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Posted about 6 years ago

Do Cheap Properties Really Cash flow Better?

It’s been nearly 10 years since the foreclosure crisis of 2008, yet there still seems to be an endless supply of cheap houses with eager investors willing to take a chance on them in the hopes of high returns. But are these cheap properties with promises of great cash flow and high returns really good investments? Read on to see why they are not for most investors

Normal 1520651014 Cheap Properties

Cheap Doesn’t Mean It’s A Bargain

Let me start by saying that "cheap" is all relative. What is cheap in one market is not cheap in another. A $75,000 3Br 1.5Ba in the Midwest property might look cheap to a California investor, but that $75,000 house might only be worth $60,000 and isn't such a great deal after all. Unsuspecting out of state investors often over pay when they think they are getting a great deal because they didn't take the time to understand values which can vary neighborhood to neighborhood and even street to street in some cities.

But, a bigger mistake inexperienced investors make is not understanding the neighborhood on the ground level. They get lured in to buying super cheap properties because the ROI's look so good on paper. Unfortunately, most of those ROI's are about as good as the paper the pro forma's are printed on and never materialize.

Even when a buyer is fully aware that the cheap property they have found also happens to be in the “hood” they talk themselves in to thinking that all they need is a good property manager that can somehow find a good tenant that is willing to live in a neighborhood that they themselves wouldn’t set foot in. Even if your property manager walks on water, they can't work miracles and turn bad tenants in to good ones. And that's the problem with these cheap properties. Most are located in high crime areas that don't attract desirable tenants. Their high vacancy rates and turn over costs are cash flow killers and can easily be the difference between a profit and a loss for the year.

Unfortunately, the real estate agent or the turn key company that you are buying from isn't always motivated to educate you on which areas to avoid. In fact, many agents and turn key companies focus on these low end neighborhoods because the returns look so appealing to out of state investors that don't know any better. When things go bad, and the will, the investor shouldn't be surprised. There's a reason the property was so cheap to begin with.

Looks Can Be Deceiving

Crime level is one of the primary factors to look for when assessing and choosing a property or neighborhood, but how do you know if the neighborhood is good? The house may look good in pictures but looks can be deceiving. Even Google Maps street view might not give an accurate picture of the neighborhood. Look at the two houses below. They are very similar, well maintained craftsman style homes. Would you be surprised to learn that one is in a very low crime neighborhood while the other is in the “hood”? The heat maps clearly show that, yet they are less than 1 mile apart.

Normal 1520651148 Neighborhood Crime Comparison

The cash flow myth

The attraction of cheap, low priced properties is the promise of high cash flow, but do they really have high cash flow? The answer is no, and the reason is simple math. It’s impossible to squeeze more cash flow out of $600 rent than $900 rent. That’s because operating expenses don’t decrease proportionately with rent. In fact, CAP Ex and maintenance will be disproportionately higher. It costs the same to replace the HVAC, fix leaky pipes and get a property rent ready again at tenant turn over on properties renting for $900/mth as it does for one that rents for $600/mth. The math doesn’t work, and it becomes nearly impossible to have positive cash flow.

A turn key company selling properties for $40K-$50K doesn’t have the margin to do a quality renovation required for a good rental. There’s not enough meat on the bones for them to replace the HVAC, roof or to remodel the kitchen and bathrooms to make them attractive to better tenants, so although your cash on cash ROI might look good the first year, you’re going to be stuck footing the bill for those big CAP Ex repairs down the road.

Also, do not confuse cash flow with CAP rates or COC returns. Low priced properties theoretically have higher ROI, but they can never produce as much cash flow as properties with higher rents.

Do these cheap properties in low end neighborhoods ever pay off?

The only time I would recommend this type of property is to an experienced, local investor that can be very hands on and already has a substantially large portfolio that is looking to diversify and add higher risk assets. Think of it as stock. Would your first investment be a highly speculative stock? Probably not, so why would you make your first real estate investment speculative and high risk? Those that do get turned off when their investment goes bad and give up on real estate when the real problem was that they just bought the wrong property in the wrong area.



Comments (2)

  1. Great post.  I especially like the point about the disproportionate repair-to-rent ratio.

    It doesn't mean B's necessarily have better cash flow, but it does mean that you have to do your calculations right.  Don't just use the gross rent multiplier. A lot of people look at that and assume that C's are better.

    Traditional analysis says to charge 5-10% of rent for maintenance.  But maintenance has nothing to do with rent. You should create an equation that relates it to: 

    1) condition

    2) square footage

    3) number of units (a duplex with 2 kitchens and 4 bathrooms will have more maintenance than an SFR with 1 kitchen and 2 bathrooms even if the SQFT and condition is the same)

    The capex is also not related to rent, it is just a dollar amount based on the condition of the big ticket items.


    1. Correction: In general B's have better cash flow but C's have better COC ROI.