Investing in low income areas?

Question

Hi Bigger Pockets,

I am not sure if this topic belongs in this forum or not.

This is my second year of investing; I have rented one sfh, flipped two houses and currently renovating a third house with the intention to sale.

I am considering buying a home with the intent to hold in a town that is not so great.You can pick a home from $20,000 to $40,000 that does not need much work with rents ranging from $600-$900.The cash flow after 8% vacancy and 10% PM, and other expenses is around 45% for the deal I’m looking at assuming 20% down for financing.

Btw, this area is not a “war zone” and boarded up houses, it is just mainly low income and higher than average crime rates.I can look in better neighborhoods/towns and should be able to come up with cash flow numbers between 20-30%.

I am a softy, and tend to believe people at face value so I would be using a property management company.  My question, what is your opinion investing in these neighboring’s that are mostly rentals with the majority made up of section 8 and welfare?   Should I stick to lower rates of return or give a high cash flow, and more risk a try?

Thanks,   Jason

Roy N. · Answer

@Jason Genovese

We've encountered basically three kinds of lower income neighbourhoods:

blue collar - moderate houses, a sense of neighbourhood exists, crime is not necessarily any higher than {lower} middle class areas. The population tends to be long term (fewer turnovers) We would classify these as class C neighbourhoods:  very good rental income for the price of the asset(s), but do not anticipate any appreciation.

The lost/perimeter neighbourhood - I cannot think of an appropriate label for this type of neighbourhood (basically it is neither blue collar nor a war zone).  It shares traits with the blue collar areas (moderate houses), but lacks the sense of neighbourhood.  There is crime, but mostly of the vandalism - petty crime degree.  The population tend to be more transient (higher turnover) and you will find more folks on social assistance and more {overt} drug presence.  Perhaps the local economy is dying (wee see this in small towns).  We classify these as "D" neighbourhoods.  Similar rental income to the Class C assets, but maintenance and turn-over costs will be substantially higher.

War zone - no sense of community in the traditional sense - perhaps gang-related "turf".  Way more crime than we are prepared to handle.  We would classify these as "F" neighbourhoods.

What you described above sounds like what we call a "D" neighbourhood.  When looking in these areas, we consider the asset to be "throw away" in the sense that we would be looking for a quick payback of acquisition costs (3-8 years).  We would also model the property with a higher vacancy/bad-debt allowance (10 - 15%) and a higher maintenance cost (15% - 20%).   Insurance costs will likely be a little higher as well.

If the property still cash-flows to our minimum requirements (opportunity cost + 5%), then it's probably worth pursuing.

Michele Fischer · Answer

@Rafael Brown, I would do it again in a heart beat.  What I may do differently is more research about which blocks in the 40 block low income area are more stable than others and concentrate there, or after every 5 doors buy one non-low income property to improve the mix and sanity level.  Mixing low income and not is good for risk and diversification, but not for getting really good at one niche for tenant selection and tenant management.  In the past year we have turned half of our units over to a PM, that is an entirely different experience.  I miss the tenant relations (and having more control), but we could not find a reliable handyman for the mtc issues we couldn't handle.  Tenants absolutely do not take care of the property.  They don't know how to.  We have had very little capex because we've given up on bringing them up to a higher standard (too many things destroyed).  We have to replace carpet at every move out, vinyl flooring isn't holding up, and we buy get newer used appliances on a regular basis.  Mtc is 4% of rent, or $400/unit/month, not bad, just same stuff over and over.  Turnover cost is the same over the long term, but it is more variable, good years and bad years.

Joe Villeneuve · Answer

@Jason Genovese What you are describing is what I refer to as "shinny objects of distraction".  They look good now, and you say they don't need much work now, but by the nature of who your tenants will be, you will have in general, more rehab maintenance on a regular basis, than in nicer areas.  This isn't a criticism of the tenants, this is a practical observation.  The lower income means they simply don't have the means to take care of their houses like those with higher income levels...it has nothing to do with attitude, although this too will be an issue.

One more thing, "I am a softy, and...", means you are letting emotions creep into your investing decisions.  Don't.  You will lose.  I'm not saying you want to be a Scrooge, just understand that the numbers are what makes your decisions for you...not your heart.

This doesn't mean you can't use your talents for the good of others, it just means you have to make your decisions based on numbers.  If you don't, you won't be in a position to help others either.

Rafael Brown · Answer

@Michele Fischer Levi T. thanks for the advice.

Roy N. · Answer

The two are not mutually exclusive.

Levi T. · Answer

Man, if only I could tell myself what I'm about to tell you when I got started... Buy bad properties in good area. If you buy in a ghetto, war zone, or edge of war zone, you have to live with it because you can't change it till everyone gentrifies the area, unless you can buy the entire region or neighborhood. Buy bad properties in nicer areas, this way you can turn them bad properties into nice properties and reap the reward instantly.

Rafael Brown · Answer

@Michele Fischer Thanks for sharing your experience. I am new to investing and I'm trying to figure out if buy and hold in low income (no war zone areas) is really ideal for me. Are you saying that you wouldn't do it again? How have your tenants been with regards to taking care of the properties? Did you add more for maintenance and cap ex cost (if so how much)?

Thanks,

Rafael

Michele Fischer · Answer

Jason, I am currently catering to the low income population, in the lost/perimeter neighborhood that Roy described.  You might want to check out my podcast and blog entries.  You probably also want to listen to podcast #101, where she talks about how turning low income units over to PM's is difficult.  I would say that if you can't manage them yourself that you probably don't want to go down that path.  We are currently contemplating turning a few of our units over to a PM to see if they can do better, but I don't think they can, and it could be a lot worse with extra PM costs to pay, as Brandon Turner is finding out.  Buy and Hold Forever is also a great book to help think about where to buy.  We currently have 8 rental units, where we would only have 2 or 3 if we had bought non-low income, so that part if very good for cash flow and growing net worth as we pay off the loans, but there is no appreciation and constant drama.

Dan D. · Answer

That makes sense, but if I'm going to rural areas, I want that town on a major highway with increasing population year over year within a commutable distance to the metro area.  (30 to 60 miles vs 60-90 miles).  Many seem to justify an hour commute, but getting over that gets tough.

Rural but growing.  Basically between exburbs and rural.

Follow a highway out of the metro.  As you go from suburban to exburbs, there will be a dramatic drop in housing prices.  Getting on that cusp of the suburbs/exburbs where that price drop occurs is where I am targeting my efforts for 2015.

Roy N. · Answer

@Dan D.

Rural areas present another set of variables:  Is there area growing/coasting/dying? Is the clientele population working locally, or commuting 100-150km (60-90 miles) to a larger centre?

Tenants in rural areas tend to stay longer (our observations, no stats), but vacancies take longer to fill.  The cost of maintenance/turnover could be higher if you must commute to the property.

We recently had the opportunity to purchase ~50 units (4 buildings) in the small town where I spent my teen years.   In the context of my memory of the area, the deal looked very attractive ... and it would have been if this were still the 1970s.

However the local economy has been on a 25yr decline with no sign of turnaround due to over reliance on a dwindling natural resource.  The young folks who can leave, do.  The remaining population is aging (retired) or underemployed.  Services have left the town (there is no longer a full service hospital).  The quality of the tenant population has fallen dramatically - there is more empty housing stock, so those who have any semblance of steady employment can secure their own house.   In light of the present environment, I'm not sure the deal would be worth it if the buildings were given to us.

Investing in low income areas?

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