Why the Vast Majority of Investors Should Stay Far, Far Away From D-Class Properties
There’s been a lot of chatter on BiggerPockets lately about D class properties and the dangers that such properties pose, particularly to newbies. Mark Ainley says they’re for advanced investors only, Ben Leybovich advises against buying anything under $30,000, and even I have thrown my hat in the ring by denouncing the devious impostor known as the 2 percent rule.
But I think this point needs to be highlighted again, as I’ve seen multiple newbies or out-of-state investors see their equity go the way of the Dodo bird with properties that look fantastic on paper, but only on paper.
A real estate agent I work with used to find properties for a hedge fund shortly after the crash. He set a brokerage record by closing 86 properties in one year, all under $10,000. The hedge fund's goal was to buy properties for no more than $9,000 and be all in to them for no more than $13,000. Then they would sell the properties owner-financed for $500 down and $500 a month.
At first, it appeared to be working. Even when a property was so thoroughly damaged they couldn’t bring it back, they were into it for so little that it didn’t matter.
But these types of mistakes stacked up on top of each other over and over again. Buyers who had made their payments for a few months started missing them more and more, and eventually the fund collapsed under the weight of countless boarded up, dilapidated properties.
And I should note, this was a large, seasoned company that fell to the D-class property temptation — not some first-timer.
The Temptation to Buy $20k Properties
Indeed, I experienced that temptation myself when I first came out to Kansas City from Oregon. Where I was from, houses started at $100,000. And that was for turds. Now there were houses that looked OK listed for $20,000 or less! Apartments being sold for $15,000/unit. Oh my!
A friend of ours who was investing there from out-of-state would run the numbers on these properties and come to ridiculous cap rates of 15 or whatever. But the thing is it doesn’t matter if it looks good on a pro forma. No one ever got rich off of a pro forma.
Our friend ended up losing the properties he bought out here, and we took it on the chin on the first property we bought that was in a rough area (an apartment we bought for $16,000/unit).
And we had been investing in real estate for decades.
I have seen investors who have made it work in rough areas. There are good tenants there so it’s certainly possible. But they all fall into one of three categories:
- They live there and know the area extensively.
- They are a seasoned investor and have decided to specialize in D properties.
- They wholesale and flip (i.e. they don’t hold them). Often they sell these to out-of-staters and some of them, unfortunately, a bit unscrupulously.
If you don’t fall into any of those three categories, I would highly recommend you stay away from D properties in rough areas. (And if you fall into the third, you should really up the quality of property you are turning to ensure your clients make money.)
The Reason It Is So Hard to Cash Flow D Properties
I’ll let Mark Ainley paint you the picture on how it can be to try and lease such a property:
“We got some leads on the property and some applications, but they were terrible. Criminal records, evictions, extremely low credit scores — you name it, and it was probably on one of the applications. So the property continued to sit on the market. The cost of getting a bad tenant is much higher than the cost to let the property sit, so it continues to sit until we can find the right tenant.
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This isn’t uncommon for these few properties that I have. Tenant moves in, stays for a couple years, then moves out, and it takes me a couple months to fill it. The vacancy rate of property management companies and individual properties can be very different, especially if the properties are spread over different classes.”
Square foot for square foot, a roof costs the same on a D property and a B property. Cash flow simply does not go up evenly with rent. Instead, it looks more like a bell curve, with the best cash flowing properties being near the lower middle of the market. The very bottom and the very top usually lose money.
Let's run the math. So let's say you have 123 OK Street. You're all into it for $100,000, and it rents for $1,000/month (a 1 percent rent to cost). You get a 75 percent loan at 6 percent interest only. The expenses add up to $4,500/year, and you have 10 percent vacancy:
Scheduled Rent: $12,000 ($1,000/month)
Vacancy: $1,200 (10 percent)
Debt Service: $4,500 (6 percent interest only)
Cash Flow: $1,800
Now, let's say you buy a property on 456 Skid Row. You are all in for $30,000, and it rents for $600 a month (a 2 percent rent to cost). You somehow get the same loan on this one. But because it's in a bad area and you have to deal with what Mark Ainley described, the vacancy is now 20 percent. While the taxes are lower, the maintenance and turnover are higher so the expenses are the same. Here's what you have:
Scheduled Rent: $7,200 ($600/month)
Vacancy: $1,440 (20 percent)
Debt Service: $1,350 (6 percent interest only)
Cash Flow: -$90
Now, maybe you think you won't use a loan or you can beat 20 percent vacancy. You very well can. Some do, and they do well. But what it leaves aside is that you have a very small margin of error. And what really kills these properties is what I will refer to as the Disaster Tenant.
Oh, the dreaded Disaster Tenant. If you think a tenant can’t do $10,000 worth of damage, you are unfortunately quite mistaken. I’ve seen it done, and it has even happened to us before. And usually you won’t be collecting any of that above the deposit once you finally regain possession of your broken, decrepit property.
Yes, you must screen diligently. And for the most part, when you do, you can avoid such problems. But sometimes bad tenants slip through the cracks. Or if you keep a property vacant too long, especially in a rough area, you may have an unwelcome, short-term Disaster Tenant who decides he likes all of the copper in your house and it should belong to him instead of you. An HVAC system can cost $4,000 to replace. How long will it take for the cash flow from such a property to make up for that? And that’s assuming the plumbing is left alone.
Such properties require too many things to go right for too long to make sense to most investors and all newbies. It can certainly be done and done well for a good profit. But if you don’t specialize in these areas, I highly recommend you don’t try your luck at them.
[Editor’s Note: We are republishing this article to help out investors newer to BiggerPockets.]
Investors: Do you agree with this assessment? Do YOU ever invest in D-class areas? Why or why not?
Leave your comments below!