What Can Go Wrong Buying Condo Rentals?

condo rentals

Not this small

As I alluded to in my recent investment income update, my time and attention this past month was spent on a failed attempt to purchase a new condo rental. Five days before closing, I walked away from the deal. All told I lost about $1,000 due to associated costs leading up to the purchase, but I learned a few things. In the end, walking away was the best decision and potentially saved me some future headaches and additional costs. So what happened?

Background

I’ve been searching for a new rental property on Redfin for the past year. I already have one rental, a condo that I previously lived in. Back in April I low-balled an offer for a second condo and was outbid by a flipper that paid list price. Since April, I’ve looked at a number of other properties and one recently caught my attention. The biggest draw of this unit was its premium location… perfect to walk to all kinds of shops, restaurants, grocers, and everything a high-end tenant desires. It was also an ideal location for me, nearby so I could manage it myself.
This unit was a small one bedroom, mostly updated and in excellent condition. The inspection went well and I saw very few things that could potentially go wrong with it. While small, I can’t stress enough how good the location was, down to the very block.

The DC metro region is expensive for housing. It’s also considered a bad place for investors. But I’m not interested in buying a property in another state because I want to manage it myself and don’t want the additional tax hassle. I’m willing to accept a lower return on cash for a solid property in an excellent location. Many properties in my area attract low-risk, high quality tenants with advance educations and steady and healthy salaries.

While condos are not an ideal real estate investment due to HOAs, shared expenses, and condo associations, they are the most attainable properties for me at this stage. Investors need to find their own best niche for real estate investing where they live.

Investment properties require a 20%-25% down payment. For a $200,000 property, that equals $40,000 or $50,000 required to get a good loan. Townhouses would make a better investment vehicle, but they sell for twice that price at a minimum, and come nowhere close to reaching the 1% rule (as a general real estate investing rule, rents collected per month should equal 1% of the sale price. So for a $200,000 property, rents should be around the $2,000 per month). The list price for this property was in the neighborhood of $200,000.

Condos nearby can come close to the 1% rule if a unit is priced to sell and in a great location. This property came close to the 1% rule, but not quite. Still, I knew that it would easily rent to a high quality tenant and would have very little maintenance.

The Offer

This particular property was listed slightly under fair market value compared to recent local sales figures. But it needed no upgrades and was ready to rent. I wanted to come up with a number that was below list price, but not a complete low-ball. I knew a low-ball offer would be rejected because it was a new property listing with significant recent upgrades. My agent also learned that they had rejected some previous low-ball offers.

After discussing with my agent we agreed that my offer should be 3% below asking price. That level would be difficult to turn down because the seller was motivated. It was high enough that we could expect a counter instead of complete rejection.

Upon receiving my offer, the seller replied with a counteroffer meeting me halfway on price. This was typical according to my agent. In my past experience, when someone asks you to meet them halfway on a price negotiation, they are not negotiating from a position of power. I was prepared to lose this property over a few thousand dollars so I rejected the counteroffer. After about 12 hours, the seller reluctantly accepted my original offer as they were motivated and had no others in hand.

The Financing

I have a loan guy that I’ve used five times for buying properties and refinancing. Every time he’s quoted me rates, I’ve gone to other brokers to find competitive rates. He’s beaten the competition by 1/8th every time.

All the while I was planning to buy this condo with 20% down. However, when I got quotes, the rate for 20% down on a condo was 3/8ths higher than if I put down 25%. 4.625% versus 4.25%. Since this was a long-term investment at a fixed rate, I absolutely wanted the lower rate and decided to put up the additional money to get the better rate. My lender gave me some reasons why the rate was higher for 20% down and it was all about Fannie Mae’s lending standards (for international readers, Fannie Mae is a pseudo-government entity that guarantees loans for banks).

4.25% on a 30-year fixed is a good rate for an investment loan so I locked it in as soon as I could. To my surprise, a 5/1 adjustable rate mortgage (ARM) was the same rate, so it seems Fannie Mae wants to avoid those for investors, at least from my experience. 25% down equated to almost an additional $10,000 in down payment, so I wasn’t thrilled about that. That would take my emergency/opportunity fund down to close to zero. But I could rebuild afterwards and set up a HELOC on my primary home to deal with any unforeseen expenses that came up.

