The Ultimate Guide to Investing in Condos and Townhomes

Posted by on Sep 30, 2017 in News | No Comments

invest-in-condos
Five years ago, I unwittingly embarked on my real estate investing journey. I didn’t set out to become a real estate investor — it just happened. You may even be able to relate!

As a senior in college and a Sociology major, I knew my next path would most likely lead to graduate school. My mother (thanks, Mom!) urged me to consider buying a property, as both programs I’d applied to were at the same university. So one day we decided to look at a condo I found on Craigslist, and before I knew it, I was at the closing table.

To be honest, I had no idea what I was doing. I was 21, had never “spent” that much money before in my life, and didn’t know the first thing about managing a property. It’s amazing what a few years and some hard lessons can teach you — I probably should have read BiggerPockets first. ?

When I mention that I invest in condos and townhomes to others, I usually get one of two responses: a) “Are you crazy? Everyone knows condos make terrible investments!” or b) “OK, tell me more…”

I totally get it. Most of the time when people think about real estate investing, they think of a single family home or an office building — rarely is it a condo that first comes to mind. And in some markets, that’s for a good reason because a condo truly IS a terrible investment. But before jumping on the condo hating bandwagon, I urge you to run the numbers for yourself. They rarely lie.

Note: Though I am addressing the topic of investing in both condos and townhomes, to minimize repetition I will refer to these collectively as just condos.  

Why Condos?

There are a few characteristics of condos that make them an appealing investment, especially for a novice investor like I was at the time.

First, they are usually priced lower than your typical single family home. The barriers to entry are substantially lower, which means an aspiring investor can put their money to work sooner rather than later. For many, saving for the first down payment is the toughest part; once the snowball gets rolling, though, watch out!

Second, they are generally easier to maintain. Since the homeowner’s association usually takes care of the grounds and exterior maintenance, a condo landlord is only responsible for the space from the walls in. Depending on the HOA covenants, this may or may not include the heating/AC unit and the hot water heater. Townhome units are usually similar, with the main difference being that by owning a townhome, you own the physical land underneath as well. Again, the HOA will have the last word on what the landlord is responsible for maintaining, but being able to outsource major eventual maintenance items such as the roof, siding, parking, etc. can free up mental bandwidth for other things.

Lastly, due to the ease of maintenance, they are also generally easier to manage. As a self-managing landlord, it’s helpful to be able to call the HOA manager if I see a piece of siding that has been damaged, for example. At times it feels almost as if I have a property manager without the added expense of 8-10% of monthly rents.

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How Are Condos Different from SFHs?

The biggest difference between condos/townhomes and single family homes are shared walls (and/or lack thereof). For many who are purchasing a property as a primary residence, any kind of shared space is a deal breaker. However, as a potential condo investor, you may be in luck! Denser housing is definitely more efficient with space, which is why you tend to see condos and apartments located near bustling downtowns and university areas. Shared space usually means shared costs, which is always a plus in my book. And if you buy in a sought-after location (where rents tend to be highest), you are able to benefit from the purchase price discrepancy since condos tend to be the lowest priced properties.

Another thing to keep in mind, especially if you decide to “house hack” a condo (a term invented by our lovely Brandon Turner, referring to living in one bedroom and renting out the others), is that given your shared space, condos tend to make for slightly noisier living. Unless you live on the top floor, you will likely hear your neighbors above you at some point, and depending on the thickness of the walls, you may hear the neighbors on both sides of you as well. Plus, if there is parking directly below your unit, hearing cars coming and going comes with the territory, too.

When you own a single family home, you own the entire parcel of land the home sits on, which means you alone are responsible for the upkeep and maintenance. This means setting aside capital reserves for eventually replacing the roof, landscaping, cutting the grass, etc. Some landlords pass yard maintenance duties onto their tenants, but I tend to be of the mind that the less you put your tenants in charge of, the better. With condos, this should all taken care of by the HOA.

Ultimately, this is one of the pieces of the puzzle that is entirely subjective. Do you prefer to outsource ongoing maintenance of the property to an HOA in exchange for a small cut of profits every month (assuming a healthy HOA — we’ll cover that later)? Or would you rather keep more of the profit, but do more of the work? Like with many things in life, it’s a tradeoff — you have to decide whether the tradeoff is worth it.

