In the first 19 years Stacy Schuler Wettstein owned her Oak Park two-flat, she never had an apartment sit vacant.
Every time a tenant announced plans to move out, she’d run an ad, get two to eight calls in the first week or so, and have a new tenant lined up before the old one left. “It’s been a beautiful thing,” she says. “Rent money has covered about 75 percent of the mortgage all these years.”
Then this fall Wettstein and her husband, Eric, bought a house in River Forest and advertised the second-floor unit they would be moving out of. Two weeks went by and she didn’t get a single call about the apartment. In the next ad she cut the rent $50, to $1,610, but in the next two weeks the phone still didn’t ring. It’s nail-biting time.
“I’m nervous, and I’ll be really nervous if I don’t rent it by January 1st,” Wettstein says. But from fellow small landlords who have their own stubborn vacancies, Wettstein has gotten the distinct impression the unit will still be empty when 2004 arrives. If so, she says, she might have to put the two-flat, which belonged to her parents before she bought it in 1984, up for sale.
“If it isn’t rented by then, we’ll have to look at putting the building on the market,” she says. “We really can’t afford to cover it if the apartment is empty.”
Kathy McDonald has it worse. She has a three-flat in Skokie where, for the first time in 16 years, she has an apartment that didn’t refill the same week the old tenants moved out. The unit has sat empty since June. She’s gotten a handful of phone calls, but in nearly six months got only one showing scheduled — and the people stood her up. She’s not planning to sell the building but says that for the first time since she and husband, Joseph Monahan, bought it, the building is costing money rather than making it.
Both couples are facing a harsh reality wrought by remarkably low interest rates that have prodded record numbers of renters to buy their own homes. All those new buyers have pushed home sales to new highs across the country, but they have also left landlords holding the bag. About 7 percent of Chicago-area apartments are vacant now, compared to 1 percent to 2 percent from 1997 through 1999, according to Greg Moyer, senior vice president and managing director of the regional office of Marcus & Millichap, a realty investment brokerage.
No good figures exist for the vacancy rate in Chicago-area two-flats, but nationally, rental buildings with two to four units had a 9.4 percent vacancy rate in the third quarter, up from 8 percent a year earlier and 7 percent in 2001, according to the U.S. Census Bureau.
Big commercial landlords with portfolios of hundreds of apartments are hurt by the vacancy rate, but it’s small-timers, such as the live-in landlords of two-flats who rely on rental income to cover a chunk of the mortgage, who feel the pain most acutely. After all, if the only apartment besides your own is empty, your vacancy rate stands at 100 percent.
Two- and three-flats traditionally have been great buys for people who wanted to maximize their investment. Rental income is most often better than half the mortgage payment, so the rental is carrying more than its weight.
“For first-time homeowners especially, two-family homes have been very attractive,” says Frank Nothaft, chief economist of Freddie Mac, one of two federally chartered corporations (the other is Fannie Mae) that buy mortgages, repackage them as securities and sell them to investors. “The buyer uses the rent to help support the mortgage.”
Typically, underwriters allow buyers to count on 75 percent of annual rent income to go to mortgage payments, the rest going to building maintenance and shortfalls caused by vacancies, says Brian Weis, Lakeview branch manager for Countrywide Mortgage.
Weis notes that the 75 percent figure takes into account the possibility of longer-term vacancies such as those some small landlords are experiencing. “Even though it’s a softer market now, vacancies of 7 percent aren’t so far from normal that they’re outside the lending guidelines,” he says. Neither Weis nor Nothaft sees any reason to believe underwriters will change their standards on rental income; both say the 75 percent covers current conditions.
That’s slim consolation for the Wettsteins, whose chances of filling the upstairs unit are worsened by the fact that it’s in such great condition. Because it was their home, they did it up nicely, with new windows, a whirpool tub, granite countertops and a whole-house speaker system. Normally the upgrades, and the historic neighborhood in which the building sits, would command the $1,660-a-month rent they asked. But at the historically low interest rates of the last year, $1,660 covers the payment on a $250,000 to $275,000 mortgage.
“Anybody who can afford to rent this apartment, plus utilities and parking, would be foolish not to buy instead if they have the down payment,” Wettstein says. “That’s why they’re not calling me about renting.”
