5 Risks of Buying Rental Properties in Declining Markets

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You’ve probably heard that the key to real estate investing is “location, location, location.” This is true for all different aspects of a property’s location—the larger metro market it is located in, the specific area of town, and even the specific neighborhood. Some cities can literally vary street to street in terms of where is good to buy and where isn’t good to buy.

The very first thing that comes into my mind when someone asks, “What city should I invest in?” is “A growth market!” A growth market is arguably one of the most critical aspects of any location you choose to invest in.

Why? Because investing in a declining market can pose major risks to an investment, much more than in a growth market.

Growth Markets vs. Declining Markets

There is no set guarantee that any one market will always be either a growth market or a declining market. A growth market can always switch to a declining market, and many formerly declining markets have been able to turn themselves around into growth markets. However, none of us knows when or if this will happen, so the best we can do is be as smart as we can in trying to predict which direction a market will go and deciding where we should invest.

In short, a growth market is one that has a proven trend of growth. The population continues to increase. Why would a population continue to increase? The main factor will always be jobs. If a market always has plenty of job opportunities, people will continue to live and move there.

What is the most secure way of ensuring there will always be lots of jobs? Industry. If a market is home to several big industries or smaller but extremely stable industries, job creation will continue. Conversely, a market or city that has only one major industry is at risk for losing jobs if anything were to happen to that one industry.

The secondary factor in a population continuing to increase is desirability. There should be something about a city that makes people want to live there. Southern California, for example, has arguably the best weather in the country, a million amazing outdoor opportunities, and a high quality of living. People will probably always be drawn to live there, even if they have to figure a way around the job options there.

A rural area in a northern state with notably horrible weather may have a harder time sustaining a population if it doesn’t have a lot of job opportunities.

Name a city with several large industries and therefore plenty of jobs, paired with some qualities that draw people to it, and you are likely looking at a solid growth market. Atlanta, for example, has been one of the largest growth markets I’ve seen over the past 10 or more years. The number of industries there has increased tremendously, and people are inclined to move there because housing is so affordable, and it’s a warm-weather city.

It’s close to Florida, there are a lot of cool cities people can drive to from Atlanta to visit, it’s near some amazing mountains, and people tend to really enjoy southern hospitality (it’s a real thing!). Atlanta has gotten so popular over the past decade because of all of these things. It doesn’t look like Atlanta will be declining anytime soon.

Related: How the “Second Wave of Suburbanization” Will Change Housing Markets as We Know Them

Think now about a lot of the Michigan cities, including Detroit. Remember when the automobile industry went belly-up? Well, guess what one industry had been sustaining most of Michigan? Automobiles. All of a sudden, a lot of Michigan jobs plummeted, and there was nothing in Michigan so amazing that kept people coming. People began leaving. They had to find jobs elsewhere, and there was nothing left.

Many will argue that Detroit is fixing itself and is up-and-coming, but I really don’t think anyone can argue that Detroit hasn’t been a declining market over the past years.

To read more about growth versus declining markets, as well as stable markets, check out “How to Know if Any Given  Real Estate Market Is Wise to Invest in (With Real Life Examples!).” There are two example of large metro markets in there, with statistics, to further give you examples of what kinds of things may determine whether a market could be considered growing or declining.

Now what are the risks if you go the route of investing in a declining market? Why would it matter? Is it really worth passing up such affordable prices and well-advertised returns? Why would you not want to do that?

Let’s talk about it.

The Risks of Investing in a Declining Market

As always, I speak from the perspective of rental properties because those are what I work with and invest in myself. However, these risks certainly do pertain to the BRRRR strategy, since that strategy ultimately leaves you with a rental property, but some of this may pertain to flipping as well depending on the timeframe you are working in. Flipping won’t pose quite as drastic of a risk because you are more likely to unload the property before the market changes too drastically from what it is when you buy the property, but certainly the ARV of a flip in a declining market won’t be as high as it could be in a growth market. Flippers will want to keep in mind exit strategy (which will be talked about in a second) and property values, to whatever degree it may pertain to their situations.

So, why not buy a completely affordable investment property that offers seemingly great returns in a declining market? Well, if you do, here are the risks you are potentially taking on.

Property Values

Have you ever heard that you make most of your money on an investment property when you buy? It’s true. The price for which you buy a property will greatly determine what level of profit you can expect to see from your property, from both a cash flow and an appreciation perspective.

But what happens if the property value continues to drop during the time you own it? This is what will likely happen if you buy in a declining market. As people leave a market because fewer jobs are available and people generally don’t have a desire to go there or live there, property values will have no choice but to reflect that. As demand goes down, prices and values will have to go down. The value of your property doesn’t matter if you aren’t buying it or selling it, so the value of your property won’t directly impact you a ton during the time you own the property (with a couple of exceptions that will be talked about in a minute), but it will impact you when it comes time to sell the property. You may think you never need to sell the property and can hold it forever, but there are some factors that may cause you to rethink that.

