Where to invest -- Good areas/Bad areas
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Real Estate Broker · Johns Creek, GA · Member since 2009 · 870 posts · 664 votes
14yJohn M.,
This is a good question. The problem i have with the 2%, 50% rule is that not all properties are going to be equal. MF will generally have high cash flow than SFRs and properties located in D areas will generally cash flow better than A areas but with higher vacanies, maintainance and repair costs.
Let me share with you my first SFR investment mistake and the silver lining i have learned from this mistake and how i want to position myself investing forward. I purchased a new SFR in a private golf course subdvision in a "A" area with $200,000 down 6 years ago. I secured a corporate transfer from out-of-state as my tenant who hasn't been late once with his $3000/month rent for 6 years. I had to put no money to repair as my tenant has kept the home in such good condition and has paid from his own pocket for any updates and repairs needed. I plan to hold his home for another 10 years.
Everyone here has their niche. I like to concentrate my investments in buying and holding entry level B SFRs in A areas. What i mean by A areas is where the high end homes, path of progress, and best schools are located with median household income of $130,000. D areas are places you probably won't feel safe driving to at night.
I require a minimum of atleast 10% Cash on Cash return and I do expect a nice appreciation in the niche submarkets i invest in. Personally, I have no desire to buy in C and D areas where the cash flow may be higher at greater discounts, higher maintenance and repair costs and vacancies.
I would also like to reach my real estate financial goals with the least of amount of rental properties as possible. I much rather own 10 SFRs valued in A areas valued at $500k each, than to own 100 SFRs in D areas at $50k each.
88 Replies
- Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes14y
A $100K house that rents for $1000 will pull money out of your pocket. A $45K house that rents for $850 will generate some cash flow.
That said, you have to dig a little deeper. The $100K house is a non-starter, IMHO, unless there's some other play (rent increases assured over time, appreciation - i.e., some speculate route to a profit). But the $45K house might not work either. If its hard to find tenant or they turn over quickly then your expenses may be so high its still not profitable. If you're afraid to go there at night, I also wouldn't buy in that area. But once you actually visit the area a few times you may find its not as scary as you might think.
- 14yChris ClothierBusiness MemberRental Property Investor · memphis, TN · Member since 2009 · 2k+ posts · 3k+ votes
John M. - I am going to have to agree with Jon Holdman and add something to the discussion. It seems what you may be referring to are paper returns. Lots of houses look good or bad on paper and it is highly subjective. A Seller can make houses look fantastic and a reluctant buyer can manipulate paper returns to justify saying no. You really have to dig much, much deeper into the details to determine what areas are best because the criteria can change form city to city, neighborhood to neighborhood and even block to block on the same street. You introduced management to the equation, but I am sure you know there are so many other factors - some are costs, others are attitudes, that effect the ultimate profitability of an investment property.
- Real Estate Broker · Johns Creek, GA · Member since 2009 · 870 posts · 664 votes14y
John M.,
This is a good question. The problem i have with the 2%, 50% rule is that not all properties are going to be equal. MF will generally have high cash flow than SFRs and properties located in D areas will generally cash flow better than A areas but with higher vacanies, maintainance and repair costs.Let me share with you my first SFR investment mistake and the silver lining i have learned from this mistake and how i want to position myself investing forward. I purchased a new SFR in a private golf course subdvision in a "A" area with $200,000 down 6 years ago. I secured a corporate transfer from out-of-state as my tenant who hasn't been late once with his $3000/month rent for 6 years. I had to put no money to repair as my tenant has kept the home in such good condition and has paid from his own pocket for any updates and repairs needed. I plan to hold his home for another 10 years.
Everyone here has their niche. I like to concentrate my investments in buying and holding entry level B SFRs in A areas. What i mean by A areas is where the high end homes, path of progress, and best schools are located with median household income of $130,000. D areas are places you probably won't feel safe driving to at night.
