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Should Your Rentals Be in a Stable or Shaky Neighborhood?

by Paula Pant on April 24, 2013 · 35 comments

  
Neighborhood

The other day, someone emailed to ask: “What cap rates do you look for when you buy a rental?”

It seems like a simple question, but it’s impossible to answer. There’s no magic number that I search for, because the cap rate needs to be put into context.

If I’m buying a property in a highly-desirable part of town where I’m likely to have top-notch tenants, I’ll accept lower returns. And if I’m buying a rental in a more volatile part of town, well, I expect to be compensated for the added risk.

Which leads me to the age-old rental investing question: Which is better? Should you buy rental properties in an area that’s stable and desirable, or an area that’s shaky but yields higher returns?

Obviously there’s no “right” answer to this question – your choice depends on your goals, risk tolerance, and the specific details of your area – but let’s dig deeper into the question.

Merits of a Stable Neighborhood

I’m going to use myself as an example: One of my properties is located in a fantastic neighborhood in Atlanta (Midtown). It’s walking distance to Atlanta’s most famous park, Piedmont Park, which means that the area has an “economic moat” that can’t be replicated. Add that to its proximity to walking/biking trails, restaurants, bars, fitness centers and other amenities, and the end result is a sought-after location that attracts high-quality tenants.

One of my tenants has a masters degree. Another is a recent graduate of pharmacy school. Broadly speaking, I don’t anticipate that these are the type of tenants who will rip through my drywall to steal the wiring.

They’re not necessarily “long-term” tenants, though. Some tenants have spoken to me about their job prospects in other cities like Washington DC or New York. Others have indicated that they hope to buy their own home soon.

Nonetheless, I can rest assured knowing that the tenants want to preserve their high credit scores, and these units are easy to fill.

Related: The Ultimate Guide to Tenant Screening

DeMerits of a Stable Neighborhood

The biggest drawback, of course, is that the returns in this neighborhood are comparatively far lower than what you can find in other areas. I got lucky with this particular property, which I bought in 2010, but I’ve spent the last two years trying to replicate the deal – and I just can’t. That’s why I haven’t bought anything else in this area.

It’s tough to find something in this neighborhood that’s even cashflow positive (after accounting for management, vacancies and ongoing maintenance), and it’s nearly impossible to find something that meets the 1 percent rule or has a decent cap rate.

What About a Higher-Risk Area?

One of my other properties, a single-family home in a lower-income area, boasts much higher returns (I bought it for $21,000, put $10,000 into fixing it up, and it rents for $900 per month – nearly hitting the 3 percent rule).

But some of the prospective tenants who have toured the home have told me crazy stories or made off-the-wall requests. The house demands a lot more tenant management and the vacancies take longer to fill.

Related: Should I Buy a Rental Property with Great Cash Flow in a Bad Location?

I recently outsourced the oversight of that home to a property manager, which diminishes my workload, though that house presents some nagging worries in the back of my mind. Nonetheless, it compensates me handsomely for those concerns.

So which neighborhood is “better”? I don’t think there’s any right or wrong answer. But I’m interested in hearing from other landlords, in the comments, about whether you prefer:

1) Lower returns with less risk
2) Higher returns with greater volatility
3) Some alternative scenario

Leave your comments below!

Photo: jafsegal

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{ 35 comments… read them below or add one }

James April 24, 2013 at 8:55 am

I would propose finding rentals in neighborhoods that are either-

1) on the upswing already
2) that you can improve and push into a positive direction. This way, you can obtain properties at decent prices (giving you immediate cash flow) and the returns continue to increase over the following decade.

This strategy may require small investors to band together to purchase a large amount of property and fix it up in a neighborhood, and you will want to make certain that you trust your fellow investors to not be slum lords, but I theorize that such a strategy may work very well if executed correctly- and if you can find enough investors that are trustworthy in your area to work together (or have the resources yourself to execute).

I would love to hear form anyone who has actually tried a similar strategy.