HOAs can be great, as many have an HOA manager (most commonly a property management company) that oversees everything regarding the shared spaces. This is definitely a double-edged sword, though, because any space that the HOA controls is space that you don’t control. So while the condo and everything inside might be yours, the building you are in is not owned and thus not controlled by you.

The last notable differentiator between the two that I’ll mention is cash flow versus appreciation. Single family homes tend to appreciate much more than condos, as they tend to be more in demand. Personally, though, I don’t buy for appreciation — that is like gambling to me. I’d rather purchase a steady stream of income and not worry about the market price versus purchase a property that has a lower rent to purchase price ratio but has “potential” for appreciation.

Another reason that condos may not appreciate as much as single family homes is because it is more difficult to get financing for them. We’ll cover that topic in detail after this next section.

Know Your Market

As we all know, real estate is extremely local. So making a blanket statement such as “condos are terrible investments” before actually running the numbers might be a huge mistake. Perhaps you live in a college town. Or maybe you live near a city with numerous tourist attractions that bring visitors year-round. I’ve personally talked to buy and hold investors in both the student housing and vacation rental space that easily make the numbers work.

Key to all this, of course, is doing your research. And when I say “research,” I mean talking to your local real estate agents and investors; pulling up Craigslist, the MLS, tax records, and determining whether there is a big enough price discrepancy between condos and single family homes that you can exploit; and looking at which sub-areas rent for how much and why.

Do single family homes meet the 1% rule? If not, do condos? (I’ve found the answer in my market of Raleigh-Durham to be oftentimes no and sometimes yes, respectively.)

There are some qualitative reasons why condos can be good investment properties, but the first filter should be the numbers. Personally, if a property doesn’t meet the 1% rule, I don’t even look at it. If it is hovering just around 1%, then I may or may not set up a showing, depending on other factors (such as how long I’ve been looking and/or the area).

(For those of you who are unfamiliar with the 1% rule of real estate investing, it is a general rule of thumb that says monthly rent should equal at least 1% of the purchase price of the home.)

The best way to know your market is to get in it and start looking. Drive by properties, tag along with your real estate investing friends, talk to real estate agents, and get to know your city. The last item is super important, and it’s how you can identify potential niches. For example, so far I’ve gone into student housing — not only because I’ve attended the local universities and have contacts there, but because I’ve researched the numbers and I KNOW that properties in these areas, IF BOUGHT RIGHT, are cash cows.

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Financing

Ah, financing. The crux of investing. Unless you’re paying cash, obtaining financing is crucial to the process of buying a property for obvious reasons. On an investment property purchase, the bank is likely going to ask you for a 20% down payment at minimum, and in my experience, the interest rates on investment property loans are slightly higher (but that shouldn’t deter you since if you buy right, the tenants are paying that expense anyway). Of course, if you plan on living in it and house hacking, then you can swing a loan with less money down required. This may be the best way to get started if this will be your first property or if you’re young and single.

The type of financing you need to get depends on the deal. Since my experience has been with traditional bank financing for long term buy and hold condo projects, that’s primarily what I’ll speak to. The true test of a cash cow property is to plug in the numbers using a 15-year mortgage. If the property STILL cash flows after that, you have a winner.

However, even if it DOES cash flow on a 15-year note, personally all the notes I hold are those with an initial term of 30 years. Why? That lower payment gives greater flexibility. For example, this month I replaced the floors in one of my rentals with laminate, and I was able to pay for it by not touching my day job earnings because I saved the excess cash flow from my rentals for a few months. If I’d had 15-year notes and the higher monthly mortgage payments that come along with those, I’d have no choice but to turn that excess cash flow into equity — which isn’t a bad thing necessarily, but is rather limiting.

What’s more is that if you have a few months of excess cash built up, just sitting around collecting dust, and you have no prepayment penalty (make sure of this before you sign the dotted line), you can throw that cash toward one or more of your mortgages if you want. But ultimately, you get the choice with the lower required mortgage payments of a 30-year term.

Depending on the location of the condo complex, the ratio of investor-owned to owner-occupants may be extremely high. If this is the case in a complex you are considering, know that your financing options are limited. It would be best in this scenario to secure financing with a bank that lends at non-warrantable condos before even making an offer.

