How Investors Get Burned Following the 2% Rule in Low-Income Neighborhoods

by | BiggerPockets.com

As a new investor, I lost a stunning amount of money on low-end properties.

On paper, the numbers look gorgeous: “I can charge $1,000 in rent for a $30,000 property?! What can go wrong?”

A lot, it turns out. But these costs are not always obvious, and even when they are, they’re not always politically correct to talk about.

The “2% Rule” claims that a property that rents for more than 2% of the purchase price is usually a good deal. But these sorts of shorthand rules can be deadly, especially for new investors. I touched on this as one of the 7 Lessons I Wish I’d Known When I Started Investing, and it’s worth a closer look.

Here’s how low-end real estate can end up ravaging investors and how to avoid losing your shirt.

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A Tale of Two Properties

These numbers may look imaginary, but they’re actually rounded versions of real properties I’ve owned.

  • Francis Street (or “Francis” for short): The purchase price and closing costs totaled roughly $15,000, and it needed around $25,000 in repairs ($40,000 for the non-mathematically-inclined). It’s in a rough neighborhood and rents for $1,000/month.
  • Chester Street (henceforth “Chester”): With a purchase price and closing costs of $160,000, Chester needed roughly $15,000 in repairs ($175,000 total). Young professionals live in this neighborhood, and Chester rents for $2,000/month.

At first glance, you could buy nearly four and a half Francises for the price of one Chester and earn over double the cash flow. You could also diversify your investments, with four or five properties spread across different neighborhoods rather than all that capital tied up in one property.

But here’s the thing—cash flow involves a lot more than just the cost of the property and the rent.

private-money-meeting

Cash Flow & The Real Cost of Ownership

There are entire articles, entire chapters in books devoted to how to calculate cash flow properly. We’re just going to hit the highlights here.

Cash flow is not rent minus mortgage. Beyond the principal and interest of the mortgage payment, here are just a few of the most common costs:

  • Property taxes
  • Insurance
  • Vacancy rate
  • Property management fees
  • Maintenance
  • Repairs (turnover costs)
  • CapEx (capital expenditures)

There are other costs that sometimes apply. For example, some properties have homeowners’ association or condominium fees. But you get the idea.

These costs are almost always higher for low-end properties in “tough” neighborhoods. The vacancy rate for Francis is a whopping 20%. But Chester’s vacancy rate? A mere 4%. That’s a difference of five times.

It doesn’t stop at vacancy rate, either. The last time Chester turned over, there was zero damage. The renters were attentive in patching the nail holes from their decorations and even painted over the patch marks. Floors, kitchen, bathrooms? Clean as a whistle. Chester needed about two hours’ worth of work on my part to get the house ready for the next tenant to move in.

The last tenants at Francis left the property needing $9,000 in repairs. New paint throughout. New carpets throughout. Damage to the cabinets. Filthy bathrooms. Abandoned trash (some of it bulk trash and furniture) littered throughout. Broken bannister spindles. The list goes on.

Related: Newbie Investors: Here’s the Truth You NEED to Know About $30k Properties

The Higher Costs of Lower-End Properties

Those tenants at Francis had to be evicted because they stopped paying the rent. So, in addition to the $9,000 in damage, they also cost $5,000 in unpaid rent, legal fees, and court fees.

But it doesn’t stop at the higher risk of rent defaults. Once Francis was vacant, it was broken into by junkies for use as a drug den. We had to call the cops, then board it up. Needles, used condoms, and mostly-empty 40-oz. bottles were strewn all over the floor. It was subsequently broken into again (presumably by the same junkies). I had to board it up again, this time with special screws with a non-standard head.

Francis is inside city limits, where the property tax rate is double the surrounding county’s tax rate. Even though Chester is assessed at a much higher value, its property tax bill is only marginally higher than Francis’s.

Regulation is much higher in cities as well. That means more inspections, more work orders from the city government, more registration fees, more headaches. Chester has never once had a city inspector walk through, nor does it need them. It’s in pristine shape because the renters keep it that way. Francis has had plenty of inspectors come through, and they never fail to slap me with work orders. Why? Am I a slumlord who leases out a ramshackle, falling down building? Of course not. But most of my renters have abused the living heck out of the property.

The insurance premium is also higher for Francis. It doesn’t matter that the policy is for a far lower coverage amount; statistically, there are many more insurance claims in these low-end areas. (Look no further than the break-in above for an example of why.)

We’ve touched on the financial costs of crime, but that doesn’t cover the personal safety risk. When I was 24, I thought I was tough and brave walking through these bad neighborhoods. Now I look at the violent crime rates in those neighborhoods and wonder, “What was I thinking?”

Here’s another question for you: What kind of property managers accept the lower commissions and greater labor involved in managing low-end properties? Usually bad property managers. I lost nearly $40,000 due to my last property manager. His casual indifference to my properties’ performance was staggering.

buy-and-hold

Riches in Niches—If You Know What You’re Doing

That $40,000 property, Francis, has ended up costing me closer to $100,000 over the last decade. It’s been a thorn in my side and a constant source of stress.

