Why Cash Flow is Vital When Investing in Low-Income Areas

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Let’s face it, owning long-term (or buy and hold) rental properties is not for the faint of heart, especially if you decide to manage them yourself.

There are many things you need to know about, such as contract law, negotiation skills, state specific landlord-tenant laws, and even local ordinances. And this doesn’t even delve into deeper topics, such as the most efficient ways to deal with tenant turnover. The list goes on.

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Cash Flow is King

If you do decide to be a landlord, whether you want to turn things over to a professional property manager or not, I strongly suggest that you invest in real estate that positively cash flows before taxes.

First, let’s make sure the rent is at least higher than the PITI (principal, interest, taxes, and insurance) at a bare minimum. Some folks like to include a percentage for vacancy, maintenance, or management fees as well. I agree, but at the very least, gross rent should be several hundred dollars higher per month than the mortgage payments. So far, so good — right?

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Related: “Low Income” vs. “Bad” Neighborhoods: Yes, There IS a Difference. Here’s What Separates Them.

Low-Income Areas

This is where things can get tough. Many times, the only areas that cash flow are areas that may be the tougher parts of town, either with higher crime rates, no jobs, or possibly poorer schools. The trick for me was to invest in areas on the brink of change.

Usually, I search through all the areas in my county (or the next county over) that fit in my price range. My goal was usually to be all in — purchase price, closing cost, repairs, and cost of capital — at 65% of the ARV (after repair value).

At that point, once I moved a tenant in, my goal was to cash flow a few hundred dollars per month after I got all my capital back through the refinance.

Rinse and Repeat

Once I got all my capital back to return to my private (or hard money) lender, I’d go out and find another property just like it and repeat the same process.

The reason I liked areas that were on the brink of change was because the property value hadn’t fallen yet, but the perception was that the neighborhood was about to decline. I’d go in and steal a good deal, fix it up nicely, still get a good appraisal on the refinance, and then cash flow my way into wealth.

An old-time investor had told me this strategy, and I just did what he said, but it worked.

After 30 years of using this strategy, here’s what happened. I’ve grown my equity by a few million dollars, my tenants have paid down many of my properties, I’ve written off an awful lot of expenses (thus saving a lot of money in taxes), and I’ve borrowed out a lot of my equity to do notes and private money deals for fellow rehabbers.

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Related: 5 Tips for Owning Low-Income Rentals in Less-Than-Ideal Neighborhoods

Appreciation

As for appreciation, I haven’t done spectacularly, but I’ve done OK. I’ve been through several up and down cycles. When values are down, I hold and cash flow (and sometimes even pay down properties). When the values are up, I sell some (or refinance some equity out) to cash flow in other deals. Often I’ll sell in areas where I feel it’s now time to get out and perhaps move my capital into a more valuable piece of real estate. This is especially since today I’m more financially well-off and don’t necessarily need more income.

Unfortunately, more is not always better as a real estate investor. Today, I’m not really looking for more aggravation in my life, especially when it comes to managing more properties, whether they cash flow or not. In fact, don’t tell my property manager, but I don’t even like it when she calls me. It’s not like she’s calling to say happy birthday; it’s usually about a problem.

Today my strategy is more about cash flowing in other ways, and for me that’s usually through lending backed by real estate as opposed to in real estate.

So, let me ask my fellow BP folks: How do you like to cash flow and what’s your strategy?

Let me know with a comment!

About Author

Dave Van Horn

Dave Van Horn is President at PPR The Note Co. - an operating entity that manages several funds that buy/sell/hold residential mortgages, both performing and delinquent. Dave has been in the Real Estate business for 25 years, starting out as a Realtor and contractor and moving onto everything from fix and flips to Raising Private Money.

17 Comments

  1. Christina R.

    Great blog. I think the one caveat that needs to be clearly understood is risk tolerance for these types of neighborhoods…. the passage of time can make an area that is borderline but still one where you can refinance and use the BRRRR strategy obsolete. I just went through this with a delayed refinance, I was very lucky I successfully appealed it; just 8 months ago I had no problem hitting the 70% LTV but this recent refi initially was way off. This experience was awful, and has scared me enough presently to keep me out of acquiring more rentals in this area – where cash flow is awesome – until I can do it in all cash OR have private lenders who are happy to have their money sit there for decades by acting as the bank.

    • Dave Van Horn

      Hi Christina,

      Thanks for commenting. I’m not sure I agree that the risk tolerance should be much different in low income areas than other markets when evaluating on a cash flow basis. I think being accurate on the FMV, the ARV, and staying all in at 65% LTV or under, I personally believe it’s hard to go wrong (I say 65% because it gives you more leeway). What I didn’t mention in the article was where within low income areas i purchase. For me, I invested in multiple areas in a fairly large county (population wise) to spread out my risk. I also always bought the “worst” house in the best school district so as to still get good rents.

      Your delayed refi scenario is definitely an unfortunate one for sure but I hope you aren’t completely discouraged. There are things that can be done to avoid what you described above. Not saying unexpected things couldn’t arise or that you didn’t do any of the following but these could be some good tips for other investors with risk concerns looking to investing in low income areas.

      The first being: make sure the numbers are right upon purchase and with the ARV. I know that seems like redundant advice but I always say, there’s no such thing as bad houses just bad prices. I always make it a point to try to buy from sources that would grant me the best deal – like motivated sellers, nursing home sales, estate sales, etc. so I’m obtaining properties at steep discounts. Then I would make sure as best I could that the renovations came in within my budget – now I was an experienced contractor when I started but investors can hire one to evaluate properties alongside them.