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Paula April 24, 2013 at 9:28 am

James — That’s funny that you mention that. The other day I was thinking about a few up-and-coming streets in the Atlanta area. “If I could buy every home on that street, fix them up, and rent them out, I could completely redevelop it … ”

Of course, I don’t have the time, capital or experience to do that on my own. I’d need trustworthy partners. Which always seems to be the hard part ….

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Esau September 2, 2013 at 7:03 am

James,

That is a great way to turn neighborhoods around. As investors, we can make a difference. Look at the possibilties in neigborhoods near the city. I have a property with a view if the downtown skyline and near a MARTA train line, these are great investments even though it’s a transitional neighbrhood in the city of Atlanta. I have an investor wth a poorly run down house next to mine and I’m trying to buy it.

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Kevin Polite April 24, 2013 at 9:04 am

James, I’ve often thought about your idea and think it would work wonderfully profitable. Finding the right neighborhood and partners would be key.
Paula I invest in Atlanta as well and wouldn’t even have the capital to invest in Midtown, but if I did there are several 1 and 2 story apt buildings with about 10-20 units that would be perfect for a complete gut and remodel as upscale rentals.

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Paula April 24, 2013 at 9:29 am

@Kevin — I know what you mean! I don’t have the capital to “go heavy” in Midtown … if I could, I would. I’m pretty much priced out of this neighborhood.

What area in Atlanta do you invest in?

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Kevin Polite April 24, 2013 at 10:32 am

@Paula. We just started 2 years ago and all are in Decatur, 2 flips and 2 buy and holds and we just purchased another one. I like to say there are 2 Decaturs, City of Decatur and the rest. I focus on the Decatur in unincorporated DeKalb that is close to the city portion. City of Decatur is pretty much like Midtown as far as pricing and trying to meet 1% rule. I marvel at the folks finding $50k prop and put in $10k and can rent for $800, which are rare anywhere “ITP” For now i manage all myself and I just don’t want the hassle

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Paula Pant April 25, 2013 at 12:00 pm

@Kevin — I have a property in the “other” Decatur, too (not the City of Decatur, but the “other” part of it …. OTP and south of I-20).

Yeah, the City of Decatur is exactly like Midtown … stable houses, but a high, high purchase price and it’s hard to meet the 1 percent rule.

Esau September 2, 2013 at 7:07 am

I have 3 properties in the area near Second Avenue in Decatur. I have started to see a major change in great tenants moving to that area. I hope great investors seek that area.

Brandon Turner April 24, 2013 at 9:24 am

Hey Paula,

Great article! Welcome to the team :)

I use to be much more “shaky neighborhood adverse” but I’m starting to realize that there is a difference between dangerous and low-income, so I’ll look at low-income as long as the numbers are good and I account for the obvious problems, vacancies, increased repairs, etc. I’m not sure I’d recommend a newbie to do it, and I invest 99% for cash flow (I don’t look for much appreciation.)

Thanks for the awesome post!

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Paula April 24, 2013 at 9:30 am

@Brandon — Thanks! I’m like you, I prefer cash flow. That seems to be a common symptom of rental-property addicts like ourselves. :-)

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Sharon Vornholt April 24, 2013 at 2:12 pm

Brandon – It’s the number of gunshots per hour.

Sharon

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Esau September 2, 2013 at 7:13 am

Hey Brandon,

I also invest more in low end rentals now. I have both and you are correct, there are low end rentals and there are dangerous neihborhoods. There is a difference……Low end is great for what I like and that is great cash flow. If we get more investors like you, we will turn these areas around….

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Jose Gonzalez April 24, 2013 at 9:55 am

Hi Paula,

I have been buying rentals for year and a half now, first I thought that newer, better neighborhoods would be the best way to go. They provide me from 1.3 to 1.5 per month, all foreclousures and this numbers include the repairs.

Still, all my new acquisitions now are lower income areas, cheaper and smaller houses but what I have found is that when you go and buy between 40k to 60k houses, even though they are older… with the repairs that you can make in volume discounts those might even be as good as the newer houses, just a little more monthly repairs.

