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January March 2015 Quarterly Newsletter

P r i n t  |  R e p l i c a

Oahu’s March median sales prices were $700,000 for single family homes (6.5% higher than March 2014) and $380,000 for condos (8.6% higher than March 2014) as the strong seller’s market continues.  Inventory continues to remain historically tight with the single family home market containing 2.7 months of inventory and the condo market containing 3.4 months of remaining inventory.  Economists consider a market with 6 months of remaining inventory a balanced market where neither seller nor buyer has a negotiating advantage and home prices remain relatively constant.

The seller’s market will most likely continue until prices rise to the point where demand drops.  According to a front-page article in the Honolulu Star Advertiser, a government-sponsored study determined that Hawaii needs about 4,000 new housing starts state wide to meet the future demand of a growing population.  Last year, only 800 permits for new housing were approved.  The issue surrounding the amount of red tape involved with new housing starts is unlikely to improve in the current political climate.  Based on e-mail and social media comments, it appears that many of the residents on Hawaii feel that conservation of vacant land important enough to pay for the high cost of housing as it relates to supply constraints based.  Local economists have forecast that current condominium construction in Kakaako will be insufficient to meet the short-term demand for new housing over the next few years.

Sales price appreciation has been much tamer in the current seller’s market when compared to the last seller’s market a decade ago even with historically low interest rates.  We think that stricter lending guidelines has helped keep a lid on the amount that aspiring owner occupants can pay and stagnating rents have limited what investors are willing to pay.

A Mixed Plate of Talk Story

Life in Pahoa is returning to normal after residents have lived under the threat of having their homes cut off by lava flowing from Kilauea’s crater.  Over the past few weeks, the lava flow has slowed, cooled and hardened.  The Hawaiian Volcano Observatory has downgraded the danger to Pahoa from a warning to a watch and businesses that fled the approaching lava at the beginning of the year are returning.  Malama Market returned to Pahoa after closing the week prior to Christmas because of the lava threat.  The grocery store resumed operations on March 18th.  The lava flow stopped 400 yards short of the shopping center.

After eight long days of searching, rescuers were finally able to find and free a 45-foot humpback whale from hundreds of feet of heavy-gauge fishing line that had become wrapped around its tail.  An onshore witness first spotted the entangled whale off the Northwest coast of the Big Island.  The whale circled the Big Island for four days before crossing the channel to the south shore of Maui.  An inflatable boat was used to reach the whale and kegging bouys were attached to the fishing line to slow the whale and keep it near the surface while the line was cut from its tail.  In unrelated news, we witnessed two whales breaching and slapping their tales in the water while camping on the north shore.  We could hear the tale slaps in our cabin.  It was quite amazing.

The tourism industry should enjoy another year similar to 2014’s record number of 8.1 million visitors, according to a forecast by the University of Hawaii’s Economic Research Organization (UHERO).  Leading Hawaii economist, Paul Brewbaker, has argued that tourism is currently capacity constrained since the number of available hotel rooms on Oahu has actually declined over the past decade.  Three announced projects underway should help provide some incremental capacity to the island.  A Courtyard by Marriott hotel will open up next to the Polynesian Cultural Center in June providing North Shore vacationers an option to the Turtle Bay Resort.  Embassy Suites has announced that it will open a second Hawaii hotel in Kapolei with 180 rooms.  And developer, Irongate, has started construction on the second tower of Ritz-Carlton Residences, Waikiki Beach.  The 324-unit West Tower is scheduled for completion in early 2016 and the 246-unit East Tower will be completed in 2017.

The Honolulu Authority for Rapid Transit’s (HART) elevated rail system has dominated the news during this year’s legislative session and most of the press has contained bad news.  Mayor Kirk Caldwell pushed for an indefinite extension to Oahu’s 0.5% General Excise Tax (GET) Surcharge to finance the project that is currently projected to be $910 million over budget.  Several state lawmakers are furious because Mayor Kirk Caldwell was one of the main drivers for pushing through the 0.5% surcharge with assurances that the tax increase would be temporary.  Since the surcharge is not set to expire until December 31, 2022, Governor David Ige has indicated that an extension is not currently necessary and he wants better total cost figures for the project’s completion before taking any action.  HART has been either reluctant or unable to provide a total price tag for the elevated rail project.  Neither the state house nor the state senate has currently passed a bill extending the GET Surcharge expiration date.

