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January to March 2018 Quarterly Newsletter

P r i n t  |  R e p l i c a

Oahu’s median sales prices in March were $760,000 for single-family homes (1.1% higher than March, 2017) and a record $435,000 for condos (8.8% higher than March, 2017). Single-family home sale prices have flattened over the past year and may have reached the limits of affordability for Oahu’s current income levels. Supply continues to be extremely tight with only 2.1 months of remaining inventory for single-family homes and 2.6 months or remaining inventory for condos. Recent bills passed addressing “monster homes” and changes to affordable housing rules will dampen development of additional housing. The supply constraints are likely to continue in both the short and long term and the housing cycle will continue to be driven by changes in demand. Affordability will constrain future price increases and rising interest rates pose the greatest threat of an eventual market downturn.

The University of Hawaii’s Economic Research Organization (UHERO) reports strong visitor growth. 5% more tourists visited Hawaii last year than in 2016 and the numbers will likely continue as airlines add to the number of available seats to the islands. Airlines have 10% more seats available in April compared to last year with Kauai seeing a 60% rise from the Western U.S. and Kona experiencing a 30% increase. Economists struggle with predicting when tourists will no longer be able to find places to stay as politicians drive an ever-larger percentage of accommodations market underground. Transient Vacation Rentals remain a major source of controversy on the islands and public dialog still focuses on trying to catch and punish property owners that violate city land and building codes. A Hawaii columnist accurately described a major driver behind the law-breaking trend by quoting one property owner. “People have worked out a way to actually pay their bills and get ahead for once. I don’t see how we can be treated as criminals when we are just trying to purchase property in Hawaii and have help paying for it.

A Mixed Plate of Talk Story

Hawaii real estate investors should keep a close eye on a bill that passed over from the Senate to the House that would seek a Constitutional amendment to increase taxes on investment real estate to fund public schools. The state teachers-union is pushing the bill that would establish a “surcharge” on investment homes valued at more than $1 million and on visitor accommodations. State legislators and public school teachers apparently took notes when the City and County of Honolulu successfully raised taxes on a majority of out of state property owners that can’t vote in Hawaii’s elections.

Carl Bonham, executive director of the University of Economic Research Organization (UHERO) briefed the House and Senate money committees, he outlined the benefits of accelerating the development of 33,000 additional new homes over the next seven years and cautioned that building so many more homes would require changes in the way that the state and the counties regulated development. Bonham estimates that the residential building would add an extra 0.5% to the state growth domestic product (GDP), and increase employment about 1%, and attract about 5,000 people to a state that has been experiencing a decline in population. Unfortunately, state legislators did not take the brief to heart. House Finance Chairwoman Silvia Luke focused on her favorite punching bag, Mayor Kirk Caldwell, by implying that nothing was happening at the city level, yet she failed to mention the regulatory hurdles created by the Department of Land and Natural Resources (DLNR). Senate Ways and Means Chairman, Donavan Dela Cruz, summarized the presentation as “another plea” to cope with the housing crisis. While Bonham framed the issue as an opportunity if lawmakers reduced regulation, the “housing crisis” will likely continue by the lack of action at the county and state levels.

Mayor Kirk Caldwell recently signed a bill into law that imposes a moratorium of up to two years on building permits for houses whose interior square footage exceeds 70% of the lot size. For instance, a house may not be larger than 3,500 square feet on a 5,000 square foot lot. The new law has already affected a couple of sales for property that Stott Real Estate, Inc. has listed with development potential. The moratorium will not help Oahu’s affordable housing problem.

The state house of representatives has submitted a budget that removes the $8 million requested to fund existing homeless programs and provides $30 million for “ohana zones” across the islands against the recommendation of the U.S. Interagency Council on Homelessness and the U.S. Department of Housing and Urban Development. The national agencies report that government sanctioned tent cities don’t work and only distract communities by arguing whose neighborhood should host them. A recently shuttered temporary ohana zone highlights the problems of the tent cities. Of the 51 homeless that stayed at the camp while it was open for eight months, 28 were kicked out for behavioral issues or drug use, arrested, or left voluntarily. While two people found permanent housing, four moved in with family, and 17 others were placed in other temporary shelters, the camp failed to keep the chronically homeless off the streets and failed to help those suffering from drug addiction and mental illness. Most Hawaii residents feel that the homeless situation is getting worse and state officials are failing to take effective steps to alleviate the problem.