I require a minimum of atleast 10% Cash on Cash return and I do expect a nice appreciation in the niche submarkets i invest in. Personally, I have no desire to buy in C and D areas where the cash flow may be higher at greater discounts, higher maintenance and repair costs and vacancies.
I would also like to reach my real estate financial goals with the least of amount of rental properties as possible. I much rather own 10 SFRs valued in A areas valued at $500k each, than to own 100 SFRs in D areas at $50k each.
- Investor · Fort Worth, TX · Member since 2011 · 1k+ posts · 450 votes14y
It is my opinion that when investing in "bad" neighborhoods, you should do so with cash if possible and use leverage in the higher class neighborhoods. That way you can handle vacancies and turnovers in the bad neighborhoods and you can actually afford to buy properties in the good neighborhoods.
- Specialist · Portland, OR · Member since 2010 · 3k+ posts · 1k+ votes14y
The question should not be, is it a good or bad neighborhood, it should be, where is this neighborhood going. Being in a neighborhood that sells for a bad neighborhood price that can become desirable if surrounding areas become too expensive for the typical starter family, can be a good investment appreciation and cash flow wise.
If you buy into a declining area and you need to sell, chances are cash flow won't exceed the loss you face in a sale of property nobody wants.
Another problem with low cost properties is if you buy a house for 15k and spend 10k on repairs it may still comp out at 15 k, plus your repairs, taxes etc end up being a large percentage of a $500 per mo rental.
One way to make money in bad areas is to capitalize on others mistakes, such as, an overimprovement that you don't pay for because the last investor lost money. In other words, you need to really know what you are doing in a bad area.
In a good area sometimes it is just time that does the work for you.
- Real Estate Investor · Toronto, Ontario · Member since 2010 · 413 posts · 114 votes14y
I agree with Jeff Sielicky up and coming neighborhoods are where the most profits can be found. When a neighborhood jumps from a C class to B class it can be very lucrative for savvy investors. Comparing different classes of neighborhoods is like comparing apples to oranges. Lower income areas have higher risk but should be offset with higher yields. Also a good idea might be to work with a property manager who is active in the area. This may look like a extra expense but could pay off huge for the overall success of your portfolio.
- Landlord · Seattle, WA · Member since 2010 · 3k+ posts · 1k+ votes14y
Originally posted by John M.:
It seems like the worse the neighborhood, the more the rental profit.Curious what peoples opinions are of investing in good areas with less return vs less nice areas with better return.
On the surface this is true. The markets are going to push for this because bad areas tend to be more risky than good areas.
Problem is like other have said the market is far from perfect. There are distressed homes. There are homes that are poorly marketed. There are homes that have less surface appeal. There maybe more foreclosures in an area.
If you know your market, you have a better chance of understanding what is a good deal in any particular neighbor and will more likely have an idea if an area is improving or deteriorating.
For me this is one reason that the numbers are only part of my due diligence. The numbers have to make sense, but the location has to make sense to.
You also might find other factors peculiar to a property that effect price. A property that has a great view of the town dump probably will be priced less than the home next to it that has trees blocking this view.
- Investor, Entrepreneur, Educator · Springfield, MO · Member since 2009 · 21k+ posts · 12k+ votes14y
All good comments! Jeff would probably go on to say, do your best to change the neighborhood for the better.
So, you're thinking of being a slum lord for the intial cash flow, have at it! Later on you might be introduce to property compliance issues with the city, the brain damage dealing with tenants in such areas and city wanting to redevelop the area. Maintenance generally eats up that cash flow, costs of evictions are not cheap and most tenants have been there before and they may be your only tenants as....really, who wants to live there vs. who needs to live there?
The next book should be entitled...."The Plight of Slumlords"
Get a good area, where the property is marketable, leveraged that has cash flow and keepit up, you'll do better in the long run IMO.
