With market in doldrums, now may be great time to buy small rental properties

November 15, 1992|By David W. Myers | David W. Myers,Los Angeles Times

It's no secret that the housing market in most of the country is in the doldrums.

TC Gone are the heady days of the late 1980s, when you could buy a home or small apartment and sell it a year or two later for big profits.

But today's sluggish sales, lower prices and low mortgage interest rates are causing some investment experts to say that now is a great time for patient investors to buy small rental properties.

Combine those factors with a sharp drop in the construction of apartments and forecasts of population increases in many areas, and you've got a strong argument to invest in duplexes, triplexes and other small apartments -- so long as you don't count on getting rich quick.

"If you expect to buy a rental property and make a fortune overnight, forget it," says Michael Layana, a real estate agent in Culver City, Calif. "But if you invest with the expectation of holding it over the long haul, you'll turn out just fine."

Although buying a small rental complex in today's soft market may seem alluring, don't make the mistake of thinking that owning one is an armchair experience.

Maintenance duties aren't the only headaches afflicting small-time landlords. Those ideal tenants may turn out to be rowdy or deadbeats. And don't forget the paperwork.

If you still believe that buying a small rental makes sense, you must then decide what you hope to achieve by buying one.

You might be willing to settle for a break-even cash flow or even a small monthly loss, especially if you can write off all your losses, or the property's appreciation potential is good or you plan to live in one of the units to lower your housing costs.

But if your primary goal is to establish steady monthly income, you'll probably have to make at least a 30 percent down payment to ensure a positive cash flow.

It's a good idea to visit a bank or other lending institution and set up a modest line of credit.

There are many sources you can use to raise your down payment for rental property. If you don't have a lot of cash on hand, you may want to liquidate low-paying certificates of deposit or savings accounts to raise cash.

Or consider selling some of your stocks or bonds, especially if investing the proceeds in real estate would help diversify your portfolio.

Once you've determined how much cash you have for a down payment, you'll need to zero in on the neighborhoods that have the best appreciation potential. Some of the best prospects are often found in areas where there are lots of new commercial projects.

New stores and offices indicate that business people have faith in the area. In addition, of course, their workers will need a place to live.

Expansion and remodeling projects are also clues that a neighborhood is on an upswing and that prices will rise.

Schools are important too, because most renters have children. Visit the schools in the neighborhoods you're considering, and ask for the results of the state-standardized tests that all districts must administer each year.

Finally, consider local rent-control laws; these ordinances vary widely.

Investors in big apartment complexes have many ways to determine a project's value. Some will buy if the purchase price is a certain number of times the annual rent. But those formulas aren't appropriate for small rental properties. You'll need to consider location and how the expenses stack up against income.

To determine the property's cash flow, ask the seller for a profit-and-loss statement and any other information about the building's annual rental income and expenses. Some investors ask for the seller's last few Schedule E tax forms, which landlords must file annually with the Internal Revenue Service.

Obtaining a mortgage to buy rental property is a bit harder than it used to be, in part because many lenders are skittish about lending in today's sluggish market.

Rental property still offers tax write-offs. Assuming that you "actively participate" in its management -- an IRS requirement easily met by most hands-on investors -- you can depreciate your rental property by 3.64 percent a year to boost your after-tax profit.

You can also offset rental income by taking deductions for mortgage interest, property taxes, maintenance and other items.

SELLING RENTAL PROPERTIES

Q. I intend to finance my children's college education by selling ,, rental properties. Will I still have to pay capital gains and state taxes on those sales? I doubt that my children will receive any financial aid because of my assets.

A. Sure, you'll have to pay the taxes -- if you own the properties when they are sold. But the tax picture may be quite different if the property is owned by the children at the time of sale. You can give each of your children up to $10,000 a year tax-free, or $20,000 in a joint gift. Such gifts may take the form of equity in real estate properties. The advantage is that your children are likely to be in more favorable tax brackets than you and thus pay lower taxes. If this seems attractive, you should see a lawyer or an accountant to make sure there will indeed be tax savings and to iron out other details.

(Send questions, including your name, address and telephone number, to: Kenneth Hooker, The Boston Globe, Boston, Mass. 02107-2378.)

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