What are non-warrantable condos? Basically, when a bank gives you a loan, in the majority of cases they turn around and sell that loan to Fannie Mae or Freddie Mac. However, Fannie and Freddie impose rather strict guidelines on the loans that they will buy — one of them being the investor-owned to owner-occupied ratio should be 50% or lower. Thus, if a condo doesn’t meet these “warrantability” requirements, it is considered “non-warrantable.”

But have no fear, there are banks that will loan on non-warrantable condos — you just have to find one that keeps their loans and doesn’t sell them to Fannie/Freddie. In many cases, this describes credit unions and smaller mortgage banks.

These financing limitations could help explain why condos tend to sit on the market for longer than single family homes and why they don’t appreciate as quickly. It is also something you want to keep in mind for potential resale down the road. Personally, this matter doesn’t keep me up at night because I plan on holding my condo investments for a long time, but your mileage may vary.

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The Downside(s) of an HOA

I’ve covered many reasons why HOAs can be beneficial (such as ease of maintenance and shared costs of common space), but there are some risk factors concerning HOAs as well that you need to be aware of.

Before you buy a condo (or any property for that matter), make sure to do your due diligence. Request copies of all the HOA governing documents, including the covenants, bylaws, financial statements, budgets (for past years and current) — and perhaps the most important, a statement of reserves. The reserves are the amount of cash on hand to pay for large expenses, including the roof.

Each HOA is different, but in many areas they also limit the amount of allowed rental units — most likely in an effort to preserve the integrity of the community and keep the condos “warrantable” for ease of financing (and thus resale). This will definitely derail your plans if you are planning on renting out your unit, so the sooner you find this out, the better.

While it’s true that you own the physical space inside the condo unit, unfortunately, the HOA’s decisions still trump yours.

The possibility of a special assessment can also be daunting, which is why it’s important to inspect the health of the HOA financials. If a tree fell on your building and the entire roof had to be replaced, would they be able to cover that cost? Or would they need to assess a one time fee to all owners in order to collect enough money for those repairs? That is what is meant by “special assessment.” In some cases, they are a one-time fee, but they can also be required for multiple years in a row if the HOA is truly in a pickle.

Being a Condo Landlord

Once you’ve invested in a condo, this is when the fun really begins! The great part about real estate (in my opinion) is that there are many ways of making it work — a few tweaks might even bring you higher cash flow. It’s totally possible to capitalize on unique advantages.

I’ll use my properties as an example. They are located about 10 minutes away from downtown Raleigh and 5-7 minutes away from NC State University. This means that space is always in demand, whether it’s from students or young professionals who work in the city. It’s also less than a mile to Interstate 40, which can take you to Durham/Chapel Hill in 30 minutes or less, depending on traffic.

With student housing, offering individual leases is a huge plus, as many don’t want to take the risk of paying for an apartment and then having their roommates screw them over by not paying rent. This way, everyone is accountable for only their portion. The added bonus for investors? You can usually charge more for this!

Another interesting trend I’ve noticed around college housing is the demand for short-term leases. Some students might be traveling abroad for a semester or they might be international students staying in the United States for only a semester. Apartment complexes in the area charge an extra $100-$200 per month for a short-term lease, if they even offer it at all (many don’t). I decided I would start allowing short-term leases for an extra $25/month.

Since these condos are located in a great area, there is never a vacancy issue, even during “off” months or in the summer. Yes, increased turnover means I have to go in there and clean between tenants a little more often — but it doesn’t take me much to quickly vacuum and sanitize everything, especially if it’s just one room.  

(Note: I’ve very recently hired a house cleaner in order to focus my time on my real estate brokerage business, so I may up my short-term rental fee an extra $50 per month, which is still reasonable).

These are just a few ways that I have personally juiced the returns on my rentals. There is a fine line between automation and being hands on — and only you can decide the perfect mix for yourself.

You can achieve a good balance by using automation to fill the gaps. For example, Cozy.co will collect rent payments for you and deposit them into your bank account. The catch is that it is delayed, so it takes about 10 days to process, but you do receive an email notification when your tenants have paid. Other property management tools out there might have additional options, such as letting tenants submit repair requests.

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Conclusion

Hopefully I’ve illustrated a few good reasons not to immediately reject condos as potential investment properties. While there are a few things to watch out for when it comes to the HOA, if you find a lucrative niche, a condo can be a cash cow — even in spite of the HOA fees paid every month

From Bigger Pockets