In the meantime, the rail project continues to disrupt residents, businesses, and non-profit organizations as people along the approved route are forced to move.  Traffic along the H-1/H-2 interchange has been getting progressively worse as construction above the highway forces lane closures during various times.  To add insult to injury, West Oahu commuters had to deal commutes exceeding 3 hours because the ZipMobile failed on March 31st, clogging up the highway.  According to data released Tuesday, Honolulu had the third worst traffic behind Los Angeles and San Francisco.

Hawaii is ranked the second-worst state in taxing the poor due to the state’s reliance on the General Excise Tax.  Since Hawaii essentially taxes every good and service including rent, food, clothing, and medicine, the poor in Hawaii pay taxes on more items than most other states.  At least the State of Hawaii is consistent in that it taxes all Hawaii residents (rich and poor) more than the national average.

A recent study pegged Hawaii’s construction costs as the highest in the nation and twice that of the national average.  The study by Rider Levett Bucknail validates the complaints of our property management clients regarding repair costs.  Many investor clients just have a hard time accepting what it costs to maintain a property in Hawaii when they compare those expenses to that of similar properties elsewhere in the country.

University of Hawaii’s research on healthy aging is generating interest.  The state of Hawaii has the highest percentage of healthy seniors in the nation.  Bradley Wilcox, one of the world’s experts on healthy aging, left Harvard University over a decade ago to learn why Hawaii seniors are the healthiest in the nation.  While genetics plays a role, foods containing certain nutrients help ward off disease.  Eating the right foods like Okinawan sweet potatoes, turmeric, and certain seaweeds lessen the risk of age related diseases and might actually slow the aging process.  Wilcox co-authored “The Okinawan Program” after studying Okinawans, who are the longest living people on the planet.

Hawaii’s nursing homes have been rated the best in the country according to the latest report from the Centers for Medicare and Medicaid Services.  39 % of Hawaii’s 46 nursing homes received the highest rating of five stars, higher than the other 49 states.  That is welcome news since Hawaii has the most rapidly aging population in the country.

Even though Hawaii has some of the healthiest residents, a rapidly growing doctor shortage is causing concern.  Hawaii’s doctor shortage jumped about 20% in 2014 to approximately 890 unfilled positions.  The problem is likely to get much worse since 18% of the doctors are 65 years old or older.  Time consuming government regulations imposed by Obama-Care and decreasing reimbursements are encouraging some doctors to throw in the towel and discouraging other doctors from starting up their own practices.  The shortages are most acute on the neighbor islands where it is two to three times harder to find a physician.  The growing shortage has also prevented disabled and elderly drivers from obtaining drivers licenses because the review board has four of the five positions vacant for the past seven months.

Hawaiian Electric Company (HECO) is trying to defend their proposal to credit owners of roof-top photo voltaic systems at a lower “wholesale rate” than the current “retail rate” because it claims that the current program shifts the costs of maintaining the electrical grid onto customers that don’t have rooftop systems.  Some installers are urging the Public Utilities Commission (PUC) to turn down this request because it makes homeowners less likely to install environmentally friendly PV systems on their homes.  We would give some credence to HECO’s argument if they did not have a monopoly position in the electricity generating and delivery market.  For their argument to hold water, HECO needs to break out the charges for maintaining the grid versus the charges for producing electricity.  HECO currently charges rates about three times higher than other utilities throughout the nation.

HECO tried to delay all permits for new rooftop solar systems in highly penetrated areas until the PUC rules on their request to lower the reimbursement rate to customers when their solar systems provide more electricity then the home needs.  HECO recently announced their decision to further delay approvals in a letter to customers who have applied for rooftop solar permits.  Critics cried foul over HECO’s attempt to flex their monopoly power over Oahu’s electricity grid and PUC quickly stepped in and informed HECO that they could not postpone permits unless the additional installations would compromise the integrity of the electrical grid. Over 1,500 HECO customers have waited for more than a year to receive approval for their rooftop solar systems.  Some customers have waited more than 540 days for approval.  A report from the Solar Foundation suggests that Hawaii lost 400 installation and project development jobs related to HECO’s permit delays.  The delays have forced solar installation company Electrical Solutions to file for bankruptcy and several more bankruptciess are expected.

