Should I Buy Several Cheap or a Few Pricier Houses? An Investor’s Analysis

36

I get this question all the time: “Should I buy cheap property somewhere else with higher cap rates or more expensive property where I live?”

I wanted to buy cheap property once. It’s very tempting. So is it a good idea? Let’s run some numbers and find out.

Most investors turn to cap rates to decide which property to buy, almost like a magic wand. But cap rates can be deceiving and should be used with caution because there is a lot they don’t take into account.

What is a cap rate exactly?

Cap Rate = Net operating income/sales price

  • Net operating income is simply the yearly gross income minus operating expenses (i.e. property manager, yard maintenance, vacancies, repairs).
  • Sales price is what you will pay for the property.

Related: The $30k Rental Property: How to Finance & Profit From Cheap Real Estate

Real World Example

We’ll use two very different different homes for this example.

Expensive Property

  • You make $29,000 a year in rental income
  • Property costs you $270,000
  • Manage property yourself
  • Yard maintenance is $1,200 a year
  • Vacancy loss is about $200 a year
  • A typical year in repairs costs you $1,000 (not replacing major components)
  • NOI: ($29,000 – $1,200 – $200 – $1,000)/$270,000 = 0.099 or 9.9% cap rate (very good for a single family home)

Dirt Cheap Property

  • You make $6,000 a year in rental income
  • Property costs you $30,000
  • Manage property yourself
  • Yard maintenance is $1,200 a year
  • Vacancy loss is about $100 a year
  • A typical year in repairs costs you $600 (not replacing major components)
  • NOI: ($6,000 – $600 – $100 – $1200)/$30,000=0.14 or 14% cap rate (unrealistically excellent cap rate to prove a point)

Based on the analysis, the cheaper property has a lot better return on the income invested. What most people don’t put into cap rates is the cost of major repairs which tend to be similar between really cheap and more expensive houses. Let’s see how that changes things.

Here is an example of prices for different components of a house and how fast they wear out.

Lifespan Cost Cost Per Month
Paint

8

$2000

$21

Roofing

20

$4000

$17

Oven

15

$700

$4

Washing Machine

10

$500

$4

Dryer

10

$500

$4

Interior Paint

15

$1500

$8

Carpet

10

$3000

$25

Bathroom and Kitchen Linoleum

15

$700

$4

Furnace

20

$3500

$15

Kitchen Remodel

30

$15000

$42

Bathroom Remodel

30

$5000

$14

Total Monthly Cost

$157

More expensive property:

  • Monthly income = $2,400 – mortgage ($1,600) = $800 a month left over
  • Average operating expenses are $200 a month
  • Average costs to repair major systems in the house over time are $157 a month
  • Monthly profit $800 – $200 – $157 = $443

Less expensive property:

  • Monthly income = $600 – mortgage ($142) = $458 a month left over
  • Average operating expenses are $158 a month
  • Average monthly costs for major systems in the house $157 a month
  • Monthly profit $458 – $158 – $157 = $143

So, to make the same monthly profit while paying off the loan as a $270,000 house, you will need three $30,000 homes. That might not be bad. Considering that you are putting 20% down on each investment, you will make more monthly profit per dollar invested when buying the cheaper homes. It doesn’t end here. There is so much more to consider.

Appreciation

What about appreciation (increase in home value over time) if you want to sell one day? Let’s say appreciation is 5% for the more expensive home (that’s why homes are more expensive in those areas) and 3% for the cheaper home (that’s why prices are cheaper in those areas).

If you wanted to sell in 20 years, the cheaper home would be worth about $54,000 and the more expensive home about $720,000. A little after year three, you will have made more in just appreciation (not including profit or pay down) on the more expensive house than the cost, appreciation and profit of the cheaper house. By year 18 you will make more in appreciation every year than the cheaper house costs. To get the same appreciation return using cheaper homes, you will need to buy and manage 13 ($390,000 in cheaper homes) of them.

Let’s look at how much your time spent managing was worth in just appreciation assuming three hours a month per house over 20 years. The cheaper house will be worth $75/hour and the more expensive home $995/hour. 

Management Time

Let’s say you pay the houses off and want to retire on that income. If you manage the more expensive property, you will make $2,400 a month (assuming the value of money never changes over time). You will need 5 cheaper properties to get the same amount of cash flow. In other words, you make 5 times more per hour of work with the more expensive house.