That beeing said, I believe that is not the house itself that has to be the main focus. If you are able to get a 50k house in a decent (by decent I assume that a HOA is in place and the neighborhood looks maintained and the yards in order) neighborhood the most important thing is to find GOOD tenants, pick them up strictly with more background check intensive than the higher income ones… I achieve this not myself though… I have a great property management company that does this for me since they neither want to manage bad tenants!!

So beeing in both sides of the coin, Im more like Brandon Turner said… A complete CASH FLOW guy so I seek for the higher yields and focus more on the details to reduce management risks.

Thanks for the post!!

Jose

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Paula Pant April 25, 2013 at 12:03 pm

@Jose — $50K houses (purchase plus initial repairs) in an area with well-maintained yards is a great find. The market (in Atlanta) is getting more expensive … Most of the $50K houses that I look at have overgrown front yards with cars propped up on cinder blocks in the front. :-) If I could find a great $50K in a nice neighborhood with great tenants, I’d be all over it!

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Keith Dunn April 24, 2013 at 10:01 am

Hello Paula, I work with investors in Detroit that will ONLY rent to section 8 tenants and average 15% and more in some cases. If you want HIGH returns, section 8 is the way to go.
GUARANTEE INCOME is a must with lower income areas. Section 8 tenants will get you there. Most people think Detroit is the WORST place on the planet yet it generates over a BILLION dollars a year in rental income. with a population of about 700,000 people. The average rent is 750/mo. About 130,000 people rent single family homes in Detroit.85% are section 8. You can buy a 3 bedroom 1 bath brick house rehabbed and rented to a section 8 tenant for 35-40k. As a wholesaler you can be all in for 20-25k then flip it for 35-40k. The KEY is knowing what areas to buy and have your exit strategy in place before you buy.

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Dawn A. April 24, 2013 at 12:12 pm

I get properties in the middle — not warzone, but not high-end. This seems to work well for me.

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Anubhav April 24, 2013 at 12:13 pm

Thanks Paula Pant for sharing your experience….and Keith Dunn explain about guaranteed income….I 100% agreed….

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Sharon Vornholt April 24, 2013 at 2:17 pm

Hi Paula – Welcome to the blog.

Both types of properties have advantages and disadvantages. But if you intend to be in the game for the long haul, you usually can’t go wrong in nice middle of the road houses that will continue to appreciate.

Those really low end cash cows that could be labeled “disposable houses” won’t take you down the path of long term wealth like the other ones.

Sharon

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lisa April 24, 2013 at 2:32 pm

Well, every market is different. My 35k, built in 2010 2 bedroom condo in Columbus OH is in a middle class neighborhood earning 700/mo. However, my low income John Hopkins East neighborhood in baltimore, definitely low low income, rents for 975, and costs 40k for fix/rehab. Higher cash flows for the low low income area, definitely. And in richmond, my current acquire/rehab is 45k, and I can gt 900/mo in rent, and that is a lower middle class neighborhood. I am sorta hooked on lowermiddle class area (where there are jobs), than the others. The cash flow is great without the worry of being *jacked* when you least suspect it. Also, if I feel comfortable as a single female, thats my major concern. I have felt comfortable in certain “warzones” and not in others. My gut is the final decision maker. And,I have a great property manager that whips them into shape with a trip to rent court when they don’t pay, so I worry less now.

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Jeff Brown April 24, 2013 at 5:51 pm

Welcome to BP blog, Paula.

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Paula Pant April 25, 2013 at 12:03 pm

Thanks Jeff!!

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Dennis April 24, 2013 at 9:48 pm

Easy answer: If you invest in nice neighborhoods where tenants have masters degrees, you will need to keep your day job, and take on the risk of lots of leveraged properties. These properties will need to be a cut above unless there is a major rental unit shortage.

Low income you pay cash or make a great owner financing deal, this is why it is best to buy on the cusp of once nice areas now on the road to becoming complete rental areas. Section 8 rentals are a key marker to a neighborhood change over. A few Section 8’s in an area spells owner occupied flight. It may be different in your area, but not in mine.