All the while, Chester has purred along smoothly, with clean, respectful renters who pay their rent on time every month. They leave it just as they found it. When a turnover comes along (far less frequently than at Francis), there’s no shortage of prospects eager to sign a lease with me.

Is all this candid talk comparing low-income neighborhoods to middle-class neighborhoods making you uncomfortable? Good. Perhaps if we had a more candid conversation about the problems plaguing low-end neighborhoods, we might make more progress in solving them. In my experience, the first people to reflexively defend low-income neighborhoods are the last people to invest their own money there.

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

Buying and managing rental properties in bad neighborhoods can be a lucrative niche for investors who know what they’re doing. It comes with dozens of risks, each of which must be mitigated. Understanding how to mitigate those risks takes experience and usually some hard knocks. Even Nakeisha Turner, who has aggressively invested in low-income neighborhoods surrounding HBCUs, has learned some hard lessons.

If you’ve done a handful of deals and have started gaining a firm grip on how to forecast cash flow, you can always ease your way into lower-end properties by gradually buying lower-cost properties.

But take it from someone who’s been burned countless times: Low-end properties come with higher risks than you realize.

Ooh, there’s so much in here to get readers riled up! Who’s ready with some indignation or a quip? Or perhaps there are some readers who have been there themselves and can share some firsthand experiences about these risks and costs?

Let’s hear it all!

About Author

Brian Davis

Brian is a rental expert with a passion for house hacking! He and his partner Denise are the founders of SparkRental.com, which provides free mini-courses, webinars and other education on passive income and house hacking.

40 Comments

  1. Susan Goldthorp

    There is absolutely nothing in this article I could disagree with. However one danger to look out for is when the market is hot like it is again now renters are forced into areas they wouldn’t ordinarily choose to be in because that is all they can afford. So you can have a few good years with good tenants who will move out once the market changes and they can find better areas for the same rent. This is something I noticed 10 years ago, just before the crash and how things changed afterwards.

  2. Wilson Churchill

    Yeah.. Stay out of bad neighborhoods. The niche is to find neighborhoods where both good and bad tenants can be found and to only rent to the good ones. If you rent to trash don’t be surprised when your house is trashed. Go through a hundred applications if necessary. Be patient.

  3. Tim Sabo

    Brian, you hit a Grand Slam with this one! We have experienced the life as landlords of low-end properties, and you are so correct: low-end properties cost way more to keep than mid-range or better. Here in PA, we have the added benefits of 1) having no real ability to collect the legal judgments we win against tenants, and 2) having to foot the bill for tenant’s unpaid water and sewer bills or face property liens. Oh, isn’t land-lording wonderful?

    We truly believe our mission is to provide nice homes for folks who simply can’t afford them, but boy have we had to learn the tough lessons of ‘super-screening’ and ‘get-out’: we are now going through approximately 50 applicants per vacant unit until we fill one. And we have learned to tell folks very quickly that it’s time to go. My seven-year old (Kindy-garten Landlord) coined the phrase ‘get-out’, spoken in a kind of ghostly voice, which we all knows means the tenant has worn out their welcome. I could share stories too, but you have done all of us a great service with this article. God bless you, and Happy Land-Lording!

  4. If you enjoy your quality of life, I will make it simple for you. Only buy homes (and neighborhoods) that you would live in. If your are in your 20’s…. sorry, your judgement just might not count. Mine didn’t when I was 25. Think of yourself as 40 with a wife and a couple of kids. If you wouldn’t live there under those conditions, save your money until you can buy a better property.

  5. Christopher Smith

    I went the high road from the very beginning, despite lots of snickers from the 2% slum lord crowd. Now every time I turn around I am reading one horror story after another from many of those same folks, while I just keep sailing along like a dream.

    What’s the old expression about he who laughs last……………..

      • Christopher Smith

        I’m no crystal ball reader,

        I just knew I wanted nothing to do with renting older properties in run down neighborhoods and renting to folks that statistically have a much higher likelihood of defaulting on their obligations. Plus I had money at just the right time (2009 to 2013) and I was located in an area where houses just 2 to 5 years old were selling at 35% of their previous sale price highs.

        It was really kind of a no brainier actually, why buy run down homes in run down communities when top shelf inventory is going for fire sale prices. The only hard part was dedicating about 3/4 of my total net worth to an investment at a time when everyone else seem to think the world was coming to an end.

  6. Dirk Jackson

    Thanks for the post. Am I missing something about your numbers? 2% of 40K is 800? 2% of 175k is 3500? Yet you say the rent was 1000/mo and 2000/mo respectively. So according to this you are overcharging the low income tenants and not charging enough for the working professionals. Maybe your “low income tenants” I guess that means non white are just tired of you overcharging them. While the “working professionals” I guess that means white are getting a good deal so why tear things up. These articles are really getting old everyone uses all these code words to turn it into a racial thing. That is just the vibe I get from these types of post. I guess if you met me in person you would toss me into the low income crowd too. Being poor isn’t a racial thing its a financial thing you seem to be confusing the two. I own several properties in your “low end” category and the tenants come in all shapes and colors. Thanks again!