Stott Property Management, LLC’s recent experience with the City and County of Honolulu’s approach to housing the homeless made the Honolulu Star Advertiser’s article covering U.S. Vets master lease approach timely. We recently started managing a property that housed a tenant receiving financial support from one of the non-profits funded by the city. The non-profit e-mailed over a contract for Stott Property Management, LLC to sign that required the company to open its books to the city and non-profit if they suspected that the tenant was being treated unfairly. In other words, Stott Property Management, LLC would have to put up with a “fishing expedition” if the landlord tenant relationship went sideways. Stott Property Management, LLC refused to sign the contract and gave the tenant and the non-profit written notice to vacate after reading the onerous contract. The tenant vacated and left truckloads of personal belongings and trash behind when checking out and the non-profit took no action to remedy the situation leaving the owner holding the bag. U.S. Vets on the other hand, signs a “master lease,” and takes full responsibility of the rental property and then houses homeless veterans. The organization pays the monthly rent regardless of occupancy and is required to return the condition back to the landlord in the same condition minus normal wear and tear once the lease arrangement ends. This arrangement is a much better approach to helping those in need get off the streets.

Catholic Charities Hawaii has taken matters into their own hands by building Meheula Vista, a senior affordable rental project in Mililani. The second phase of the four-phase, 301-unit project, was recently dedicated and the charity is breaking ground on phase three. Each phase consists of 75 affordable units that provide one bedroom, one bathroom, a full kitchen, common areas, a community room and a resident manager’s unit. The non-profit decided to start with low-income seniors because they are a growing segment of Hawaii’s population. It is expected that more than 25% of Hawaii’s population will be over the age of 60 by 2020.

A Hawaii appeals court has ruled that bed-and-breakfast business owners may not discriminate against gay couples, even if the owners live at the residence. The judge ruled that owners living in the same dwelling shall not refuse people based on their sex, sexual orientation, or marital status if the rental is on a short-term basis. The judge found that a bed-and-breakfast is subject to the state’s public-accommodation laws like any hotel, motel, or inn.

The Armed Forces Disciplinary Control Board put out an advisory in late December warning service members of violent crimes occurring in Waikiki. According to the notice, the board estimates that there have been more than 1,000 violent drug and alcohol-related arrests in the vicinity of the intersection of Kalakaua and Royal Hawaiian avenues and the intersection of Kalakaua and Kapahulu. Mayor Kirk Caldwell only became aware of the notice in mid-January. Police have responded by using new recruits to increase police presence in Waikiki during the late-night and early-morning hours.

On Saturday, January 13, 2018, many people in Hawaii received the following emergency alert on their cell phones: “BALLISTIC MISSILE THREAT INBOUND TO HAWAII. SEEK IMMEDIATE SHELTER. THIS IS NOT A DRILL.” Fortunately, Tim’s general cynicism concerning the competency of large bureaucracies (government and non-government), and more specifically Hawaii’s government bureaucracies, turned out to be true. Tim told Tracey, the state of Hawaii government just screwed up an emergency drill. It took the state 43 minutes to broadcast that the emergency alert had been sent out in error.

Both the state and the FCC conducted an investigation into the incident. The findings from the state’s internal investigation revealed that the employee who sent out the emergency alert confused an exercise recording that started a drill, with a real threat. Five other employees executed the drill correctly. According to the report, the employee had been a source of concern for more than ten years due to poor performance and had previously confused drills for real events. The investigator documented in the report, “I find a preponderance of evidence exists that insufficient management controls, poor computer software design, and human factors contributed to the false alarm and its delayed retraction.” The FCC weighed in by stating that The Hawaii Emergency Management Agency (HI-EMA) did not establish proper protocol or resources resulting in the false alert and delayed retraction. The HI-EMA administrator and another executive resigned and a third supervisor is facing suspension without pay in addition to the fired employee.