With low income the cash flow is instantaneous, if not you paid too much, cap rates mean nothing, nor does cash on cash return. If you are smart you should not buy anything that requires any of your own money be used unless you can quickly get it all back.
Return on investment should be an infinite number, as none of your money should be in the deal.
With low income you will not need to own, many properties, vacancies are not really that big a deal as the monthly nut is just about nothing. I have a house that has been vacant for 2 years, do I care? Not really I paid $13k the owner gave me a 100% loan at zero percent interest with a payment of $150 a month until it was paid off. The payments started after I had a tenant in place. I turned the place into a rooming house with three men paying $125 a week for the first year, that is $1612 a month rent, or $19,350 in the first year.

The total taxes on this house were $178 a year, insurance $500, utilities $1500 a year, mortgage payment $1800. Let’s round it all off $2200 and double it for vacancies (never one) and maintenance (none this folks are curmudgeons). $14,900 net, do this for 2 years which is work as curmudgeons are a management challenge. Show these folks the door, use the profits to renovate the house into a single family nice enough place, rent for $900 a month. Accept this time all you need pay is taxes and insurance, the tenants get all the other bills, including small ongoing maintenance.

You can see owning just owning ten of these would end most folks need for a day job, owning 20 ends a need for a 401k. With 20 a management company could give you lots of spare time to fiddle away.

Not get rich quick without working a bit, but not so bad if you plan things right.

One piece of advise never buy a rental property near a bar, one day the place will be selling drugs and bullets will be flying. Low income people sometimes have bad habits, these habits will chase other low income people out of your rental units. The tenants that will fill the void generally like drugs and bullets flying, these same folks are hard to extract money from.

Peaceable low income areas are what you should be looking for.

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lisa April 25, 2013 at 9:54 am

So true. Having a property mgmt team means big checks keep coming in, and if you do the rehab correctly, the only thing you have to worry about is the taxes and water and very little maintenance.

To be honest, people have a perception of fear in these neighborhoods. That means that there are a ton of cashflowing opportunity. I see people purchase properties for 100k, and rent for 1000/mo, where I have the same cashflow but paid a total cost of 35k. I don’t feel my way is necessarily better, its just interesting how different the clientele become and cashflow opportunities.

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Phil Damjanovic April 26, 2013 at 1:00 pm

Dennis,

What I’d love to know is how you talked a seller into owner financing 100% at no interest, and no payments until a tenant is in place?!?! Was the seller desperate? Or are you just a slick smooth-talker???

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Dominique Brown April 25, 2013 at 9:02 am

I think you need a healthy mix, but if I had to choose one.. I’ll take multiple of the shaky neighborhood all day. This has been my bread and butter for the past 4 years. You mentioned one key thing… Management. If you’re not the property manager, remember you do not have to deal with the headaches of the lower end area.

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Paula Pant April 25, 2013 at 12:07 pm

Hey Dom! Fancy seeing you here! :-) I know you’ve had great success with your Section 8 rentals. I’m with you — I like a healthy mix of both — although if I had to choose just one, I’d take the lower returns / nicer homes route. It might make as much money, but I like the peace-of-mind. :-)

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Jeff Brown April 25, 2013 at 10:06 am

After my third bad experience in less than a stellar location, I made the decision to insist on stellar quality. The acid test has evolved to, ‘Would I put my 82 year old mom to live there alone?’ There’s no wiggle room in that question.

Sometimes this isn’t possible in certain — most? — markets. That was true for me in San Diego, which is why I shook the dust of that region off my shoes forever. Location quality is valued more or less by different investors for sure. Folks do what remains in their comfort zone. Mine doesn’t allow me into less than ‘Mom’ areas for long term investments.

Short term investments? Still won’t venture into war zones for any reason. However, we have no problem whatsoever in taking on projects in average or slightly below average areas, then selling them to investors with different comfort zones.

Comfort zones rule all of us, right?

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Scott Smull April 25, 2013 at 10:52 am

I purchase single family homes in low income areas in the city of Philadelphia for one reason only; CASH FLOW! I personally interview and run extensive background checks on ALL adults living in the home or should I say on the lease. I have had a few bad ones get past me but each year I get better and better. All come with stories and more stories but I make it clear verbally and in writing no excuses, no drama, and no disrespect to the home or my workers will ever be tolerated. I make these homes 2013 safe, clean, and quite frankly very nice residences if taken care of. I need the cash flow and cannot hope for possible long term appreciation except that if it should happen —Halaluhah!