Several University of Hawaii sports teams enjoyed more successful seasons this year than in recent memory.  The UH Wahine basketball team finished the season 23-9, finished first in the Big West Conference, and just missed making the NCAA tournament by losing in the Big West Conference tournament final to Cal State Northridge.  The UH Men’s basketball team finished 22-13 and also just missed the NCAA tournament by losing to UC Irvine in the finals.  The UH Men’s effort was more notable because they were able to focus on their games with their star player and former coach, Gib Arnold, embroiled in controversy for NCAA recruiting violations.  The UH Men’s Volleyball team is currently ranked #1 in the nation and enjoying a 14 game win streak.  The UH Women’s Sand Volleyball team (known as the SandBows) is currently ranked #2 in the nation with a 10-1 record.

The future of the 50,000 seat Aloha Stadium continues to be debated and maybe the latest projections will spur the state into action.  Aloha Stadium hired a consultant that recently reported repairs to just maintain health and safety issues would cost approximately $200 million over the next 30 years and would escalate to $400 million if nothing was done for the next six years.  Consultants estimate that a new stadium seating 30,000 to 35,000 fans would cost between $134,000 and $300,000 to build.  Maybe state legislatures will wake up to the fact that it is unrealistic to expect the University of Hawaii to regularly sell out the stadium when taking these facts into account.  Yankee Stadium has a capacity of 50,000 seats (New York City has a population of 8.4 million) and Fenway Park has a capacity of 37,000 seats (Suffolk County has a population of 1.5 million).

The iconic Coco Palms may welcome new guests in the spring of 2017, 15 years after being destroyed by hurricane Iniki in 1992.  Kauai’s planning commission approved development plans and permits on March 10th.  The Coco Palms Hui LLC also plans on opening the ocean-front Seashell Restaurant.  Tim Kelley’s parents stayed at the Coco Palms and ate at the Seashell Restaurant back in the day.  They remember their stay fondly and we would not be surprised if they returned when it re-opened.

Kauai’s Film Commission recently made $3 million in movie production expenditures from “Jurassic World,” the fourth film of the Jurassic Park movie series.  The recent news reminds us of a fond memory involving our son, Mark, years ago.  The family went on a “movie tour” where the guide showed the sites of many movies filmed on the island of Kauai.  The tour was actually well done and the tour guide reminded us several times that Kauai County required all the sites to be returned back to their original state once filming was complete.  The final stop was the site of the gates to Jurassic Park.  When my son saw the old gates to the entrance of the privately owned ranch, instead of the magnificent gates that he expected to see from the movie, he loudly exclaimed “What a rip off!”  After a good laugh, we learned that the gates to Jurassic Park were made of Styrofoam.

Pacific Business News recognized Tracey Stott Kelley as one of Hawaii’s Top 50 Residential Real Estate Agents ranked by Sales Closed in 2014.  Tracey finished the year at #24.  Thank you to all of our clients who helped make 2014 another successful year.

Odds & Ends

Flushable Wipes:  Stott Property Management wrote a letter to their tenants prohibiting the flushing of wipes down the toilets after plumbers had to be called out to remove two main sewer line clogs.  In each case, the plumbers pulled out a wad of “flushable wipes.”  It appears that Stott Property Management is not the only group having to deal with this problem.

In recent years, some adults have started to use wet wipes, long used for baby care, to clean themselves.  Some manufacturers have branded their products as “flushable.”  Wastewater officials and plaintiffs in class action lawsuits against the manufacturers are challenging these claims.

The wipes often combine with other material like congealed grease to create a superknot.  These knots can grow as they travel the sewage system like snowballs and they can eventually overwhelm treatment plants like one in north Brooklyn.  New York City is not alone.  Wet wipes, which do not disintegrate like toilet paper, have plagued many states like Hawaii and Alaska.  A wastewater official was quoted:  “I agree that they’re flushable.  A golf ball is flushable, but it’s not a good idea.”

Mortgage Interest Tax Deduction:  Taxpayers can generally deduct mortgage interest on their primary residence and one vacation home that is elected as a “qualified residence” for tax purposes.  Generally, you can deduct interest on mortgage balances up to $1,000,000 of Acquisition Indebtedness, and up to $100,000 of Home Equity Indebtedness.

There are three pitfalls to avoid when choosing a mortgage strategy:

  1. Pulling cash out of your primary residence to buy a vacation home and then trying to deduct the interest.
  2. Paying cash for a home and then taking a mortgage later.  Deducting the interest is not allowed.
  3. Illegally deducting interest on mortgage balances that are classified home equity indebtedness.