- richmond, VA · Member since 2011 · 18 posts · 4 votes14y
John, I to live in the Richmond area and have noticed the same thing. Everyone so far has made good points. I have seen quite a few people do well by buying in gentrifying areas in Richmond ex. Old Manchester, Jackson Ward, Oregon Hill, and I think it's a good plan. The house everyone on here is using as an example of a bad low income investment would be anything in the Jeff Davis area and alot of parts of church hill still. You can go in and buy but what is the area going to do over the next 5 years? The answer for the areas I just listed is probably nothing. I agree with everyone on here that these properties might be more headache than they are worth. If you want a strong investment in an area that is on the rise my opinion is parts of the northside ex. Barton Heights, around brookland park blvd. The closer to vcu the better.
- Investor · Mission Viejo, CA · Member since 2012 · 627 posts · 204 votes14yOnly if you are doing something very wrong. I've got a few +/-$100,000 houses, and they are all cash cows. Buying them with loans would be a good example of doing something wrong. You can buy three times more houses with loans, but you have three times more liability, three times more maintenance, and the worries that come with having to make loan payments.
Originally posted by Jon Holdman:
A $100K house that rents for $1000 will pull money out of your pocket. - Investor · Dallas, TX · Member since 2009 · 718 posts · 913 votes14y
I know this is a topic that's been discussed repeatedly, but I think it's worth knowing whether you are using Fannie Mae financing as long term financing. If you are then, then even a house with a $70,000 ARV is going to be tough to finance. (My experience is that most conventional lenders won't go below 50K and max LTV is 70%.) Also, you'll need decent comps to support an appraisal to get that financing, which is tougher on those lower end houses.
- Investor · Hampton Bays, NY · Member since 2009 · 907 posts · 258 votes14y
I invest in Dayton Ohio and a large number of the properties in this city 2 and 3 bedroom homes, are selling at under $30,000 . I can definitely say this is a poor area but what makes an area a "bad" area. My tenants are decidedly low income and yes they live here because they need to. Any of them would rather live in an affluent part of town. They are however good hard working people who enjoy living in a clean well maintained property and deserve to be treated with respect and the expectation that they will care for the property as if it were their own. Maintenance in this area has been higher than expected but that is because the homes are all built in the 1920's and older homes cost more to upkeep. Investing in this area will require more attention and cost than in an A area but I believe The return is worth it.
There are cities across the middle of the country that have been hard hit before the recession and when the economy comes back these areas will bounce back and provide above average appreciation in addition to above average return based on rental income. .
- SFR Investor · IN · Member since 2008 · 137 posts · 24 votes14y
John M.
Are you looking strictly for a rental strategy? Look for a good spot on the risk/return frontier. for instance, 22% gross ROI is much more attractive than 10%, and it would take a massive amount of risk to mitigate this gap. Plus, with 2 holdings to every one as opportunity cost, your risk is diversified with the "bad neighborhood". Also, if $100K is the "good neighborhood", then likely the $45K neighborhood is not all-out tenement ghetto, and has a strong risk-return dymanic, despite the relatively lessened aesthetic.
Your question is one that I had pondered and experimented with, by trial and error, for the first few years of my investing career. My holdings now center around houses with an all-in cost averaging $31K at over $700/mo gross rent. run the math on that. as importantly, this is NOT ghetto, and MOST of my 30+ houses perform on the lease for the first contract.
I've developed a very good paradigm for this program in particular. It seems to address your question directly, and with the empirical data to support my argument.
- Investor · Hampton Bays, NY · Member since 2009 · 907 posts · 258 votes14y
Vincent, I appreciate your detailed response. You say these properties are not in the ghetto. Perhaps I am somewhat naive but what precisely makes and area a ghetto? I understand that if I drive through a neighborhood with house after house boarded up it may not be the best area to invest in but what criteria would you use to warn you to keep out? Crime statistics , income level, ratings of schools?
