My Out-of-State Search: Sidebar - Buying Site-Unseen

I once had a financial adviser.  He was a nice, professional and charismatic guy. But after meeting him, and then hiring him, we fired him shortly thereafter.  For all of his likability and underlying knowledge about finances, he failed to understand one key principle: the appropriateness of all investments is unique to the situation.

Over the last several weeks, I've been wrestling with an investment hurdle: should I invest in city where I've never been, or should I stick the money in the S&P for a while?  To address this, I searched forums and blogs.  I spoke with experts.  I reviewed what little literature I was familiar with.  And I had a discussion on the BP Forums(Link).  And I didn't get my answer until I realized a key key principle: the appropriateness of all investments is unique to the situation.

Many investments are universally bad, but good investments are far more difficult to define.  Volatility, accessibility, yield, risk, transparency, control, relationship to inflation, security, portability, taxes, etc. are just some of the features of an investment.  All-to-often, people lock into the "total return" metric, and while that's important, it's rarely the most important indicator of a "good" investment (though is a good way to differentiate REIs that are similar in other measures).  As such, the appropriateness of investing in a house and in a city where you have never been, is a decision that should consider how each of these characteristics of the investment fit with the individual, his/her goals and current portfolio. 

In this post, I will attempt to explain the characteristics of investing in unseen markets, and then explain why I believe my course of action is the appropriate one for me and my family.

Characteristics of Unseen Markets

Buying in an unseen market is simply more risky than buying in a market that you've walked.  This is the elephant in the room, and a point that any out-of-state investor must understand.  With that said, seeing a property on a weekend visit is still miles away from being a market expert, but walking a street is certainly better than having never been to the city.

There are many reasons for this increased risk, but here are what I believe are the most prevalent:

• Neighborhood.  Just as important as the street that the house is on, is the neighborhood that the house is in.  What do the parks look like?  The schools?  The grocery stores?  How nice are the nice places and how bad are the bad ones?  Are the homeless people walking around?  Hookers on the street corner?
• 
  
• Street.  Streets have a feel that largely impact a houses appreciation, rentability, rent amount, ability to sell, etc. etc. etc.  What do the lawns look like?  Are houses vacant?  Are there dead cars lining the street? Are there hookers walking the street?
• 
  
• House.  You will always notice things when you walk a house!  Or - at least you should.  And many of these do not get conveyed in pictures or video.  Note that a decent inspector should tell you if there are structural concerns, but he/she will not tell you if the paint is chipped, the carpet smells bad, or the back yard is loud with road noise.  Is there a hooker buried in the back yard?
• 
  
• Team.  It is true that no one will look out for your interests as well as you.  And most people on your team including your RE agent and PM will have some sort of a conflict, meaning they get paid if you buy.  While this is always the case, when you're buying unseen - you must put a lot of trust in their judgments.  
• 
  
• There is also risk that your team is either unethical or idiotic.  And even if they are competent, assembling and managing a team is more difficult if you're buying in an unseen market.  This poses both threats to revenue, capital expense and operating expenses.  The extent to which a nominal visit changes this is unclear.
  

Characteristics of unseen markets: Return and Yield

Investing in a market where you have connections and expertise will be more profitable than the alternative.  However - I would argue that the difference between buying unseen, and having toured the property once, is negligible.

Risk Mitigation

The above list of risks paints a scary picture.  But, I think that this list can be mitigated (not eliminated) through several strategies:

1. 
   
2. Street.  Google Street View is a wonderful tool, and while it will not speak to everything, I would argue that it's very useful.  Looking at comps (sales and rental) is also a good way to address this.
3. 
   
4. Neighborhood.  There are oodles of information online such as park reviews, school reviews, school rankings, company reviews, crime rates, street views, etc.  Again, these are not 100%, but can provide an overview of the area.
5. 
   
6. House.  In addition to 100+ pictures, video of a property is probably a must.  Multiple, non-correlated options of a property are also helpful, and will provide insight into the house, street, neighborhood, etc.
7. 
   
8. Team.  This is actually not a major concern of mine.  Online reviews are helpful, and I have experience working as a recruiter where my job was evaluation of competency by phone.  I'm not certain that I won't make a mistake on this front, but I feel confident that if I make the mistake from afar, that I would have made that same mistake in-person.

Additionally, there are a few things that help to minimize the potential impact of these risks:

• 
  
• Market Health. A market vacancy rate and housing market health play big factors to mitigate risk.  If you swing-and-miss in an area with a high vacancy rate and unhealthy/unstable housing market, your losses may double those of a similar swing-and-miss in a low-vacancy/stable market.  Note that low-risk markets often have a lower upside.
• 
  
• Hiring a consultant.  We plan to hire someone who is familiar with the local market and pay them a flat fee for a review of the property (removing all conflict of interest).  This person would have no connection to anyone else on the team, and would be in addition to a traditional inspection.  In fact, we may hire that person through BP.  We plan to do this, and have included it in our budget.

But the biggest way to mitigate this risk is to be able to have the assests to absorb a worst-case scenario.

Worst-case Scenario

Let's assume that we swing-and-miss; and we miss badly!  We put $25,000 down on a $100,000 place that everything goes wrong on, such as:

We overpay by 5% ($5000), in an area that depreciates by 2%/year for 2 years ($4000).

We buy in a bad rental market, and get rent way lower than expected and have a towering vacancy rate of 50%.  On average, we lose $400/month.

We get a horrible tenant who doesn't pay/get evicted, costing us $2000.

That tenant does damage to the property, costing us $5000.

Then we sell ($9000 closing costs/agents/minor repairs/etc.)

If the damns burst and everything goes wrong, over 2 years we lose $400/month in cashflow, $9000 in equity, and $9000 in fees, and $7000 in repairs/evictions  All told, down ~ $35,000 meaning we lose our capital + $10,000.

Would we be upset?  Of course.  Actually, I don't know that "upset" would begin to capture how we would feel.  We would be pissed!!!  But, would the wife and I be OK?  Yes.  Would we be OK financially?  Would we still be OK if other bads happened on our other rentals?  Yes.  And would we still be on track for retirement?  Yes.

Don't get me wrong, we couldn't do that too many times before we would have to make some difficult decisions, but remember that risk declines over time - both as you buy additional properties and become more familiar in the market, and as you buy additional properties and increase your portfolio size, and as time passes and your percent leverage declines, and as your 'at risk' rental gets some history behind it.

Summary

Out of state investments are risky.  And, buying without seeing the property increases that risk!  Being hyper-diligent can help to mitigate these risks, but many risks will remain and have actual costs associated with them.  Plan for these, budget for them, and base your decision on the worst case, rather than the best case scenario.

As such, I do not advocate that most people buy out-of-state.  And if they do, the clear best-practice is to view the property prior to purchase!

But, the appropriateness of all investments is unique to the situation.  And fortunately, we are in a position where we can manage much of that risk, and in a worst-case scenario - absorb the rest.  To say it another way, we keep a large cash-reserve for a rainy-day fund, and this buffer enables us to take risks like this without posing serious challenges to our financial standing.  

Tally Ho!