Hire an Experienced Negotiator:  We recently sold two parcels of vacant land for a client that helps highlight the value of hiring an experienced agent to represent your interests in a red-hot real estate market.  We often witness the results of owners who hired an inexperienced or discount real estate agent in a seller’s market because they figure that “anyone can sell the property.”

Stott Real Estate has represented buyers who were not given the opportunity by the listing agent to bid higher in a multiple offer environment.  We are always baffled as to why a listing agent would not want to encourage a bidding war on a property that they listed.

Our clients wanted to sell two parcels of vacant land that were located right next to each other.  Both lots were approximately the square footage and one lot was located on a street corner.  Tracey received multiple offers on both lots and asked the competing buyers to bring their highest and best offers.  Tracey ended up selling the interior lot for $50,000 over asking and the corner lot just above asking.  The extra money the owners made far exceeded the total commission that they paid Stott Real Estate, Inc. and they may have not received that opportunity had they hired an inexperienced agent or discount broker that lacked Tracey’s negotiating skills and tenacity.

Normal Wear and Tear

The term, normal wear and tear, is normally associated with rental properties and we will touch on how to differentiate between normal wear and tear and tenant damage at the end of the article.  This article discusses how normal wear and tear can affect owner occupied homes, second homes, and rental properties.

Hawaii’s Climate:  Anyone that has lived in Hawaii for more than a few years can attest to the toll the warm, humid climate takes on homes.  Exposure to winds directly off the ocean will accelerate the deterioration of paint, fasteners, windows, appliances, and electronics.

Hawaii’s climate allows residents to minimize or avoid the use of air conditioning and the high cost of electricity (3 times that of most areas in the United States) encourages conservation.  Additionally, many older homes, including ours, were built using tongue and groove siding supported by 4 x 4 posts known as “single-wall construction.”  The lack of insulation associated with single-wall construction makes air conditioning impractical and expensive. While single wall construction houses take advantage of Hawaii’s trade winds to keep a home comfortable, the interior of the home is exposed to the same humid air as the exterior of the home.  Appliances, electronics, and fixtures, will rust, break, and fail more often than homes in dryer climates and more often than homes that have central air conditioning and heat.

The high cost of materials and labor compound the expense of cleaning and maintaining a property.  One of the most common complaints that we receive from our clients has to do with the cost of repairs.  Unfortunately, the price of owning a piece of paradise is expensive in more ways than one.

In the span of 10 years, we have replaced every appliance once and our dishwasher twice.  The electronics panel of our third dishwasher does not currently work properly, so we may have to replace our dishwasher once again very soon.  We have replaced each television once and our personal computer twice.  The nails on the side of the house facing the ocean breezes started rusting within one year of painting the exterior.  Every subsequent attempt of rust proofing the nails has failed so far.  We are faced with the need to replace our kitchen and bathroom cabinetry since some of the cabinet doors and drawers do not close properly.  Even though we have become very adept at using gorilla glue (much to Tracey’s chagrin) to hold cabinets together, the wood has started to disintegrate to the point of being beyond repair.

Detailing our experiences over the past decade is not meant to scare away potential homeowners or solicit sympathy.  We are simply trying to establish a realistic expectation of what it takes to maintain a Hawaii home over an extended period of time.  Tim often has discussions with investors who are convinced that careless or destructive tenants drive up their repair costs when the real culprit is “normal wear and tear.”

Inspections and Routine Maintenance:  Inspections are absolutely critical for people that own investment property and second homes that sit vacant for significant periods of time.  One major source of new property management clients comes from owners that have come back to the islands to inspect their rental property and are shocked by how poorly the property looks and functions.

Owners who try to manage their investment property from out of state often rely on tenants to identify and coordinate necessary repairs for them.  Some tenants, will not report problems and either try to make repairs themselves or just live with issues because they are afraid that the owner will raise the rent if “they complain too much.”  The oblivious owner is happy that the “great tenant” pays the rent on time and keeps repair expenses low until he or she comes and visits the home for the first time in five to ten years.  The owner discovers that their investment property is now a “wreck” and the owner does not have sufficient rental income to make the repairs because he or she kept the rent the same for fear of losing the “great tenant.”

Some property managers do not conduct routine inspections and fail to identify and correct maintenance items on a regular basis.  Many of these property managers fall into the same trap of thinking that their tenants will notify them when normal maintenance should be completed.

