The other day, someone emailed to ask: “What cap rates do you look for when you buy a rental?”
It seems like a simple question, but it’s impossible to answer. There’s no magic number that I search for, because the cap rate needs to be put into context.
If I’m buying a property in a highly-desirable part of town where I’m likely to have top-notch tenants, I’ll accept lower returns. And if I’m buying a rental in a more volatile part of town, well, I expect to be compensated for the added risk.
Which leads me to the age-old rental investing question: Which is better? Should you buy rental properties in an area that’s stable and desirable, or an area that’s shaky but yields higher returns?
Obviously there’s no “right” answer to this question – your choice depends on your goals, risk tolerance, and the specific details of your area – but let’s dig deeper into the question.
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Merits of a Stable Neighborhood
I’m going to use myself as an example: One of my properties is located in a fantastic neighborhood in Atlanta (Midtown). It’s walking distance to Atlanta’s most famous park, Piedmont Park, which means that the area has an “economic moat” that can’t be replicated. Add that to its proximity to walking/biking trails, restaurants, bars, fitness centers and other amenities, and the end result is a sought-after location that attracts high-quality tenants.
One of my tenants has a masters degree. Another is a recent graduate of pharmacy school. Broadly speaking, I don’t anticipate that these are the type of tenants who will rip through my drywall to steal the wiring.
They’re not necessarily “long-term” tenants, though. Some tenants have spoken to me about their job prospects in other cities like Washington DC or New York. Others have indicated that they hope to buy their own home soon.
Nonetheless, I can rest assured knowing that the tenants want to preserve their high credit scores, and these units are easy to fill.
DeMerits of a Stable Neighborhood
The biggest drawback, of course, is that the returns in this neighborhood are comparatively far lower than what you can find in other areas. I got lucky with this particular property, which I bought in 2010, but I’ve spent the last two years trying to replicate the deal – and I just can’t. That’s why I haven’t bought anything else in this area.
It’s tough to find something in this neighborhood that’s even cashflow positive (after accounting for management, vacancies and ongoing maintenance), and it’s nearly impossible to find something that meets the 1 percent rule or has a decent cap rate.
What About a Higher-Risk Area?
One of my other properties, a single-family home in a lower-income area, boasts much higher returns (I bought it for $21,000, put $10,000 into fixing it up, and it rents for $900 per month – nearly hitting the 3 percent rule).
But some of the prospective tenants who have toured the home have told me crazy stories or made off-the-wall requests. The house demands a lot more tenant management and the vacancies take longer to fill.
I recently outsourced the oversight of that home to a property manager, which diminishes my workload, though that house presents some nagging worries in the back of my mind. Nonetheless, it compensates me handsomely for those concerns.
So which neighborhood is “better”? I don’t think there’s any right or wrong answer. But I’m interested in hearing from other landlords, in the comments, about whether you prefer:
1) Lower returns with less risk
2) Higher returns with greater volatility
3) Some alternative scenario
Leave your comments below!