The Downfall

Everything went smoothly the weeks after my offer was accepted. The inspection was good and that contingency was lifted. The seller agreed to fix problems that we identified. All was going to plan, however, I was adamant about receiving the condo documents early on to see how the association was managed. Frequently, condo docs are an afterthought, especially for first-time home buyers. But they are extremely important. You don’t want to buy into a poorly managed condo association. Buying a condo means you must adhere to their rules, regulations, and fees. If you fail to pay, you could be foreclosed upon. If other owners fail to pay, your fees may go up quickly. If there’s an outstanding debt, you may have to deal with a one time cost to pay it off. If the reserves are low, more rate increases may be needed to catch up.

I’ve dealt with a lot of condo association crap with my other condo. Rates increased steeply for the first few years and major things went wrong on a regular basis. With better management now, it is running more smoothly with no increases for the past two years. But still, my prior experience with condo associations made me a skeptic.

My repeated requests for the documents were met with “it’s out of our control, we’ll get them when we get them” from my agent. Buying the property is contingent on reading the documents and agreeing you will adhere to the rules and payment requirements. The seller’s agent kept saying, “you’ll get them and there will be no surprises.”

In the last week before closing I started getting limited documents. They lacked very basic facts like how many units were part of the association and when roofs were replaced. I requested more information and the seller had to jump through hoops to get it. Something wasn’t right. The HOA’s dues had increased 8% from the previous year with no explanation given. I had to make another special request to see a reserve study. No audited financials were delivered, only a sad one page budget.

One Fannie Mae requirement is that the condo management company must furnish a form answering questions. Certain thresholds must be met for Fannie to guarantee the loan and to protect their interests and those of the borrower.

For an investor loan, Fannie prefers owner occupancy rates at the condo association to be greater than 50%. In this case, 56% of the units were rented out by investors, so the owner occupancy rate was only 44%. To get around this it’s common for loan brokers to submit a letter for an exception, which is often granted. 6% is not a big deal, even to Fannie.

Upon further analysis, Fannie chose to reject the request for exception. The reason? The HOA fee delinquency rate was 15%, meaning 15% of residents were not paying their dues. That alone was a huge red flag!

This was all happening without my knowledge. Had I seen that 15% delinquency rate, I wouldn’t have made an offer. But that’s not how the process works. They conveniently never gave me that information. Luckily and surprisingly, Fannie Mae had my back. Fannie rejected the request for the exception and suddenly I was loanless.

My no-nonsense loan broker called me to break the news. He said there were other loan products out there, but none with terms as good. Under these circumstances the rate would have been 100 basis points higher and on a 5/1 ARM. A higher rate threw off my profitability. Too much risk. Not to mention, I wanted nothing to do with that delinquency rate. I also came to find out the association had changed management companies just three months prior to all of this, and they were already unhappy with the new company! AND it turns out, the seller was on the association’s Board of Directors. Another red flag. He saw this mess first hand and wanted out of there.

While a salesperson by trade, I find my loan broker to be very knowledgeable and trustworthy. I took comfort in his advice which was the same determination I made upon hearing the loan status… walk away from this deal. So that’s what I did.

Lessons Learned Buying Condo Rentals

The $1,000 I lost was for the inspection, appraisal, and title search. Not cool, but it doesn’t bother me too much at this point. That money came out of my other condo rental reserves which are very healthy.

I now have a bitter taste in my mouth for condos. Headaches can be avoided by simply buying a duplex, townhouse or single family home instead of a condo. Unfortunately, those other property types are much more expensive in the top locations near me and would require a lot more money down.

Maybe I could have requested more of the condo documents prior to making an offer. Considering how that process went, I probably wouldn’t have gotten them.

Leading up to the closing, I consolidated a lot of cash in my checking account to cover the down payment and closing costs. Getting that money together really made me feel like I was going to miss it when I cut the check. I like having a lot of cash on hand for emergency and opportunity purposes. After closing I’d have to build up my reserves again and cut back on dividend investing. The cash-on-cash return would have been about 9% at the high end of rent and 6% at the low end after all my expenses. Tough to find returns like that in my area. But had there been a major association headache or rate increase, that return could have dropped quickly.

Conclusion

The unit went back on the market the same day we signed the contract ending our transaction. My agent said the seller didn’t care as he thought the unit was worth a lot more than my offer. The unit went pending again a few days later. This time it will likely sell as an owner occupied unit. Unfortunately for the buyer, they’ll soon learn of the mismanaged association they’ll be joining.

For now I’m putting my rental aspirations on hold, and I’m probably done looking at condo rentals. The next step up is a townhouse in a less desirable location, or deeper into the suburbs. A decent townhouse would take twice the down payment, but the ones I’ve inquired about would not collect the required rent to make the numbers work. I’ll need to expand my search and be more patient if I’m going to buy a second rental.