McDonald, too, says of her $1,175 apartment, down from the original asking rent of $1,250, that “over the years this has been the last stop before you buy your own home. Now they don’t need this stop.”
The vacancy problem may be hitting small landlords in affluent neighborhoods hardest, because renters there are more likely to have been able to convert to homeownership than lower-income workers who will rent permanently. Chris Porter, who manages an investor’s national real estate portfolio but personally owns three two- and three-flat buildings in the North Side St. Ben’s neighborhood, notes that “any product under $1,000 a month isn’t hard to rent now, but when they get over $1,000, they say, `I can afford a mortgage, I’m not going to rent anymore.’ If they’re able to pay over $1,000 and they haven’t bought, I’d say run their credit. There must be a problem there.”
If in fact small buildings are running a higher vacancy rate than the market overall, Porter contends that’s in part because apartments in two-flats can’t compete with the lure of new condos — even rental condos.
“The two-flat used to always be worth more in rent than the apartment in the 50-unit building, because it had the inviting yard and tree-lined street,” he says. “But with all these new condos and condo conversions you’re competing with, that condo is a better-looking product with a brand-new kitchen and granite countertops and central air. Your two-flat with the 1970s kitchen and the junky dishwasher doesn’t look as good, even with its old wood and plaster and charm.”
As a result, rents are declining or standing still. Porter says he is charging $1,200 for apartments that commanded $1,500 just two years ago. Yitzie Sommer, Marcus & Millichap’s Chicago director of research services, says for all types of apartments in the area, actual rents, or what landlords pocket after subtracting the cost of any concessions, such as rent-free months, have dropped about 4 percent from the third quarter of 2001 to now.
(McDonald suggests committed renters are in the catbird seat here: “I want to keep the two tenants I do have while that third apartment is empty, so I’m not about to raise their rents.”)
But even if two-flat units have lost their appeal to renters, there’s no sign that they’re losing their strategic value for buyers. Wettstein and McDonald say they’d heartily encourage anyone to buy a two- or three-flat, even given their tough recent experience.
“The beauty of this process is that I still have two other tenants helping pay the mortgage,” even while the third unit is empty, McDonald says. Wettstein, too, says, “I’ve made a killing on this investment. The building is worth almost three times what I originally paid for it. Oak Park is appreciating like crazy.”
Freddie Mac’s Nothaft says owning a small building as a residential landlord is probably an even better idea now than it’s been in the past. Because of low mortgage rates, he notes, “the big drop in the housing payment is an important offset of the temporary weakness in the rental income.”
Countrywide’s Weis advises buyers of two- or three-flats to get as much information as possible from the sellers on the status of existing leases in the building: When do they expire, and is there any indication tenants will move at the end of their lease?
No matter what, he says, these days it’s best to assume there’ll be a period of vacancy at the end of any lease. He notes that with real estate values and tax bills going up, ownership of a building where somebody else pays part of the mortgage is especially attractive.
Nothaft, too, points out that Freddie Mac’s figures show home values in the Chicago area have risen 39 percent in the last five years and show signs of continuing their rise. Buying a two-flat, he says, is a great way to maximize the growth of your investment. Simply put, by buying more, you get a larger stake.
Weis says, “The smart thing to do is probably buy now while you can get a relatively good deal and then because of the soft rental climate, charge slightly less than market rent but raise your rents later as the market picks up.”
Just don’t bet the farm. Knowing that a prolonged vacancy could damage your ability to pay for the property, don’t get overextended, either with upgrades to the building or with second mortgages on it. Keep it as close to paying for itself as possible.
Sommer, too, emphasizes that the drop in the cost of homeownership has been larger than the drop in rents. Even with a stretch of a few months’ vacancy that has to be covered out of the landlord’s pocket, Sommer says, the combination of mortgage interest deductions and the rising value of the building “make the rental loss peanuts.”
Even as she sits with an apartment vacant for half the year and no prospects for getting it rented, McDonald agrees with the three lending experts. “I’ve had a good 16-year run,” she says. “Buying a building where your tenant covers a big part of the mortgage is still a great way to build wealth.”