A recent paper published by the University of Hawaii Research Organization by a grad student reported that 2019 is the best time to invest in a PV system with a battery backup. The working paper by a Ph.D. student analyzed the declining costs of battery systems, pending reduction in federal tax credits, and a range of electricity rates. The student concluded that homeowners who invested in a system in 2019 would improve their net savings by 17 – 32% on Oahu compared with buying the same system in 2017. The paper provides food for thought for homeowners on both Oahu and the outer islands.

Record tourist numbers and social media posts that make finding Oahu’s scenic hikes easier to find have resulted in ever increasing numbers of rescues by the Honolulu Fire Department. A typical search and rescue operation for hikers involves 12 to 17 personnel and costs about $1,500 per hour. At the more popular tourist destinations like Diamond Head Crater and the Lanikai Pillboxes, rescue teams typically treat people for heat exhaustion or sprains. However, more dangerous hikes can result in serious falls. In a two-week span this past January, firefighters airlifted three people who fell from 20 to 75 feet on the Pali Notches trail which leads to the highest point on the Koolaus. In fact, several hikers suffering serious falls were taking selfies at the time. Experienced hikers recommend hiking with a club first before tackling more difficult hikes on your own with friends. Officials at the Department of Land and Natural Resources recommends sticking to the state maintained Na Ala Hele trails system where information can be found on www.hawaiitrails.org.

Rising alcohol bills at bars and restaurants show consumer confidence according to economists and local craft breweries and distillers appear to be benefiting from enthusiastic tourists and locals. Tim and Tracey visited Waikiki Brewing Company in Kakaako recently to try out their craft drinks and smoked meat before seeing comedian Bryan Regan at the Blaisdell Concert Hall. The food, drinks, and service were excellent. Waikiki Brewing Company has two pubs located in Waikiki and Kakaako.

Hawaii’s Merrie Monarch festival paid a special tribute to the Hokule’a, the Hawaiian ocean sailing canoe, when it returned to Hilo for the first time since 2014. The Hokule’a left Hilo in 2014 for its world-wide tour showcasing the Polynesian navigating techniques that brought the original people to Hawaii. The crewmembers of the original voyage in 1976 were given special canoe paddles and the hula dancing featured themes of voyaging.

Researchers at Maui’s Pacific Whale Foundation are trying to determine the reason for the drop in Hawaii Humpback Whale sightings over the past three years. Biologists don’t currently think that the whales’ numbers have dropped and are investigating a shift in the whales’ yearly migration patterns. Until recently, February has been the peak whale-sighting month.

The brush-tailed rock wallaby are native to Australia and look like tiny kangaroos. Two wallabies escaped from a private zoo in 1916 and they established a colony that is estimated to currently consist of about 40 animals in Kalihi Valley. An injured male wallaby was found near the Halawa Correctional Facility and zoo officials conducted surgery to remove an injured eye. Zoo officials suspect that the animal was injured in a fight with another animal. The zoo is currently looking for a permanent home once the wallaby completely recovers from surgery.

There were fewer than 60 Nene left on the planet in the 1960s. Today, there are nearly 3,000 and the Nene could be removed from the endangered species list next year.

Tax Changes

Stott Real Estate, Inc. is not licensed to provide legal or tax advice. Licensed professionals such as attorneys or certified public accountants should be consulted concerning questions related to tax strategies.

The Tax Cuts and Jobs Act of 2017: The law changed taxes for both corporations and individuals. At the corporate level, the graduated income tax rates with a top rate of 35% was replaced with a flat tax of 21% and the alternative minimum tax was eliminated. The corporate tax overhaul provided business both tax relief and simplified the tax code. Most of the discussion in this newsletter is limited to changes with the individual tax code and changes that can impact real estate investment since Stott Real Estate, Inc. specializes in residential real estate.

