Recently an investor passed me some information he was given on a potential first investment property and asked for my opinion on the deal. I first asked him what his goals for buying a property were because I don’t always want to judge a property on whether or not I would buy it, because another investor may have different desires than I do and/or different goals. I want to be sure I look at a property relative to what might work for that investor. When I asked him what his goals for a first property were, he said he was “scared s***less” and just wanted a property that didn’t turn out to be a “loss and disappointment.” Also worth noting is this investor would be a long-distance owner. He is in the typical California boat, as are so many of the rest of us, not able to buy cash-flow positive properties locally. Knowing his fear going in, my immediate thought in looking at this property was that I wanted to focus on risk factors. For someone who is new and scared, the more risk factors there are, the more shaky the investment. Higher-risk properties are fine for those who know how to handle them, but I prefer to leave those to the more experienced guys. So with risk being the major concern, I dove into the property to see what was being offered.
I want to be clear that my intention in showing you what I consider to be red flags about this investment opportunity is not to tell you whether or not this is a good investment. I can’t say that for sure because maybe someone buys it and makes a fortune off of it, who knows. My intention is rather to show you what caught my eye as being a risk factor. It’s no secret that I prefer higher-quality hands-off properties for my personal portfolio, but in no way does that mean I don’t support cheaper properties or fixer-uppers if those are something you are interested in.
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Evaluating the Risk Factors
The ad (verbatim, I make no claims to the math or any other declaration):
I assume as you read through the ad you were already starting to form an opinion about this investment opportunity. What are your thoughts? Here are mine, and remember that I don’t point any of these out as judgments, I merely highlight the things I consider to be red flags in terms of risk. I will show you the ad again, this time with the “red flags” marked.
Don’t worry, I’m going to elaborate.
- Cleveland. No personal judgment here, but Cleveland doesn’t actually have a lot going for it. Well, I take that back. It is ranking up there in statistics. While it does rank as a good place to invest in real estate by some, I’ve also seen it listed under, “10 Worst Places to Live”, “America’s Top 10 Miserable Cities”, “America’s Top 5 Worst Housing Markets”, and others. Did you know that only two cities (Detroit and Flint, MI) have had a faster rate of residents leaving the city over the past 3 years? Again, not saying investing in Cleveland is good or bad, but you definitely want to understand the market you are buying in. I’d say there are quite a few risk factors with Cleveland as a market.
- Built in 1927. That is really old. Plan on a lot of maintenance, regardless of what condition it is in when you buy it (unless it’s been fully gutted and rebuilt inside, which I doubt).
- Newer for that area? That means most of the houses around it are older than 1927. In that price range, we are officially talking a low-quality area then. I’m picturing shacks.
- Local managers. Who exactly are these “local managers” and what are their backgrounds? Why do I have a hunch they have no idea what they are talking about?
- $5k of rehab. Since when are local managers contractors? I would put money on that if I were to hire an independent inspector that they are going to find way more than $5k worth of work that needs to be done to this place. “A little TLC” has been a very popular euphemism in real estate ads throughout history.
- Can be rented for. So the units aren’t rented now? Why not? And has it been so long since they were that you don’t know an actual rent amount?
- $650/month tenants. I’ve known multiple investors who owned properties that had tenants paying sub-$750/month in rent ($750 and $1000/month are standard thresholds) and not one of those tenants ever lasted more than a year, most not even making it 6 months. And almost every time one of those tenants left, major repairs had to be done to the property. So between vacancy times and repairs, those tenants became quite costly. I’m sure not all $650/month tenants are bad, but I’d definitely count on upping my expense allocations for them.
- Close to everything. That’s a broad term. What is “everything”, exactly? It kind of matters.
- Big health care industry. Such as?
- In the middle of a turnaround. Hasn’t Cleveland been “in the middle of a turnaround” since at least the mid-90s, if not before? That’s a really long turnaround. What is the evidence that supports the supposed upswing?
- Medical mart. There is documented controversy over the feasibility of medical marts. How is this one doing?
- Casinos. Known for transient employees, which make for transient tenants, which make for high vacancy costs.
- 20 calls a day? Some of the best properties I know of don’t get 20 calls a day. The only places I’ve ever known to get that many calls are the ones advertising “No credit, no problem! 1st month’s rent free!” Those kinds of ads don’t exactly bring in stellar tenants who send in money each month.
- Filled in a week. One week from what? When the last tenants leave? If you can fill it that fast, why do you not have tenants in there now to know actual rents? Filling a property that fast also further encourages the idea that the managers are putting anyone with two thumbs and a signature into the property, meaning good luck ever seeing a payment from them.
As I said, these are just the things that jump out at me about this ad that warrant further inquiry. The two potentially deal-breaking factors for me are the unknown condition of the property and the quality of the tenant pool. I would absolutely require an actual estimate of repair work needing to be done on the property (by a licensed inspector) and the tenant history (any long-term tenants? Any support for that vacancy claim?) Those two, in my opinion, are the critical issues. The rest are just risk-increasers. Everything may be manageable, but you need to be alert and aware of them in more depth. Much more depth.
Most properties can be a success if bought right and run correctly (there are some areas of some states that you literally can’t get tenants into properties, but I don’t think this property falls into that category). However the more the risk involved, the more work and diligent effort it will take to run it correctly, potentially to debilitating levels. What an investor has to do going into any buying deal is assess their personal experience level, understand the risk factors of that deal, and then combine the two (experience and risk factors) and see if they are a logical fit. For a new, inexperienced, long-distance investor I would not recommend touching this property with a 10-ft pole. For someone who understands the Cleveland market and has experience with this type of property, then I would completely support asking more questions, getting more info, and hiring an inspector to check out the property.
So maybe the first step as a new or less-experienced investor should be learning what factors increase risk in an investment property. This goes for flipping properties as well and not just rental properties. I pointed out a lot of factors that increase risk with this article, but there are of course others so be sure to keep your eyes peeled. Once you understand what factors increase risk, you can then weigh out 1) your experience in handling those risks and 2) your desire to deal with those risks. If you have neither the experience or the desire to handle a particular deal, don’t do the deal. There are plenty of ways to lessen risk, so don’t settle for a tougher property just because you think you have to.
What was your first impression of this property? If you have bought properties like this, how was your experience?