocation costs to pay the tenants. Once the units are vacant, the seller will likely need to make improvements before selling. TICs will be the highest and best use, and also the best way to recapture costs. The seller has to make some tough decisions, but continuing to pay out-of-pocket is no longer an option. He is currently consulting with a sharp San Francisco landlord-tenant attorney to get advice on how to proceed and weigh out the options.

Unlike the above scenario, many 2-4-unit property investors have done rather well. There are a number of different strategies that vary from property to property. Some investors hold on to the property for a long-term return on investment; they wait out the market and tenants. Others are more aggressive and negotiate buy-outs or evict problematic tenants. One thing is certain though: buyers should make a very thorough analysis and have a plan of action in mind before going into a new property; reviewing the disclosures is critical in making an informed decision.

A friend of mine, Irving, has a portfolio that consists mostly of 2-4-unit buildings. He has managed to make money on almost all his investments by calculating potential investments beforehand. He bought in areas where he thought the market would improve. For example, he was an early investor in the Lower Haight. His primary objective in a purchase has always been location. In San Francisco, vacancy was also an important factor, along with tenant profile and existing rents. Condition, while still somewhat important, has never been as critical as the other factors. If he was considering a property in poor condition, but it had a vacancy factor with upside, he saw opportunity in the property.

Irving has shied away from single family homes that have been carved into units, as they typically aren’t done well, and are often in poor condition. Some investors in today’s market are taking the opportunity to legalize or add accessory dwelling units. If the return on investment can be recaptured in a reasonable amount of time, the effort is worthwhile.

What does this all mean in terms of technological advances? In San Francisco, it all depends on the property. The demand for housing in San Francisco is huge, and vacancies are low even with all the new construction. A recent SF Gate article stated that growth is slowing in some Bay Area housing markets—this would also be the case in San Francisco if it weren’t for the number of people moving in from abroad. With a combination of the high demand for housing and rent control, the installation of technological improvements won’t necessarily net a huge margin in increased rental return.

On vacancies, new kitchens and baths net the best return and the highest rents. Most of the 2-4-unit housing stock is in older buildings, and the cost and ability to install technological upgrades may outweigh the return. For example, if you own an older building with fixed income, installing smart gadgets, like a smart thermostat, appliances, or home security systems, doesn’t make a lot of sense. Keyless entry systems, tankless water heaters, or even some of the newer decorative fireplace systems can pay off. Each property is unique: evaluate what you need and whether smart systems make sense. As an owner-user, new smart technology can offer quality of life and make all the difference.

With or without new technology, the 2-4-unit market is holding strong. Inventory has dropped slightly and prices are up over last year. It will be interesting to watch what happens in Q3 and Q4. Year to date, there have been 232 sales in the 2-4-unit category (including mixed-use) on the multiple listing service. Last year during the same time period, there were 243 sales. Year to date, the average sales price is currently at $2,051,956; last year during the same time period, the average price was $1,941,637. Price per square foot year to date is $656.40; last year during the same time period, it was $641.94.

In 2017, we’ve had several properties close after a significant amount of time on the market, which sent the average days on market askew. This is a good indicator of the limited inventory and tight market. A vacant fixer-upper on Fair Oaks closed after 630 days on the market, with over $1 million in price reductions. Another on Grove closed after 480 days on the market. Without including these two properties, days on market year-to-year are about the same: 50 days. There are some great lending products, and cash is still prevalent in the market.

I’ve always liked 2-4-unit properties. As an entry-level buyer, I’ve had success. I do a thorough analysis before purchasing, just like Irving. I consider location and tenant profile. As long as the building isn’t falling down, I’m fine with deferred maintenance (if the price is right). On MLS, I look for out-of-area agents, because they often don’t know our market. They tend to over price and under market, which is exactly what happened on Fair Oaks (my guess is we’ll see this property back on the market in about a year, completely redone, with smart technology).

Technology-wise, I switched to tankless water heaters years ago—the best thing I ever did. I’ve considered keyless lock systems and I’m ready to take the plunge. I’ve installed a Nest thermostat and security system in my own home, which I just love. Nest took some getting used to, and I know I’m not using the system to its full potential. The biggest problem with smart technology is that it keeps getting smarter, so what you buy today could be less expensive and improved next year. There are lots of new products to consider, but my advice is not to go too crazy on a 2-4-unit rental property.

Kilby Stenkamp is a realtor at Vanguard Properties. She can be reached at [email protected] or 415-370-7582.