Problems from Deferred Maintenance:  The biggest problem from failing to address routine maintenance as required is the snowball effect on the cost and time involved to address several years of repairs all at once.  Many people can handle a few hundred to a few thousand dollars and coordinate the efforts of one contractor as needed.  Few people can write a check for tens of thousands of dollars and efficiently coordinate the efforts of several contractors when a house has suffered neglect over an extended period of time.

Repairs tend to get more expensive over time when left unaddressed.  A simple matter of repainting the exterior when it wears becomes much more expensive if the wood rots when surfaces get exposed.  Torn screens can lead to pest control problems and neglected leaks can lead to higher utility bills and water damage.

Renting a property with deferred maintenance invites a host of problems.  The most responsible tenants typically have a minimum set of standards that a poorly maintained home fails to meet.  The resulting tenant pool is limited to those tenants that have limited options due to financial constraints or credit issues.  Additionally, many tenants will feel that they don’t have to care for a rental property if it appears that the owner does not care about it.  It is very difficult to identify and properly document tenant damage and withhold funds from a security deposit in a poorly maintained home.  Owners that rent poorly maintained properties run a greater risk of having to evict a tenant and suffer large losses from unpaid rent, attorney fees, and cleanup costs.

Strategies for Success:  We typically recommend condos and townhouses in well-run associations for investors and people seeking second homes.  Maintenance fees cover insurance for the building and external maintenance.  Therefore, the only wear and tear that an owner has to worry about addressing personally are the contents of the unit and possibly the windows and entry doors.  Owners in an association can also benefit from lower maintenance costs associated with economies of scale.

Investors should hire a property manager that offers routine inspections as part of the service and uses third party contractors to conduct any necessary repairs.  There is a potential conflict of interest if a property management company also has an in-house repair organization.  You don’t want to be boosting your project management company’s bottom line by paying for unnecessary repairs.  We have hired property managers to manage our Texas investment properties even though we have extensive property management experience.  It is extremely difficult to manage a rental property when you are thousands of miles away.

Consider hiring a home inspector to do an inspection about every five years if you own a second home (particularly if you visit infrequently or make it available to friends and family).  We are aware of an inspector that offers a discount to his standard rate for existing homeowners.  You will receive an unbiased opinion on the condition of your home and can address repairs before they become more expensive problems.

Documenting Tenant Damage:  The state of Hawaii requires that the landlord obtain a signed property inventory and condition from the tenant when a tenant checks in.  If the landlord does not obtain a signed copy of the property inventory and condition form, then the landlord may not withhold any of the tenant security deposit for cleaning, repairing tenant caused damage, or replacing missing items.  Stott Property Management takes a video of their rental properties when a new tenant checks in to provide a visual record in addition to the signed property inventory and condition form.

Disintegrating screens, rusted fixtures, disintegrating curtains, faded paint, and worn and faded carpet, and dry rot, are all considered normal wear and tear.  Obvious tenant damage consists of holes in walls and doors, stains, unapproved modifications, cracked and broken surfaces, and bent window treatments.  Trying to charge a tenant for “normal wear and tear,” may land you in small claims court.  The Hawaii court system is very tenant friendly and a landlord’s documentation must be in order if a tenant ever challenges money withheld from the security deposit.

Selling is an Option:  As a general rule of thumb, an investor will need to put down at least 50% of the sales price to break even on a rental property.  Oahu investors typically receive a far lower cash flow than investors who buy property in other parts of the United States.  We believe that a real estate investment should improve your monthly cash flow.  Think twice before turning your existing home into a rental if your calculations project a negative monthly cash flow before repairs.  You would be better off selling and placing the tax free capital gains into a savings account.

Homeowners that live in their homes for more than two years receive a significant tax break if they make money on the sale of their home.  The capital gains tax exemption is $250,000 for a single person or $500,000 for a married couple.  This huge tax advantage starts to disappear once you turn your home into a rental.  Several would-be landlords decided to sell once we helped them crunch the numbers.

If you currently own a Hawaii rental property, and you are unhappy with your cash flow, then consider conducting a 1031 exchange into another property that will provide you with more potential.  We recently covered 1031 exchanges in our last newsletter and we can send you an overview if desired.  If you are interested in more details about a 1031 exchange, then please check the appropriate box on the business reply card,  call us at 800-922-6811, or email at [email protected].

If after crunching the numbers, you are still unsure as to whether you want to sell or rent, then we can put your property on both the sales market and rental market at the same time.  Please contact us at 800-922-6811 or [email protected] if you would like to discuss selling versus renting in greater detail.

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