Going the more expensive route gives you a lot more time to do things that truly make you happy. That’s why we invest in the first place, right?

Related: Why Buying Cheaper May Come with a Hidden Price Tag

Economy of Scale

At the front end, cheaper properties are very tempting because they can bring in more money per dollar. At the back end, the more expensive properties bring in a lot more per amount of work and per year from appreciation. Whichever you choose is up to you.

I’m sure some of you are thinking, “Well, I can’t afford an expensive property.” My advice to you is to buy what you can afford as long as there is cash flow. Over time you will be able to gain equity and save up money so you can buy something that will increases your income per hour.

Things to keep in mind:

  • Costs for long term and short term repairs are similar between cheap and more expensive properties because of the cost of materials and labor. This usually isn’t taken into account when using cap rates.
  • High end homes will tend to have much lower cap rates, but the income per effort will be much higher.
  • Low end homes cash flow better, but you are more likely you will end up with tenants who don’t take care of your property and end up costing you more in repairs. The time you spend finding tenants and dealing with problems goes way up. They won’t be the same between cheap and expensive properties.
  • Don’t go too high end. It’s easier to find tenants and keep vacancies low if you buy properties in the price range most people in your area can afford. Higher demand properties are going to be easier than higher end properties.

“Happiness is not something ready-made. It comes from your own actions.” – Dalai Lama

So, what do you think, investors? Have you opted for cheap homes or have you gone the pricier route?

Leave a comment, and let’s talk!

About Author

Brett Lee

Brett Lee is a licensed Real Estate Broker in Portland Oregon where he helps people achieve a better future so they can do the things that truly make them happy. Brett is also a buy-and-hold investor, property manager and investment advisor.

36 Comments

  1. Stephen S.

    I know you are trying to make the argument that you already agree with – but your numbers are deliberately skewed I think. Yard maintenance costs are the same mowing some postage stamp sized yard as they are landscaping the much larger lawn on a house worth ten times as much? And remodeling a kitchen costs the same $15K in both houses? A 15 square roof costs the same as a 50 square roof?

    It’s not that I don’t still love you and all that – but come on now.

    • Dawn Anastasi

      I have never paid $15,000 to remodel a kitchen in a $30,000 house. There’s $1,500 worth of cabinets, maybe $1,000 for the flooring, then paint, countertops, sink, faucet, etc. You’re not going to get to $15,000 that way. For a $270,000 house maybe $15,000 for a kitchen remodel is more realistic.

      • Rahul Singh

        I was thinking along the same lines. I also wanted to add the total invested dollars. In the proposed comparison, investor’s purchasing power is 270K so theoretically he should be able to buy 9 30K properties. With your assumption of 6k a year rent, you are looking at 54k in rent. Not to mention, the labor rates will much lower in those areas to lower your maintenance costs.

        However, I do want to thank you for putting it together to get me started on thinking about it.

      • Randy E.

        Dawn, that’s how it works for me, too. Best case scenario is I can clean and paint the cabinets and not have to buy new ones, but after that it’s just new faucets, paint the walls, get a stove and fridge, and maybe new countertops. I always put new flooring in kitchen and baths.

        And baths are even less expensive. A new toilet and faucet, usually a new vanity, maybe a new tub. Tile the tub area if needed, paint, and that’s about it. Nowhere close to $5000.

  2. David Beard

    Good points here, especially that the work effort will be much less with good tenants that will take care of the property, and that many maintenance expenses are fixed and not variable with rent.

    Might want to just drop in a placeholder for taxes and insurance when computing NOI (2.0% of value per year would probably cover these in most areas of the country). These expenses are variable to the home’s value, so they are much higher as a % of rents for the higher end property.

    Counting on appreciation is crystal ball gazing and a function of a million unknowable things. Countless investors went bust in 2008-2010 banking on this.

    The nicer property is also easier to finance, enabling you to get some reasonable leverage and get the extra depreciation tax benefits that entails, gets more money invested quicker with less effort in finding properties, and the total closing costs will be much less than getting loans on multiple smaller properties. It’s also easier to resell, as it’s not just a “rental” but can be sold as an owner/occ home.