- 14yKevin PolitePro MemberInvestor · Decatur Atlanta, GA · Member since 2011 · 610 posts · 232 votes
These are all good responses and I guess it depends on what strategy you decide to take. I've had luck with buying in areas between good and bad areas that are starting to turn around. The first one I bought last year had a few foreclosures in the area and 15 years ago I wouldn't have even considered. But when I was checking out the n'hood I noticed 2 things. Expensive Baby strollers and wireless access points as I drove around. This told me a new type of tenant/owner was moving in.
Secondly, if I had a lot of capital I'd love to buy 5-10 homes within .5 mile of each other in the type of neighborhood I described above. I think that would turn around a neighborhood really fast and you'd get higher rents and down the road a much greater chance of appreciation. Wishful thinking!
- Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes14y
Originally posted by Stephen Masek:
Only if you are doing something very wrong. I've got a few +/-$100,000 houses, and they are all cash cows. Buying them with loans would be a good example of doing something wrong. You can buy three times more houses with loans, but you have three times more liability, three times more maintenance, and the worries that come with having to make loan payments.Originally posted by Jon Holdman:
A $100K house that rents for $1000 will pull money out of your pocket.Anything you own free and clear with generate cash. If you believe the 50% rule and use a PM, this $100K house generates true cash flow of $6000 a year. That's a 6% ROI. That, to me, is inadequate. If I self manage, I get to collect the PM's cut and cash flow is more like $8000 a year. That's 8%, which is still less than I can get using that $100K to make hard money loans through a broker and dealing with tenants is a LOT more work than dealing with a hard money broker. And, sure, I've heard people claim they don't have the expenses I'm assuming by the 50% rule or the 35% self managed variant. Trouble is I've seen these other expenses and know they're real.
Saying "Buying them with loans would be a good example of doing something wrong" certainly puts you in the minority for rental property investors. If I use that same $100K to buy three houses with 75% LTV loans at 6%, my NOI with a PM is $18,000 a year. I'm assuming $25K each down and another $8K and change for fixup and acquisition costs. P&I on each would be $450 a month or $16,200 a year. That leaves only $1,800 in true cash flow, which is much better than my initial "will pull money out of your pocket". My bad. They're roughly break even. Over time, you would hope rents and expenses would rise roughly in line with inflation while your payment remains flat and eventually goes away. So, these may be OK if you're not looking for current income.
But I'd hardly consider either scenario to be cash cows.
- Investor · Mission Viejo, CA · Member since 2012 · 627 posts · 204 votes14y
Jon:
Here are the actual numbers for one of two of our houses.
The first was built in 2006. It has a concrete tile roof and is finished with stucco , so the first significant maintenance item will probably be a water heater. Purchase $90,000. Replace carpet, paint, minor repairs $5,000. Total invested $95,000. Rent $995, property management $79, insurance $32.17, property tax $97.15, HOA $42. That give a 9.4% annual return before maintenance. It should need very very little maintenance for quite a few years. We prefer a better return, but this one is especially likely to appreciate.
The second one: Total invested $86,800.74. Rent $1,100, property management $88, insurance $69.33, property tax $100.75, no HOA. That give an annual return of 11.6% before maintenance. It was built in 1995 and is finished with stucco, and in wonderful condition when we bought it, so the next major expense will be a roof, and it may need a water heater somewhere during the next few years. It still generates above 10%.
- Investor · El Dorado Hills, CA · Member since 2012 · 1k+ posts · 1k+ votes14y
There are considerably higher returns in lower end properties, if you have the time and stomach for it. Since I have a full time career and young kids I don't have the time or energy to deal with lower end properties so I look for nice properties in class A areas. I can self manage my 12 units in less than 10 hours a month with very few issues and the 8.8 return is acceptable to me. If I were a full time landlord I would probably have large section 8 complexes for the highest ROI... but it takes full time dedication to keep control of lower end properties. If you cannot stay on top of lower end properties and tenants with a firm hand they can turn sideways on you quickly and the ROI can shrink just as quickly.
