There’s a body of truisms out there that I like to call “real estate investing common knowledge.” These are the lessons that people read about on forums, hear about on podcasts, watch videos about – and never question. But here’s the thing: if you invest in Los Angeles – or any other large, urban, gateway city market – you need to question these truisms because they may keep you from acquiring good investments in your market.
Case in point: I was working with a client last week, and we were considering a property near Culver City, an area of Los Angeles that’s exploded over the last decade, largely fueled by an influx of young tech professionals. It was a good property, but my client, looking at the Redfin listing, said, “Well, the elementary school ranks a 3 out of 10. That’s not very good. Let’s look at something else.”
I didn’t want to get into a long thing with him about why disregarding an otherwise promising property because of the local elementary school’s low rating was a bad move – so I’m writing a blog post about it! This begs the question: do good schools really matter when investing in Los Angeles and markets like it? If you ask me, the Midwest orthodoxy on this is dead wrong, and I’ll tell you why.
Future Tenants: Who Prioritizes Good Schools?
Let’s explore the logic behind buying rental property near good schools. Good schools attract tenants with kids because parents want to send their kids to good schools. Fair enough. Moreover, good schools attract sticky tenants – i.e., tenants who aren’t going to move out. If the tenants have children in the local school, they’ll be inclined to stay put until their children are out of school, right? I mean, a good K–8 school could keep a tenant in place for nine years. And what if the tenant has two or three kids? That could be a twelve or fifteen-year-long tenancy. And common knowledge also tells us that turnover kills profits, so fifteen years with no turnover is a huge win, right?
Maybe in the Midwest, but not in Los Angeles, and this is why we LA investors need to question the common knowledge. Let me explain.
Why are Rent-Controlled Markets Different?
Los Angeles is a rent-controlled market. In the Midwest and the Southeast and Florida and Texas, you’ll find almost no rent-controlled markets. In those markets, a landlord can raise rent as much as the market will bear. A new tenant moves in at market rent, and fifteen years later, that tenant is still paying market rent for a unit of that condition.
Not so in Los Angeles. Here in LA, we have a rent stabilization ordinance that limits how much a landlord can raise rent on an existing tenant each year. The allowed increase is tied to the Consumer Price Index, which is a proxy for inflation. For nine of the last ten years, that allowable increase has been 3%. Rent on an existing tenants can be raised only 3% per year.
Over that same period, market rent has grown much faster, sometimes 10% percent in a year. However, a landlord can only achieve that market rent increase if one tenant moves out and another moves in. Only at vacancy can an LA landlord charge any price they want and achieve what the market will bear.
So what does it means for an LA landlord if market rent is growing faster than rent control allows. Let’s say that rent control limits increases to 3% while market rent is growing at, say, 5% per year – that’s a conservative average for Los Angeles.
Market rent and controlled rent diverge over time. The starting point is LA’s current median rent, according to rent café dot com, of $2,355 per month, or $28,260 per year. In five years, market rent is 10% higher than controlled rent. In ten years, the gap is 21%, and in fifteen years, market rent is a full third more than controlled rent. In other words, if you’re an LA landlord and place a tenant in a median apartment and prevent any turnover over the next fifteen years, in year fifteen, you’ll collect $44,000 in rent instead of $59,000.
Periodically Restoring Market Rent
This is not a knock on LA’s rent control, which actually provides stability in an otherwise very fluid market and, I think, makes LA a better place.
What I am trying to point out is that, in LA, you don’t want a tenant in place for fifteen years. You want tenant turnover every couple of years so that you can restore market rent to the unit.
This begs an interesting question. For an LA landlord, what’s the ideal length of a tenancy given the costs of a tenant turnover? After all, when one tenant moves out and another moves in, it costs money to clean or renovate the unit, and there’s probably some period of vacancy, too. To answer this question, we’ll make a model.
Investors of all stripes use models to get a sense of possible future outcomes. Real life has too many variable and too much random chance for anybody to know what’s going to happen. But by eliminating variables that aren’t germane to the question at hand and simplifying variables that are, an investor can use a model to inform her or her choices.
The Ideal Length of Tenancy
For our model, we’ll start with the current median rent of $2,355. In our model, whenever there’s a tenant turnover, we’ll say it costs the landlord $1,500 to prepare the unit for the next tenant and that there’s a month of vacancy between tenants. So those are our simplified variables: a $1,500 make-ready cost and a month of vacancy between tenants.
The question is, what turnover rate is most beneficial to the landlord? To answer this, we plugged different turnover rates into our model, then tallied up the cumulative income over fifteen years.
On the one hand, let’s look at an example with no tenant turnover. A tenant moves into the unit at $2,355 per month. There’s no turnover, so there are no make-ready costs or vacancy, and rent is increased 3% per year. Over fifteen years, the cumulative gross rent from the unit will be $525,605.
On the other end of the spectrum, let’s say the same unit sees turnover every single year. Rent starts at $2,355, increases 5% to the new market rent every year with each year’s new tenant, but also incurs a month of vacancy and a $1500 make-ready cost every year. In fifteen years of this scenario, the cumulative gross rent from the unit will be $540,348.
So right off the bat, using the model we created, turnover every year is better in Los Angeles than no turnover. Granted this would likely be more hassle (which has real costs to your mental health) than it’s worth but is that the sound of common knowledge being utterly destroyed?
But what’s the ideal length of tenancy in Los Angeles? Based on our model, it’s four years. Over a fifteen-year period, if the unit turns every four years, it should generate $578,076 in gross income – the highest of the different turnover rates analyzed.
Three- to six-year turnover rates provide the best return. A two-year turnover rate, as well as seven through nine years between turnovers, also provides a good return. But once the unit is turning over every nine years or more, your returns really start to tumble.
Good Schools = Long Tenancies?
So what does this have to do with good schools? I’m not saying you should avoid investing near good schools – especially if you plan on living there with your children during their school years. Incorporating private school costs into the model would also make it look different. But if you’re taking a more tenant-centric strategy the quality of the local public school shouldn’t matter if you’re trying to target that three- to six-year turnover sweet spot.
Who stays in an apartment for three to six years? Families? Not usually. Young professionals stay in apartments for three to six years. If you’re looking at an investment property near Culver City or any other trendy, gentrifying, urban part of Los Angeles, your ideal tenant is a young professional in their late 20s with enough disposable income to afford a good apartment but not enough to buy a house. You want to provide a home to that young professional for the next three to six years, at which point he or she will have enough disposable income to buy a house, and you’ll find a new young professional to put in the unit at market rent for another three to six years.
Until 2019, I lived for a decade in Echo Park, a neighborhood that gentrified immensely in the time I lived there and is now an absolute hotbed of development. Why is Echo Park so hot? Well, it’s between downtown LA and Hollywood, two big employment centers where you find a lot of offices. But more importantly, Echo Park is cool. Some of the best new bars, restaurants, coffeeshops, concert venues, and clothing stores in LA are in Echo Park. And while the neighborhood was pretty affordable a decade ago, now it’s pretty expensive because it’s become so cool. So developers want in on those high rents and they’re building new apartment buildings like crazy.
But guess what Echo Park doesn’t have? You guessed it: good schools. Logan Street Elementary, which covers kindergarten through eighth grade, scores a 2 out of 10 at GreatSchools.com. And the high school, Belmont, comes in at 3 out of 10.
So all I’m saying is, if you pass on a good deal near Echo Park or Culver City or other LA neighborhoods like these because the school ratings are low, well then you’re not paying attention to what the professional LA investors are doing.