The Investment Scientist

Be Careful When Buying a Condo as a Rental Property

Posted on: May 3, 2012

Two months ago, we bought another investment property.

Read Condo Agreement!

The condo with two bedrooms and two baths was being sold through a short sale. The asking price was only $80,000. We did our research; the condo could rent for $1,300 per month in the market. So it’s a no-brainer.

At the time, there were four other bidders. We decide to be aggressive and employ an escalation clause. We would bid $80,000, but if someone bid higher than us, we would increase the bid by $500 increments, up to limit of $95,000.

In the end, we won the bidding for a price of $88,500. The next aggressive bidder was only willing to pay up to $88,000.

With condo fees less than $2,000 and taxes less than $1,000, the cash-on-cash return on this property is over 14%. Where are you going to find such a good investment in today’s world where 10-year Treasury bonds are yielding less than 1%.

All was hunky-dory until one day we decided to stroll the neighborhood where the condo was located. We bumped into a gentleman who happened to be the president of the condo association. He told us that the association has a 30% rental cap imposed on owners of the units. In other words, no more than 30% of the units can be rented out at one time. Condo owners who want to rent their unit need to get approval from the association, then wait until the percentage of rental units dips below 30% and a rental slot opens up. As a new condo owner, I can expect to wait for years (if ever) before a rental slot is available.

If the condo can’t be rented, it has no value to us. For whatever reason, the seller did not disclose this key information. Armed with this new information, we decided to void the contract. The seller threatened to sue us.

He has absolutely no ground because he is liable for incomplete disclosure. I am writing up this experience to serve as a cautionary tale to all condo investors – check the condo documents to make sure there is no rental cap provision before you sign the contract.

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11 Responses to "Be Careful When Buying a Condo as a Rental Property"

The object of investment real estate is ROI. I have nine lovely rental properties, all fitting the same criteria. Single family, 1000 sq.ft., usuable basement space, nice neigborhoods. Most of the properties are even the same floorplan and builder. We know what it takes to turn this type of property around because it’s our niche. At this point all my monthly expenses, car expenses, and even taxes are being paid for by the residents. Taxes aren’t so bad when you arrange for someone else to pay them!

When I first looked at investment real estate I eliminated condo’s. The object is ROI, I couldn’t find a good reason to give the HOA part of my ROI. Additionally, here in flyover country, most condos are populated by older empty nesters that don’t want to cut the lawn, freshen the flower beds, or shovel snow. While my resident is out working all day to make a living, the board is having a meeting(s) to make rules on how the tenants live. I can imagine a tenant wanting the NFL package on Direct TV while the board makes a rule that allows no satelite dishes

We buy the ugliest houses in nice middle class communities. I’m handy and do a lot of the work myself. The cash on cash return for us is about 16.7% and we, my wife and I, make the rules

Ron,

The cash on cash return you are getting is fabulous, probably only possible in your neck of the wood. I got another condo for $98k without rental cap, that one can fetch about 14% cash on cash return.

In DC and its vicinity, to get above 15%, one has to get into undesirable neighborhoods. My wife has a colleague who is doing just that. He bought at dirt cheap and rents to section 8. His cash on cash is north of 25%.

I learn a lot from your comments. As I build up my real estate portfolio, I am sure you have more things to teach me.

Michael

It is illegal per federal law to restrict access to broadcast communications, so bans on satellite dishes smaller than a certain size (1 meter in most places) cannot be enforced. There can be limits, but no bans. See http://www.fcc.gov/guides/over-air-reception-devices-rule for details. People talk about the big bad gubmint, but private regulations (HOA or corporate) can be worse.

Michael, the skin color of your wife’s colleague is not relevant. Hi might have a german shepard as well, but that’s not relevant either. The fact that he owns properties in undesirable neighborhoods is relevant, but you are insinuating there is a relationship between undesirable neighborhoods and black people. While that may be the case in many instances, it is not the rule and should not weigh into housing and business decisions.

Don’t mention or act on such items, as at the worst it is racist, as the least it has racist overtones.

Tim,

I just censored the politically incorrect word.

Michael

Nice. Keep up the good advice.

Tim.

Sometimes regulation (and good practice processes) are a blessing: if you were entering the contract in a jurisdiction with the legal framework we have in Queensland, Australia, the contract would have carried clauses to protect the purchaser from such ‘unknowns’ at time of contracting – and thus saving time and legal fees as will arise in your instance.
A 14% return on a rental property certainly would be a ‘no brainer’ – but as our securities regulator (ASIC) says: if it seems too good to be true, it probably is!

Here the law requires seller to disclose all material facts and buyer may back out of a contract if that is not done.

In fact, I was able to purchase a very similar condo unit at a neighboring community for $98k (a bit higher than the original $88). I have found that rental returns are monotonic to distance from the city center. Washingtong DC downtown rental return is about 3%. The condo I purchased is at the edge of DC metropolitan area. Going further out is farmland.

Cheers Michael – my observation from this side of the Pacific is that you are in a great position to capitalise on the clean-up from the 2004 through 2007 property bubble: but you might only have another year or so to get that advantage as the market slowly catches up with the ‘backlog’! Cheers, Eric Walters

Eric,

I realize that. In fact, there has been a 180% change in the low end of the market in the last 18 months. When I purchased my first rental 18 months ago, ton of cheap houses were sitting on the market for months, some years without so much an inquiry. By the time I closed the first purchase 10 months later investors have already cleared out cheap houses on the market.

In my latest purchase, I have 4 other bidders and I had to bid rather aggressively. The seller (a bank) was asking for $90k, I won the bid with $98k.

No only small time investors like myself are swooping in, big hedge funds are getting into actions as well. The best time has passed, but great deals still exist.

Michael, I unfortunately just got myself into a similar situation. I made an offer to purchase an REO condo last month. At the time I asked my broker if the condo can be rented. The answer came back was a “yes” and my broker promised to get back to me with “written confirmation from HOA”, however he never followed through and stupidly from my end, I made an offer and was later accepted by the bank.

I had asked for a master deed however the HOA would not give me that unless I order the documents through homewise.com, and it took me 2 weeks to obtain the master deed. I was just able to go through the master deed today when I found out the rental cap (30%).

The only contingency I have at the moment is the finance contingency. I would like to back out this offer but what ground I would have? I have the contingent approval from the bank on the financing and the expiration date is the day after tomorrow. I applied the loan as an investor loan, can I request a denial letter from the bank so I can get my Ernest money back?

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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