While the law did lower individual tax rates across the board for all income levels, the law did not make filing any simpler. In fact, the law most likely made tax planning more complicated because Congress had to placate many special interest groups in the Republican Party to pass on a party line basis and reconciliation rules required budgetary changes to expire. The law also left the Alternative Minimum Tax and the Obamacare Tax (3.8% tax on interest, dividends, and capital gains on high income individuals) in place. The law did reduce the fine for failing to obtain federally approved medical insurance to zero. The lower rates are set to expire on December 31, 2025.

The new law limits the mortgage interest deduction to interest on $750,000 of acquisition debt ($375,000 for married taxpayers filing separately) for mortgages starting on December 15, 2017. Homeowners whose mortgages started before December 15, 2017 may still deduct mortgage interest on $1,000,000 ($500,000 for married taxpayers filing separately) of acquisition debt.

The law limits itemized deductions for all nonbusiness state and local taxes including property taxes to $10,000. That does not go far in a state with high taxes. A married couple that owns a $700,000 house (below the median sales price on Oahu) will max out their tax deduction at a combined income of $98,875.15.

Real Estate investors can also take advantage of writing off investments per Section 179 of the tax code for roofs, heating and air-conditioning, fire protection, alarm systems, and security systems in addition to improvements of the interior portion of a building previously allowed. Like-Kind Exchanges per Section 1031 of the tax code for investment real estate remains.

Hawaii Act 107: The 2017 legislature raised taxes for high-income individuals and families. Taxpayers filing jointly pay a 9% marginal rate for income over $300,000 ($150,000 if filing separately), 10% marginal rate for income over $350,000 ($175,000 if filing separately), and 11% for income over $400,000 ($200,000 if filing separately). Hawaii taxpayers in these income brackets will already have reached the $10,000 cap on state and local tax deductions.

Residential A Changes: Residential property on Oahu without a Home Exemption is considered Residential A. Residential Property with a Home Exemption is taxed at 0.35% of the assessed value. The Honolulu City Council has raised the property taxes on Residential A properties as follows:

0.45% of the assessed value up to $1,000,000

0.9% of the assessed value for property over $1,000,000

If you are living in your Oahu home and have not filed for a Home Exemption, then you should do so immediately. Not only are you paying high property taxes, those property taxes may no longer be deducted from your federal income tax bill.

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 15 years, Tracey and Tim have replaced every appliance once and our dishwasher three times. 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 recently replaced all of our kitchen cabinetry because the cabinets that came with the home literally disintegrated. Gorilla glue can’t delay a kitchen remodel indefinitely.

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.” We can assure you that we have not been abusing our house or our belongings.

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 their routine. Stott Property Management, LLC inspections serve three purposes. We check to see how the tenant is taking care of the property, we look for unreported maintenance issues that should be addressed, and we communicate normal wear and tear items that should be addressed either immediately or during the next vacancy. 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, LLC takes digital photos or 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.

The most common make-ready bills that Stott Property Management, LLC charges tenants after they check out involve cleaning and disposing of personal items left behind. We make sure that carpets have been professionally cleaned prior to a tenant checking in so that we can require the tenant to professionally clean the carpet when they move out. Making sure that a property is clean before a check-in helps minimize, but does not entirely eliminate, arguments over cleanliness during the checkout. Keep in mind that dirt is not normal wear and tear.

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, cracked and broken surfaces, and bent window treatments. Trying to charge a tenant for “normal wear and tear,” may land you 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.

Second homeowners should be aware of a recent change in the federal tax code’s treatment of mortgage interest. Taxpayers can still write off the mortgage interest on a second home, but the combined value of the two mortgages (primary and second home) may not exceed $375,000 if filing singly and $750,000 if filing jointly. People that live in expensive zip codes that own a second home on Oahu may find that the reduced tax savings makes maintaining two homes unaffordable.

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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Area # Price Range
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