For the time being, I’ll be doubling down my dividend investing and keeping a healthy opportunity fund for other possible investments that arise or a big market downturn. For now, I’m done with condo rentals.

Have you ever had to walk away from a real estate deal?

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19 Responses to What Can Go Wrong Buying Condo Rentals?

  1. writing2reality August 27, 2014 at 9:07 am #

    Tough scenario here, but I think you’ve made the right move. My buddy went through this for a while when looking for a place to buy in Chicago a couple of years ago. Associations can make or break the bank in so many ways, so being able to figure out the nitty gritty details of how they’ve been run and operated is extremely important, as you’ve laid out. Surprise assessments, the age of the building, what expenses they do or do not cover, and what limitations can go on the property, etc.

    For my unintentional rental property, I’ve been fortunate to have a solid association and well-run management company at the helm. Best of luck as you expand your search!

    • Retire Before Dad August 27, 2014 at 9:54 am #

      W2R,
      The whole ordeal was disappointing. But, when the deal fell through, it opened up a lot of other things. Namely, the next few weekends I won’t be looking for a tenant. And I have more cash ready to put other places. I’m glad to not be stuck with a crappy association, that is for sure. The money lost came from reserves that are meant to take risks with, so I don’t mind losing a little.
      -RBD

  2. JC @ Passive-Income-Pursuit.com August 27, 2014 at 9:56 am #

    In my experience if someone that you’re dealing with isn’t all that straightforward it’s probably a sign you should avoid that deal. This sounds like the right decision based on the HOA. I know another rental property would have been nice to add but I came to the same conclusion for our own rental aspirations.

    • Retire Before Dad August 27, 2014 at 10:36 am #

      JC,
      I don’t know if they were trying to hide something or simply inept. It was probably the latter. Docs were coming from the current and previous mgt company. Someone was on vacation. Blah blah blah excuses. The selling agent thought everything was fine and was so surprised I walked. Agents always want the deal to close. That’s another thing buyers need to watch out for. Agents always have that in the back of their minds, no matter how personal their service to you is. Using Redfin helped me because they aren’t paid the same as normal agents, so closing isn’t as critical for their compensation.
      -RBD

  3. roadmap2retire August 27, 2014 at 10:25 am #

    Wow…sounds like you dodged a bullet there….lots of red flags. Glad to hear that you walked away from it all. Also, thanks for sharing your experience – its always great to hear these stories first hand to find out what the problems out there are…and a lesson on something to look out for in the future if I ever decide to invest in a condo.

    cheers
    R2R

    • Retire Before Dad August 27, 2014 at 10:39 am #

      R2R,
      Glad to share! My loan broker said these are much more common in recent years. He sees something similar once a week. There’s plenty of condos in my area, and I think good management companies are elusive, especially for smaller associations like this one. Pair that with people underwater still on their properties and they tend to rent them and/or become delinquent. Oh well, back to the drawing board!
      -RBD

  4. jm August 27, 2014 at 10:52 am #

    I’m currently in a similar situation. Although, the property I’m checking out today is out of state. Can’t get the numbers to work out—1% wise here in California. I’m currently in escrow, and I’ve got a ton of questions to ask the seller about the property. I’m paying for an inspection, an appraisal, and a survey. These are “turnkey”, and in the process of rehab as we speak, and hence the inspection of the property in it’s current rehab stage I think is the absolute minimum I need to do as far as due diligence is concerned.

    I hear you though, if the loan doesn’t fund because the appraisal comes in lower, I’m not going to put in more cash at closing unless the 1% rule is met. That is the absolute minimum. I’ve had other rentals in the past, and none of them met the 1% rule; hence I sold one of them for a nice profit, and am using those proceeds to buy this next one.

    $1000 is nothing, compared to a bad investment with an unhealthy HOA. Assessments, regular increases in monthly dues, will eat away at your returns. Thanks for the post. I was thinking about investing in a condo here in southern California, but a little more east (inland empire), because the numbers came close to 1%; but I noticed on Redfin that there were a lot of units for sale in that complex, which to me is a big time red flag.

    all the best,

    j

    • Retire Before Dad August 28, 2014 at 7:00 am #

      J,
      Out of state adds a whole new layer, but those turnkey properties seem like a good way to go when out of state. Make sure to get those questions answered! CA is similar to my area, but probably much worse in many place. Good luck with your investment.
      -RBD

  5. Income Surfer August 27, 2014 at 5:47 pm #

    Glad it worked out for you RBD. Great job on your due diligence. You went above and beyond what I would have, even though I agree condos are a tricky beast. Down here (in Florida) we have tons of condos and their associations make the paper every week. I really love the ones where banks foreclose…..but don’t pay the condo fees……then something major breaks…….and the individual owners get hit with a special assessment of thousands $ per unit.