  3. FRED GROH

    I DONT SEE THE APPRECIATION PART A 270K HOUSE IN 20YR WENT TOO 720K WOW..
    I DONT THINK ANYONE CAN HANG THERE HAT ON THAT HAPPENING..LETS SEE
    MY BROTHER BOUGHT A HOUSE AND IT WAS 100K I WENT UP AND DOWN IN THE END
    IT WAS WORTH 140K IT TOOK 25 YRS ..LETS SEE I BOUGHT 12 30K RENTALS AND THEY ARE
    CASH FLOWING ..AKA THE PIG WITH LIPSTICK 30 YRS AGO THEY WERE SELLING FOR 30K SAME THING
    ITS ALL ABOUT CASH FLOW,,WHAT I LIKE IS I BUY A HOUSE FOR 15K PUT 5K IN RENT 750
    A 500 NET CASH FLOW 6K YR IN 3 YEARS ITS AN ATM …AND YOUR 20K IS THERE AT THE END..

  4. Stephen S.’ point is undeniable, several of your assumptions / numbers are skewed towards the argument you’re trying to make. That doesn’t mean your argument is entirely wrong though.

    If you’re self managing, it should be easier managing 1 unit than 3, managing 10 than 30, and 100 than 300. Scalability is a big factor for us smaller investors. If you can comfortably self manage 40 rentals without any help, you’d prefer managing 40 units each worth 100k, than 40 units worth 50k.

    There are a lot of other hidden costs (time and $) in having a ton of small deals, for example bookkeeping and accounting, advertising, legal fees etc.

    We invest in notes and over time we started moving away from low balance notes for these exact reasons. Servicing fees are the same whether the note is worth 20k or 200k. Foreclosing is the same. BPOs, title searches, all the same. So everything else being equal, I’d buy a 40k note over a 20k note.

  5. Terrence Arth

    Brett, I think you are spot on. With that said, Steven has a very solid counterpoint, that the expenses will be much more variable and less consistent between the two. For example, in a lower quality rental, a drywall patch might be somewhat visible beneath the paint and it is perfect acceptable to the new tenant because there are different levels of premises acceptability in a $650 per month rental than in a $2000 per month home. I have had a few repairs done that I had to have had redone so that the quality was up to par. A rough carpenter does a different quality level of work than a finish carpenter–I failed to ask that very question. But like Steven said, I’m probably making my own argument as I have only bought newer units in nicer neighborhoods. I guess its just me but I’ve learned to profile my business model along that strategy as that is what makes me comfortable. Newer, nicer, higher priced.

  6. Randy E.

    As previously mentioned, your numbers are deliberately skewed. I get the premise of what you’re saying and to a small degree I even agree with the underlying logic. But playing with the numbers like that only serves to weaken your overall point in my eyes.

    For instance, $1200 a year for yard maintenance? That’s ridiculous! I am the sole or joint owner of several properties in that price range and the tenant is responsible for yard maintenance in every instance. And it’s that way for nearly every other rental in that price range in my area that I know about. And that’s just one instance of number tinkering. I could disprove the prices you list for at least half your list.

    Besides, I think you’re ignoring one HUGE fact. Many investors can’t afford to purchase a $270K rental property, especially for their first few properties. Maybe they’ll grow to that point, eventually. But if I had to save and save for a $270K rental property before I could enter the game, I’d still be saving.

    The more expensive property may indeed prove to be the better overall investment. That doesn’t make the inexpensive property a bad investment. Everything is relative. I tell an investing buddy who is in the same financial stage as me that some properties we come across are great opportunities … just not for investors with our bank accounts.

    Honestly, the entire article (and similar articles I’ve read on BP) reek of elitism. Like those car magazines that heap praise upon cars that cost $120K, but dump on bread-and-butter cars that cost $15K. I understand that to someone who earns $10K/month at their job, investing in a property that nets $500 month hardly seems worth the effort, especially if that investor is also managing the property. It may not be viewed as an efficient use of his time. However, for someone who earns $2000/month at their job, investing in a property that will increase their overall earnings by 25% is a big deal, and certainly well worth the effort. I understand that someone who is living an upper-upper-middle-class lifestyle (and may have their entire life,) personally dealing with tenants who live in or near poverty may be challenging — I understand it may be hard to relate to and understand tenants when your life experiences are so much different than theirs.

    It’s okay that some RE investors have climbed the ladder so far that investing in a $30K property is a joke not even worth laughing at, much less considering. It’s okay that some RE investors enter the game with a $300K budget for their first property. It’s not okay to denigrate those of us (and our investment properties) who are forced to invest in such homes.