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Amie April 25, 2013 at 6:10 pm

I actually own one house in a desirable neighborhood in one city and another house in a less desirable area in another. I agree with what Brandon said, low income doesn’t necessarily mean dangerous, depending on the area. The better property typically rents faster and to higher “quality” tenants, yes, but the lower income area residents typically don’t move for reasons such as buying a new home or getting a better job out of state. In fact sometimes less than perfect credit can mean they stick around for a while so it’s not such a bad thing if they are reliable (a big if at this point).

If I were to buy another property I’d buy for the cashflow in a lower income area. Appreciation is very hard to gauge and I don’t like saying too many “what ifs” but the market could drop out just as you want to exit the market or retire whereas with cash flow you’ve already had your answer on the property. Also with low cashflow properties you need more capital all around to keep things going.

Something I’ve had to watch out for is if you are out of state it can be hard to find management companies for lower income properties or they can proportionally charge higher fees for those (for example they charge 10% or $135/mo min, or don’t manage properties that rent for under $x/month). I can see them trying to protect their interests but this is something I have run into that can bring costs up.

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Melisssa Woycechowsky April 26, 2013 at 5:45 am

I manage rentals in a mostly low income areas in Syracuse. I think if you live in the area and know how to fix things and are very choosy who you rent to there is a good chance to make money. If you live out of town and you want to go the low income route, you have to work very closely with a good property manager or you will end up losing money very fast.

Many of the people I manage for are not making money. Some of them bought at inflated prices and high interest during the real estate bubble. Some bought the cheapest property they could find. Most of them had management that was incompetent or crooked before I took over, charging outrageous prices for work that was done badly or not at all. Now the delayed maintenance issues are coming home to roost. It’s hard to get good tenants in properties that have been neglected, but the owners have poured so much money into them that they are broke.

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Esau September 2, 2013 at 6:55 am

I personally did not invest in lower end rentals until last year. I think having both works great for me. I am very pleased with the results i’m seeing from my low end rentals. I make it a point to introduce the potential tenants to the neighbors, it builds a bond and they tend to stay longer and pay their rent. Not all of the low end tenants pay late, these tenants in most cases just want a decent place to live. I also get many referrals for these areas. I think failure comes when investors over invest and rents are too high for the area. I’ve seen rentals in areas I get $700 a month and other homes are way overpriced at $995 a month in the same area. It’s easy to own homes outright in these neighborhoods. Esau

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Michael September 13, 2013 at 12:07 am

Have owned homes in Dubai and Abu Dhabi since 2005 and was able to pick up properties at 12-13% yields, now prices have gone up to the point where you can’t find anything above 7% yields. Have now done research on Atlanta (50-60k), Charlotte (70-90k), South Bend (25K section 8 homes). Found this article very useful but want others feedback as to whether I can build up a portfolio while living overseas, let me know if these resources would be enough to get started.
1. RE Agent that knows my criteria
2. Strong reputable property management company that caters to my type of property

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Frank November 9, 2013 at 6:15 pm

What is the 1% rule? searched the BP site & nothing came up – (2% & 50 % did)

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Paula Pant November 9, 2013 at 11:01 pm

@Frank – It’s a modified version of the 2 percent rule, in which you look for gross income that’s at least 1 percent of your purchase price. (In other words, a $100,000 house should rent for at least $1,000 per month, gross). It’s useful if you’re buying nicer houses in nicer neighborhoods.

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Frankie Woods September 24, 2014 at 12:14 pm

Great article. I started in higher end properties, buying mostly primary residences every 3-4 years. For the most part, I’ve like the appreciation. However, I bought a higher yield property meeting the 2% rule a couple months back in a C neighborhood. I haven’t stabilized it yet, but am excited about the possibilities. I will admit, it’s a little harder to sleep at night now though, haha!

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