Real Estate Arbitrage

Real Estate Arbitrage is a strategy that is commonly used especially in urban and highly populated marketplaces.  However, it’s not a topic that is talked about a lot. If you live in a market where it’s difficult to get properties to produce positive cash flow, this is a  strategy that you should consider as part of your overall investment strategy.   What is an arbitrage? An arbitrage is a purchase of an asset in one market for the purpose of making that asset available in another market to take advantage of inequities in price. In real estate, when you wholesale or flip a property you are in effect participating in a type of real estate arbitrage. However this is not the type of arbitrage I am referring to  here. The type of arbitrage that I am referring to takes place in the rental market.    So how does the real estate arbitrage strategy work in the rental market?   With this strategy, you purchase a property for a certain amount. However, instead of renting out the entire property to one renter, you rent out different parts of the property to different renters. This allows you to generate a higher monthly cash flow because of economies to scale. In any rental market, the smaller the size of the unit the more money you make per square foot when compared to similar units of larger sizes. A tenant renting out a 1 bedroom apartment is generally going to pay more per square foot than a tenant renting out a 2 bedroom apartment in the same market.   Here’s an example of how this works.   Suppose you are looking to purchase property in Forest Hills, New York, a good middle  to upper middle class neighborhood in New York City area.  Here are what the average  rents are for apartments in this area: 1BR - $1300 to $1400 a month 2BR - $1400 to $1600 a month 3BR - $2000 to $2500 a month 3BR House $3000 to $3500 a month     The average 3 bedroom 2 bathroom house goes for $700,000.  The mortgage alone based on an interest rate of 6.25% and a 20% down payment is going to be over $3400 a month. If you rent this house out to a tenant, even if you can get $3500 a month you are still going to have a negative cash flow property.With the Real Estate arbitrage what you would instead do is rent out the bedrooms to three different tenants. Each tenant would have exclusive use of the bedroom and shared use of the rest of the house. Suppose you charged $1300 a month to each tenant?   Multiply that times 3 tenants and the monthly income for this property now goes to $3900 a month. Whereas in the first scenario, this property would have produced a negative cash flow, in the 2nd scenario this property produces a positive cash flow.   Is a house out of your budget?   No problem!  You can purchase an apartment and  implement this same strategy. You can purchase a 3 bedroom condo for $500,000. With a down payment of 20% and an interest rate of 6.25% your mortgage comes out to a little over $2400 a month. Like the house scenario trying to get a positive cash flow by renting out the entire  apartment to one person is going to be difficult at best.  Even if you charged $2500 a month, you will still experience negative cash flow when you factor in taxes and insurance. Once again, the arbitrage strategy works in this scenario as well. Using the arbitrage strategy and renting the apartment out to 3 separate tenants, even if you only charged $1000 a month, you would still have positive cash flow from the unit overall.   There are some investors that take this strategy to the extreme.  For instance, I have seen some investors put as many as 2 beds to each bedroom, plus 2 additional beds in the living room. The investor rents it out for $500 a month per bed to 8 different tenants. With the apartment scenario, even if your expenses were $3000 a month, under this scenario the investor would make $1000 a month positive cash flow. I personally don’t recommend that strategy as it may be illegal in many areas of the country. You will need to check the laws in your area.  In addition a strategy like that would only work if you target specific communities that don’t mind such shared living quarters.     Two examples are college students and immigrants who have just moved to the country or are temporary in the country on a student or work visa. In addition to the additional cash flow, another advantage of using the real estate arbitrage strategy is lower vacancy costs.  If you rent an apartment out to one tenant and that tenant moves, that apartment produces no cash flow for the duration that the property is vacant. With the arbitrage strategy if one of your tenants moves out, instead of having an empty apartment producing zero cash flow, you have an apartment that still has other tenants paying rent. While you aren't going to receive the full cash flow during this period, the  good thing is that you will at least receive some cash flow as opposed to nothing at all.There are some disadvantages to this strategy as well.   For example, if there are damages to the property, there’s really no way of knowing who is responsible for the damages unless the damages are in one of the specific bedrooms. Trying to prove that in court or penalizing all of the tenants may prove difficult depending on what the laws and regulations are in the area that you are looking to invest in. Finally, you should note that the arbitrage strategy works in other ways as well.  For instance if you have a commercial space, you can rent out part of the space to another company. I've seen some owners even set up a single desk and telephone line and rent the desk out to a business owner that wants to have an office but only really needs one desk.  Be creative and you will find many ways you can use this strategy to profit  from your real estate investments.     Want more? Visit: www.misuniversity.com