    I’m making money off every property I own. I have equity I would never have if I decided such properties were beneath me. And I hope 99% of all investors in my area think as you do, because that would allow me to slowly buy as many of these properties as I can.

    Okay, I’ll get off my soap box now. Good luck to you in all your caviar home purchases. I’ll gladly stick to my pigs and mutts.

    • Terrence Evans

      I may be incorrect in saying so but the whole expensive property vs cheap property angle is totally geared towards those of us in expensive states. We often ponder the question do we invest here (Cali, or the Eastern seaboard) or someplace cheaper (like the South or the Midwest).

      With that said, I don’t disagree that the arguments are possibly skewed.

    • Andrey Y.

      Truthfully, that $120K car is probably better than the $15k car. Don’t deny it. Same thing with the $270K house. There is probably a reason that people are willing to pay $270K for it.
      I am all for “bang for the buck” in investing and in life, but lets be realistic here.

      • Randy E.

        Yes, the $270K house is probably better for living in. It’s not necessarily the better investment, though it may be. We’re all here to make the “best bang for the buck”, but that bigger bang isn’t guaranteed to come with granite countertops and marble tile.

        Just as $120K may buy you an awesome car, but is spending $120K on a car the best use of your money at this present time?

        • Shaun Reilly

          With a car it is pretty unlikely that the $120K car is far superior in almost everyway to a $15K one (by 10x? Probably not though…).

          However it is not at all a given a $270K house is nicer than a $30K house. That gap will have very little to do with the bricks and sticks and everything to do with the dirt you put them on.

          In the city I live in $270K MIGHT get you a <700sqft 2BR condo (more likely a slightly smaller 1BR) that hasn't been updated since the 1980s.
          In a "cash flow" market I own houses in I have a 4BR 2BA ~2,300sqft house with handcrafted woodwork, hardwood floors throughout, recently updated kitchens and baths (rental level, but all new) and several updated mechanicals that I was all in at about $28K when it went into service. If I tricked it all out I could have had all high end stuff and like a $35K house.
          Which is a better HOUSE to live in?

          All about the dirt…

  7. peter john K

    i second the pigs and mutts even if it is more work per dollar earned it leaves a lot more room to grow without even trying… Many high end areas today were not high end areas 10 years ago…. So someone investing in the lower class area to make extra income can do so and than later on not only have 100% equity on a multitude of properties the neighborhood could be the next bushwick or alphabet city….. (those were slums and many buildings still are but all worth millions of dollars)

    versus if you buy a house in the nice area that already has great schools the opportunity for hitting the lotto (which should not be the goal) simply does not exist so you are limiting yourself…. Not to mention property taxes can be a big factor… Also to have a house with 29000 annual income and only account for 100$ vacancy WTF is that like 3 days… yea maybe if your charging under market rent in the most desired hipster area available i think a month a year should always be accounted for maybe even 1.5 months so when you do get lucky and have a 2 day turnover you feel the luck instead of feeling the pain every other time you turn it over…

  8. John Thedford

    I prefer nicer properties. I pay more but I charge more, get better quality tenants, and have a better chance of appreciation. When it comes time to sell, nicer properties will be in higher demand. You won’t see people making offers over asking price on low end properties (generally speaking). I tend to buy newer units, have fewer expenses (repairs, replacements, etc) , lower insurance costs, and lower turnover. I know other investors that won’t buy high end properties. There is no “right” or “wrong” way…we all choose what suits us best. Thanks for the article.

  9. P. Martin

    Why would someone put a 15k and 5k kitchen and bath remodel in a 30k house? Also why would they purchase a washer and dryer? Let alone $500 each for them. $700 fridge? More like $50 off craigslist from when the owner of the expensive house buys a new one.

  10. Christian Bors

    I always hear experience investors say they prefer the nicer property due to appreciation and better quality tenants. It seems like experience investors always urge newer investors to stay away from those cheaper properties. They may be right, however I think those cheaper properties can serve as a great educational tool for future investing. If the property cash flows, it may be worth the struggle for a newer investor so they can get their feet wet.

    • Brandon Stevens

      Most newbies do and I agree should cut their teeth on the pigs, I cannot think of a better way to learn the trade. In the pigs you see it all, if I buy something that just needs a tenant how do I learn about eviction,tenants screening, what to look for when I buy, what to stay away from, the list goes on and on.

