Caveat Emptor for Watsonville Investors

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I’ve got some clients, and they’ve got some money to invest in Real Estate. They are not looking to speculate on real estate – that’s how so many people ended up getting foreclosed on in Watsonville, and in California, and in many other places throughout our glorious but fading homeland. Rather than simply speculate, my clients want to make smart, long-term investments.

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A Speculator is someone who is placing a bet – they put some money down, and their bet is that the value of whatever they buy will go up. They may have reasons to speculate that the price will rise, but it’s more of an anticipation, an educated guess. This is what so many people did wrong – they bought real estate they could not afford to hold on to, speculating that it would always be worth more than they paid for it, so they could get out, easy, and make a handsome profit for their trouble.

These clients of mine are probably not what you would call professional real estate investors – but they want to buy real estate as if they were – and after they do buy a few properties, and if they keep with it, hey, before you know it – they will be professional investors, after all, every professional has to start somewhere.

One of the primary things an investor wants is a good “cash on cash” return on investment . That is, they want to put up some cash, and have that cash investment return them money, put money back in their pocket, each and every year. So let’s say you put $100,000 down into a property, and you want to get a 10% return on your investment – that means, that after all expenses and costs, you get back $10,000 pear year on your $100,000 invested.

And that is where a lot of investors go astray, I think. They don’t have realistic numbers as to the income the property will generate and the costs that owning, financing, maintaining, and renting the property will incur. As it happens, my clients went on to my web site and found my handy Excel spreadsheet for income property analysis. It’s a really great tool (to be used for estimating purposes only, of course! Contact your legal, tax, and accounting professionals before making any investment decision!) to help you figure out what kind of a return you can expect on any given property.

There are some key numbers you need to know. The first, is the interest rate on the loan you will be getting. This is tricky – many times, your loan broker will quote you a figure, and then your actual interest rate turns out to be 1/4 or 1/2 or even a full percent higher than that. Make sure you ask for your Good Faith Estimate from the lender so you will know what your actual interest rate is going to be, and if you have to pay any points to get it.

You will also find out how much of a down payment is required. At first, my clients were figuring they’d only need 20% down for a non-owner-occupied real estate loan. Their lender informed them, when asking about their actual rate, it would be 25% down.

Another key bit of information you’ll need to know is, how much can you actually rent the property out for? The rental market in Watsonville has been extremely tight of late, and rental prices have been very high – or have they? I had recommended my clients look on Craigslist and also on Zilpy.com to see what the rental prices were looking like. The problem with that, though, is that these are asking prices for rent. It does not mean that they are the actual prices people are paying.

When you’re an investor, every month a unit sits vacant kills you. If you are asking too much for rent, you are not going to attract the kind of quality tenants you are looking for. You need to price the unit well for quick rental to attract quality, long-term tenants.

I talked to a property manager down in Watsonville about the rental situation. She said that the rental market had softened considerably, especially since the Housing Authority of Santa Cruz County had put a freeze on new housing vouchers. Ouch. According to the lady I spoke with, actual rents in Watsonville are now down about 20-25% from a year ago. D’oh.

What this means for my clients is that the amount of money they can afford to pay for a property, given their higher interest rate and lower rental rates means that they can offer less for a property than they had first thought – in order to make that 10% (or near 10%, anyway) cash-on-cash return on their investment. And there’s another important factor to consider for you number crunchers out there – closing costs and fix-up costs. It could be you need 25% down for your loan, and then another $10K for closing costs and another $15K on top of that to rehab the property so that its condition will make it desirable to rent quickly and for the highest rent possible. The $100K you thought you were investing could easily look like $125K before the first tenant moves in, and if you want to get 10% back, you’ll need to see $12,500 per year free-and-clear.

While we are on the subject, let me ask this: why are rental prices in Watsonville down 20-25% from a year ago? I don’t know for sure, but here’s what I think: it used to be there were a lot more owner-occupants in Watsonville than there are today. A year ago, there were less rental units available. All the people getting kicked out of their houses by foreclosure were competing for the scarce rental stock. Now, a lot of those formerly owner-occupied houses have turned into rental houses, thereby increasing supply. At the same time, not as many people are getting foreclosed on at the moment because of the various foreclosure moratoria which have been in place. And, of course, the unemployment rate in Watsonville is reported to be at 25% – that’s huge, and I think it means a lot of people are going to be sharing housing, families living with families, rather than each family having their own individual place as I’m sure they’d prefer in many cases but owing to the weak economy cannot afford to do so at the moment.

And, one other thing: what do you think these lower rental rates are going to do to home values? Will they have no effect? Bah, humbug. I dare say they will continue to drag down property values in Watsonville, and that we have not yet hit bottom. A lot of the buyers in Watsonville today are investors – and a real investor will only be able to pay so much for a property to get the return they need to justify the considerable risk. Also, as rental rates decrease, it blunts the incentive to for someone to buy – as the chasm between monthly rent and a full PITI payment widens, more fence-sitters are likely to stay there on that fence, and continue to wait out the market.

To all ye would-be investors, in Watsonville and everywhere else in our Golden State, I say: rock on, but play it safe, and always use your green eyeshades when analyzing any real estate investment. I’d hate to see you end up like thousands of well-intentioned but mis-guided “investors” before, with your investment dollars flushed down the drain and a bitter taste in your mouth.

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