Before we talk about those, let’s get back to this value situation.

Exit Strategy

The term “exit strategy” refers to your exit plan for your property. Do you plan to sell it or hold it forever, and if you eventually sell it, who will you sell it to? Will you continue to hold the property and refinance it to roll that money into more investments? The only one of those options where the property value doesn’t matter is if you hold it forever, but again, we’ll get to whether or not you’re likely to remain interested in holding onto that property forever.

Assuming at some point you will want to sell the property or even refinance it, the property value suddenly matters for your bottom line. If you have to sell for lower than you bought it, which is likely with a declining market, you are losing money. Always keep in mind that you will make more money selling to a primary homebuyer than an investor, so think about who would want to buy your property in that declining market in the long-run. You always want to be thinking of how to maximize your sale price, and market fundamentals absolutely play a large role in this.

Rental Income

Now, rental income directly correlates to your monthly cash flow. If you own a rental property that sustains a good monthly cash flow, meaning the income outdoes the expenses, you may never need to sell your property, so the value of your property wouldn’t matter. However, the bad news comes when you find out that typically rents will also go down in a declining market. Again, it’s about demand. If people don’t want to move or live somewhere, rents will reflect that. The lower the demand, the less you can charge in rent.

This factor might change your mind about holding onto that property forever. Even if it doesn’t change your mind on the property value front, it may change your bottom line into the negative. If rents at some point go lower than your mortgage and expense payments, you’re now losing money every month. If you are in a declining market, your property value is likely going down as well, and you’re losing on the equity/appreciation front. Basically, your main profit streams are now losing.

So, what do you do? It’s turning into a lose-lose situation. You lose if you hold it; you lose if you sell it. Again, if the rental income were to never change during a declining market, you could still be fine with that reduced property value. But it’s not likely that will be the case.

Rentability

What if you suddenly start having a hard time renting out your property at all? If people are leaving a city, there will eventually be a bigger inventory of vacant houses for rent. There may not be enough people living in the city to fill all of those houses at some point. I remember one time going to Grand Rapids, Mich., on a work trip years ago, and it felt like a ghost town, with probably 75 percent of the retail stores completely empty. This wasn’t long after the major automobile industry crash, and the city had nearly cleared out.

The same thing can happen with residential properties—more properties sit vacant because there are just not enough people to fill them all. Maybe you can still rent out your property, but it might take longer and longer to find tenants. Every day that a rental property sits vacant, it’s losing money. Especially if you have a mortgage on the property, several months of vacancy can kill your bank account. Remember, whatever rental amount is advertised for an investment property is worthless if you can’t actually rent the property out.

Tenant Quality

Maybe you can still rent the property. But who are you renting it to? You also won’t be able to collect an advertised rent amount if the tenants who move in don’t actually pay it or if they cost you a fortune in expenses, including eviction expenses. The worst part about eviction expenses is that it’s not just the eviction itself that costs you money; it’s the accompanying non-payment of rent for however many months and the consequential months of vacancy once the tenants are finally gone.

Related: What to Do if You’re Located in an Expensive Real Estate Market

If you think of a declining market—good jobs are far and few between, there isn’t a lot of diverse industry, and people generally don’t want to live there—what kind of people are most likely to live there? Oftentimes those who may not financially be able to leave. In my experience, bad tenants have been the most costly expense. Every major expense I’ve ever had on my properties has somehow been due to a bad tenant. Again, there’s no guarantee for good or bad tenants in any market or neighborhood or property, but you are either increasing or decreasing your chances with tenant quality depending on where and what you invest in.

I’m saying all this not to scare you or discourage you. Rather, I want to encourage you to understand where and what you are buying. Many investors put money into markets that I personally deem to be declining and that I would have no interest investing in myself from a fundamental market perspective. Or I hear of investors investing in extremely popular markets that aren’t declining markets right now but that may have risk factors for becoming a declining market in the future.

There will never be any rental property in any condition, in any location, that offers a 100 percent guarantee of success. The best any of us can do is try to mitigate risk as much as possible. A lot of risk can be mitigated by studying your market. When you invest in a growth market, you are maximizing your chances for seeing an increase in value on your property, for having the most and best exit strategies available to you, for sustaining rents and hopefully increasing them, and for keeping your property rented as much as possible with quality tenants.

I’m not to say a rental property can never succeed in a declining market, but why take on such dramatically higher risk levels? If you’re just an adrenaline junkie or you feel good in riskier spaces, or if you have the skills and education to take on these markets, then go for it. But as with any decision you make in real estate investing, be able to back up your decision with solid education. If you choose to invest in a declining market, do it only if you understand the risk.

If you want to read more about market analyses and different factors that determine a market’s viability for being an investment market, outside of just whether a market is a growth market or declining market, check out “How Do Real Estate Markets Differ and Which Should You Buy In?”

What’s your take? Any major market wins or losses that you can tie directly to market fundamentals?

Share below!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.