- Investor · Mission Viejo, CA · Member since 2012 · 627 posts · 204 votes14y
Please don't forget that the older houses in those worse neighborhoods are far more likely to contain lead-based paint and/or asbestos.
Lead-based paint usage fell way off in the 1950s as water-based paint became good. We (my environmental consulting company) have never found a resdiential building built 1960s to 1978 with more than 1% of the painted surface area covered with lead-based paint. About half have none.
Asbestos usage peaked in the 1970s, then tapered to almost nil by the end of the 1980s.
That means there is a sort of "sweet spot" in the middle 1950s to middle 1960s where you can find buildings with little asbestos and little lead (the topic of one of my magazine articles).
It sure is easy to fall for the siren song of the lenders, but that is a major problem with our entire society.Originally posted by Jon Holdman:
Saying "Buying them with loans would be a good example of doing something wrong" certainly puts you in the minority for rental property investors.Highly leveraged "owners" of rental properties are functioning as rent collectors for the lender. However, unlike employee rent collectors, they are stuck with most all of the liability arising from lawsuits, laws, regulations, and natural disasters.
We've used loans in the past, but we always had the cash to pay them off anytime we wanted or needed to. We no longer want to even bother with the lenders. Yes, we could buy about three times as many properties with loans (I doubt four, when all is dsaid and done), but would then have three times the liability, three times the maintenance, and the nuisance and worry of dealing with the lender (they almost never paid the taxes & insurance on time when we were using them, etc.). When you factor in the greater maintenance, it seems that the cash flow is about the same. Therefore, it would really just be a gamble on appreciation. I live 3.5 hours from the center of the Las Vegas "strip," so if I want to gamble (I don't), I'd go there.
- Rental Property Investor · Mercer Island, WA · Member since 2008 · 22k+ posts · 14k+ votes14y
The very first night I ever went to Vegas I put $200 on a craps table at Binion's and walked away a few hours later with a purple ($500) chip. But I don't assume those few hours represents the long term expectation value of playing craps. Nor do I assume that your 12 rental-years of experience with those two houses or my seven rental-years with my two rentals reflects the long term reality of owning rental property.
- Investor · Mission Viejo, CA · Member since 2012 · 627 posts · 204 votes14y
Jon, Good job. I once decided to put a few quarters in a slot machine, and it paid off. I could tell they casino personnel were irritated, and saw that they quickly put an "out of order" tag on the machine.
How did you get 12 years? We bought both of those two examples in 2011. We got others we've owned much longer, although we sold most of what we had just before or right at the peak.
- Rehabber · Glen Allen, VA · Member since 2010 · 49 posts · 18 votes14y
John,
Many people have responded and made some great points and have brought up a lot of things to think about. I am in your market and know it pretty well. We own properties in many parts of the city, Henrico and Chesterfield. We own some for $20,000 and some up to $200,000. All the best to you!
- Wholesaler · Chicago, IL · Member since 2011 · 219 posts · 38 votes14y
In my opinion, without getting technical on types of neighborhoods, I believe that any large city (especially on a body of water) is the best place to invest for the long term in. These areas are valuable and only going to increase in price over the long term.
There is nowhere to build into the body of water so therefore, expansion must take place outward from the body of water. As these cities expand more and more outward, the properties on the innermost part of the city get more and more valuable.
- 14yJohn M.Midlothian, VA · Member since 2012 · 38 posts · 7 votesOP
Awesome replies! This gives me a lot to think about. Thanks everyone.
One of the take-aways I'm reading into all of the replies is that there's no 'never invest in lower class areas' rule. I was wondering if there's the 1% rule, the 50% rule and the lower class rule, but there's not.
It seems like what I'm seeing in the higher return in lower class areas is normal, and is kind of the market adjusting for the higher headache. The question becomes, is that higher return worth it for you.If anyone else has more to add, I would love to hear it. I still haven't made up my mind.
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