      Those houses are available in my area and I do own a few, but I rarely look at them anymore. The extra cash flow is nice but the tenants are what they are and I simply prefer the 100k house I can buy for 80 fixup and charge twice as much with tenants who leave me alone 🙂

      The pigs are great for learning and growing your initial portfolio but using those paid off properties to upgrade to better ones would be my recomendation.

  11. Jim Edwards

    This analysis doesn’t really factor in the likelihood for non-payment by tenants. Based on my experience lower price properties tend to have a larger number of non-paying tenants. When you factor in 1, 2 or more months of non-payment plus legal costs the cap rates change significantly. I have personally made many investments in lower priced properties and it is probably a good starting point for many investors. Intermediate and experienced investors are probably better off with higher priced properties. Low price properties offer a lower barrier to entry but they do come with risks beyond just repairs & maintenance. If you are focused on investing in lower price properties you will definitely need multiple properties to compensate for the risk of non-payment and repair/maintenance costs. Plan on purchasing at least 5-10 properties or multi-unit properties if you want to create a full-time income with lower price investment real estate.

  12. joseph ball

    I just believe in “Little Deals”. You can’t fall very far with a little deal. The floor is close.
    A vacant month is no big deal with a little deal. It may be a heart-stopper with a big deal.
    HOA was not mentioned. In many big deals, there are HOA fees. I have yet to face HOA with little deals.
    I have said this before. I regard appreciation the same as intimacy in marriage after the kids come. It’s a good thing, we all hope for it, and sometimes it happens.

  13. Jesse T.

    While I agree with the basic premise that it can be easier to be profitable with more expensive properties – there often is a point where increased value/size isn’t rewarded much in the rental market. I think a lot of markets you have to find a sweet spot where you are being compensated in rent for most of the property value – but you are in a class of property that has appreciation potential.

  14. Cindi Anderson

    I agree with many of the points that have been made, and won’t repeat them.

    I will say this really points out the difference in location. In the areas where I have lived (California, Hawaii and mountain resort areas), $270k would be the cheap, low end house and a house that could get $29k in rent would cost closer to $1m. So every deal has its own set of numbers.

    Also, I do agree that you need to look past ROI. I had two vacation rentals; the one that was 10 times more expensive had a much lower ROI, but it was the one I kept because it was so much less work. The people who pay $400 a night barely contact me, take care of themselves, stay for 2-4 weeks at a time. The people who paid $100 a night were always negotiating for a cheaper price, canceled more often, only stayed 2-7 nights, complained more, and were generally a lot more work.

    There’s also the potential upside to consider. I bought a house at auction that was several hundred thousand dollars under market value. That allows for some things to be wrong and still make a very nice profit. I looked at another one on auction that was 1/3 the price, but anything that went wrong could have quickly eaten up any potential profit. With larger homes your profit %’s might be lower, but your $ profits much larger for the same amount of work.

  15. Deshan Kennedy

    Brett – Thank you for your article as it was a great read. I think people’s current and long term goals even though the $270 homes would be the better option, the $30k homes may help people get into the real estate investing world while working towards the purchase of the $270k homes.

    There will always be pros and cons to both purchases so to say one is better than the other is a hard argument for all. Similar to the argument about buying a SFH vs a multi-unit buts its always great articles to read no matter what side of the debate you are on. Looking forward to more of your writings.

  16. I am not going to pick apart your numbers since I believe that your premise is correct, that more expensive houses can yield more dollars per hour. I don’t think that anyone here would disagree with the statement that less expensive houses require more hours of your time. However, your conclusion is the opposite of the one that I formed 5 years ago. My conclusion was that it made sense to invest in more expensive houses that are far away and less expensive houses nearer to home. It is much more feasible for me to manage from afar one house that requires very little time per month than the 10-15 houses that I can buy in my area for the same amount of money. In my 20+ years of experience, my appreciation has been much greater in my hometown since I am familiar with property values and can buy houses for $30,000 that will appraise for $70,000 after I spend $7000 in improvements.

    By the way, newbies, I used the equity in my first houses (which were $8000 houses in the slums) to finance the downpayment for the expensive far away house. I also used my experience in dealing with very difficult tenants to allow me to easily manage the great tenants that I can now afford. Good luck in your journey!

Leave A Reply

Pair a profile with your post!

Create a Free Account

Or,


Log In Here

css.php