    My wife and I almost bought a condo at the beach a couple years ago…..and the age of the building was the biggest reason we didn’t. Everything has a design life…..even concrete condo buildings
    -Bryan

    • Retire Before Dad August 28, 2014 at 7:02 am #

      Bryan,
      I googled a lot of thing about condo rentals and Florida is often the first thing to come up. Your state was a big problem during the crisis. I have a family member that worked in condo construction and told me all about the mess down there.
      -RBD

  6. FerdiS August 27, 2014 at 11:00 pm #

    Dealing with a badly managed HOA would be deal-breaker for me — you absolutely did the right thing to walk away!

    Great blog you’ve got going here… I found it while expanding my own blogroll to a full page.

    Cheers
    FerdiS

    • Retire Before Dad August 28, 2014 at 7:04 am #

      FerdiS,
      Thanks for stopping by and commenting. Glad you are finding some useful information here!
      -RBD

  7. Kipp August 28, 2014 at 2:44 pm #

    Glad you could share this story Retire Before Dad! It seems like this could have ended up being a very bad investment, good to see Fannie Mae helped you out on this one! Interesting that they were able to obtain the information that wasn’t given to you after a long period of asking.

  8. Dividend Mantra August 29, 2014 at 3:15 pm #

    RBD,

    Man, that sucks! But glad you kept following through and demanded to see what was up.

    Your story really rings home for me. I was actually looking at potentially buying a condo up here in Michigan recently. I kept asking for docs with nothing to show for it. No budget, no bylaws, nothing. My agent kept trying to appease me, but finally I just gave up on it. It sucks that condos can be such a headache, especially when they’re the most approachable form of home ownership for a lot of people, especially in urban areas.

    But condos appear to me to have the worst of both worlds. You have many of the downsides of renting (shared walls, noise, smaller space, lack of yard, etc.) and ownership (still responsible for interior maintenance and repairs, can’t up and move quickly, loss of liquidity and flexibility, etc.). Furthermore, you’re essentially buying into a poorly-run corporation. I surely wouldn’t want unqualified neighbors running my business, and yet that’s what you have with a HOA as they run the business of the association.

    Sounds like it was a great lesson learned!

    Best wishes.

  9. Kate @ Money Propeller August 30, 2014 at 4:24 am #

    I think you made a good decision. My in-laws just purchased a condo last June and they have two tenants their living with their two sons.

  10. Integrator@financiallyintegrated.com August 30, 2014 at 1:24 pm #

    I’ve been lucky enough that our condo rental is home to a bunch of very qualified professions in the area, which is helpful as far as having high quality tenants. It sounds like this just wasn’t the deal for you but hopefully there’s another around the corner. I hadn’t heard of the 1% rule before. We are someways below that in our current rental though I don’t believe anything in the area gives quite that return.

  11. CharlesMakesCents October 1, 2014 at 10:48 pm #

    Hi, RBD,

    I’m a first time reader (and got redirected to this post from your latest income update), but I thought this was pretty interesting. it sounds like things worked out okay for you. $1000 is not too high a price to pay for a valuable learning experience.

    Also, I’d never heard the 1% rule, and it’s something interesting to think about. I live in CA, where rents are absolutely skyrocketing (+50 to 60% in the past 3-4 years) and we’d still probably need to go up another 30-40% to hit that ratio. That said, rents are currently a significant percentage higher than mortgage rates thanks to low lending rates.

    Looking forward to checking back in!

    Thanks,
    Charles

    • Retire Before Dad October 2, 2014 at 7:00 am #

      Charles,
      Glad to see you here. Thanks for reading this one and commenting. I’ve read some stuff about the rental market in California and it sounds frustrating for potential investors. Current investors are thrilled! Renters, not so much either. Financial Samurai and FI Fighter both talk about the market somewhat frequently. The DC area where I am is not nearly that bad. I do hope rents rise at a reasonable rate though as I still have my one rental.

      There’s plenty out there about the 1% rule. It’s probably not possible in most of CA. DC area it’s tough too. I think it’s a more reliable rule of thumb in more subdued markets. Thanks for stopping by!
      -RBD

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