      Secondly, I would try to get approved for the refi in advance. When I was actively buying I was either pre-approved for the refi or at least close with the lenders, so I knew before hand how fast I could refinance. I was also a Realtor who could contest a low appraisal.

      So it could be the price point at purchase, the renovation went overboard, or like what you mentioned – a changing economy that causes the property to drop in value. Most markets take a minimum of 6 months to change but there are ways to mitigate this risk. There’s a great book called “Timing the Real Estate Market” by Robert Campbell that illustrates how to use hard economic data (much of which is located in the county courthouse) as an investor that can help decide if it’s the right time to buy in a desired market.

      So I can’t argue that deals in low income areas come with risks, but if an investor can mitigate them with some of these strategies they could still find success. I also think if an investor were using hard money vs. their own capital, this could affect the deal as well since Hard Money Lenders are very strict with their screening process when it comes FMV, ARV, etc. Even if one plans to use their own money, investors can still run their deals by Hard Money Lenders to see if the numbers make sense.

      Of course nothing is fool proof in this business but hopefully these can help with future acquisitions for you and other investors. Best of luck with future rentals.

      Best,
      Dave

  2. Randy Friedland

    Great article, Dave. I never would have looked at buying when a neighborhood is perceived to be on the verge of dropping in order to get a better deal but when I think about it, if you can get the property low enough for rental purposes, it makes sense. I’ve looked at a number of properties in areas perceived to be on the verge of, or actually increasing, and seller flexibility is far more limited and I would imagine that the competition is much greater.

    • Dave Van Horn

      Hey Randy,

      Thanks for commenting! And It sure is far more competition with less flexibility to obtain a deal. As an investor, you don’t want to compete with owner occupants because at that point your competing with retail prices and they’re bidding everything up (probably with 3% FHA loans no less). Often times they’re even giving more than the asking price. Plus besides all that, areas like those likely don’t cashflow or at least as well as low income areas.

      Best,
      Dave

  3. aaron cullen

    Dave very interesting article. Thanks for sharing your experience. I just started out with a very similar strategy except I’m looking for neighborhoods that are cheap/lower income but starting to change in a positive way. Usually that means closer to downtown. Could you explain a little more about how that aspect of your strategy helped you build your portfolio? Did those property values go down as the area declined and get harder and harder to rent?
    Thanks for your time Dave, always enjoy reading your articles!

    • Dave Van Horn

      Hi Aaron,

      I actually never had strategy that involved buying in areas that I think would increase in value. In fact, I usually only go to the other end of the spectrum. If I tried to have a crystal ball and predict what would appreciate fast, it would be an entirely different strategy altogether. I’m not saying it doesn’t happen but unless you have close ties with developers or city planners you’re probably going to be gambling a bit (or at least too much for my liking).

      So on my path to build wealth I figured, there’s too much competition in that arena and there’s never a guarantee so why not just go right for the cashflow? The tenants were essentially buying me properties, I had plenty of tax write offs, and since I bought low value properties in these areas, they all went up in value over time. I was also a Realtor and a contractor so I was making money every step along the way.

      As far as your question goes, I never had a problem with renting because most low income areas are for renters rather than owner occupants. And I never bought in areas that were so bad that they couldn’t be rented or were filled with crime. I stayed away from the inner city, mostly operating in the suburbs.

      Best,
      Dave

    • Ethan Lee

      I think he is able to get great deals in these areas because people are afraid that the area is declining and want to get out quickly, giving him a deal. However, the area hasn’t declined just yet, so the appraisal comes in higher than it would have had the neighborhood already declined. This gives him more of a safety net to pull out all of his equity using the BRRRR strategy, cashflowing nicely while allowing him to go repeat the process. Had he waited until after the decline, the appraisal will be much lower, he couldn’t get all of his equity out, and the repeat process would be stalled. This strategy works because he wants to cashflow and is not that concerned with appreciation.

    • Dave Van Horn

      Hi Philip,

      Ethan is right on the money here with his response above. I wouldn’t get a high enough appraisal for the refi and I wouldn’t get as much rent to cover the mortgage if I bought in areas that the housing was at the very bottom of the spectrum. My strategy was really focused on towns where they shared a school district with slightly better areas. I would just pick the town or the border of the town with the lowest income but that was still safe.

      Best,
      Dave

  4. Stan Hill

    Dave:
    Great article, Dave. We use a similar strategy, so it’s nice to hear someone else who has done it longer and built some nice wealth.

    We like working class neighborhoods (with low crime rates) and are always looking for deals. We are also investing for income. As a result, our plan includes PITI, maintenance, management fees and a very low vacancy rate. From that we get our monthly cash flow. We’ve gotten pretty good at projecting costs and sometimes take unused maintenance costs already set aside into paying down a mortgage.

    At any rate, I have found the cash flow numbers to work better where we invest- older homes, working class, generally stable, there’s even some new construction here and there. Our last purchase a few months ago cost us $89,000. It was advertised as an SFR with guest quarters. Guess what? The “guest quarters” was a two-story apartment with its own gas and electric meters. Total rent: $1,750 per month. If only I could find more of these!

    • Dave Van Horn

      Hi Stan,

      Sounds like you’re doing it right! I do a similar thing with low crime rate areas as well (Trulia can be a good free resource for looking at that).

      As far as your SFR with guest quarters…I don’t even have to get my calculator out for a good deal that good! Keep up the good work.

      Best,
      Dave

  5. Mikael Winkler

    Great article! I’m just beginning and am looking in these sorts of areas. Good to see that there are ways to successfully invest in low income, especially because, being a newbie, I’m looking in those lower price ranges.

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