    • Tim Sabo

      Wow, Dirk Jackson, you’ve got some anger issues. Brian never mentioned any of these things, and I never even thought of that either. I understand where he is coming from, because we have experienced much the same. But we rent to white, black, Puerto Ricans-you name it, we look for the ‘best qualified’ regardless of skin color or any other differentiating factor. Maybe YOU want to see a difference, but I for one did not ‘read that into’ this article. You should talk to someone about YOUR issues, not Brian’s.

    • Eric Johnson

      Dirk,
      The 2% rule is saying that when market rents are 2% or more of the house’s value, then it’s a very good deal to own. Brian Davis is just pointing out the many fallacies of the rule while pointing out that many people in poor neighborhoods simply do not take care of the houses they rent. That is a color blind statement of his experiences.

    • Brenna Walker

      My husband and I bought our first house in a low income neighborhood. It’s just that, low income. Only five people on my entire block own their houses. Everyone else rents. When we moved here rent was going for about 700 a month. Now it’s going closer to 1200. In the four years we have been here I’ve noticed exactly one house that has a revolving door of tenants. I’m not sure why though, the house is in good repair, the neighbors are quiet and keep to themselves (I’ve started refering to our neighborhood as “The Crypt” because it’s so quiet and we have a lot of retirees moving in), the rent isn’t very high and it’s never vacant for more than two weeks. I can only guess that it’s the landlord.

      Also! An interesting side note, I totally would never have qualified to rent my first apartment by these standards. But I understand the need for them.

  7. Kevin Polite

    Brian, in general I agree with your assessment, but almost every major city and now Mid size cities inner areas are changing rapidly. For example, In Atlanta those that bought in the areas you described have quadrupled their money and some even more. Young professionals are moving Intown which is why rents in cities are now much higher than in the burbs. This has been going on for nearly two decades and I don’t foresee any changes. This is not to say the burbs won’t continue to grow and probably at a higher rate. I believe it means Intown living is much more competitive. Obviously it means you won’t get the 2% anymore, though that hasn’t happened in Atlanta for sometime

  8. Paul Merriwether

    The Francis home should have been rented out to a Sec 8 person. The Gov stands behind the lease. Cash flow is always good, however home appreciation is a better standard. If homes aren’t appreciating in an area don’t invest there! IMO a $30,000 fixer should have been sold after repairs. Even at $70,000 sales price the house note @ 5% would have only been $375.00/mth. not including taxes or insurance.

    Anyone qualifying for your $1,000 rental fee, surely can purchase your home.

  9. Most of it comes down to the landlord and his due diligence in selecting tenants and managing them as well as your property. The article is very skewed toward having landlords staying away from what your calling slumlords. Money can be made with any type of property and I believe the success or failure ultimately rests on the owner.

    It also mentions losing $40,000 from a property manager but this too goes back to the landlord in choosing a good property manager and then monitoring them the same or more as your tenants.

    We own a couple dozen properties from mid to higher end and have been doing this since our mid 20’s. Yes we have learned lessons the hard way and will continue to do so but experience has taught us many things.

    Our vacancy rates are less than 5% across the board and we self manage believing that no one cares about our properties as much as we do and if you take good care of your properties your time spent managing is overall low and the 10% fee they charge IMO is much better spent on debt reduction, home mtce or even for us. I should note we are in smaller mid-western towns.

    Quite honestly, we have rented houses to janitors & doctors and both have trashed places and not paid rent as mentioned above and one of the lessons is the amount of money they make doesn’t necessarily make them good or bad tenants and we have seen this many times in our over 25yrs in the Rental business but generally it is true that those having a larger income at least have the ability to pay.

    We have said this for years that the house is the easy part, the tenants are where you lose/make money.

    • Eric Johnson

      Dirk,
      The 2% rule is saying that when market rents are 2% or more of the house’s value, then it’s a very good deal to own. This is a landlord “rule of thumb” when looking at houses to see if they have a simple business case for buying them.

      Anyone who buys in Santa Clara at this time is losing money every month and is betting they’ll recoup it & make money when they sell. That isn’t a wise business practice.

      • Paul Merriwether

        When buying property in the Bay Area in the 30 yr’s I’ve bought and owned it has never been about a positive cashflow. It’s always been negative. However, APPRECIATION has been OUTSTANDING!!!! Buy, fix, rent, refi … buy another (if you can afford too).

  10. Daryl Anderson

    It’s all in tenant selection. I am investing in low end areas in Cleveland and haven’t had many problems for years. I had to get burned a few times to find the right tenants but now that I’ve found them, business is great in the 40k properties!!!

  11. James Kojo

    Great post! There’s a key concept that this article (and Steve in the comments) touch on, but doesn’t state explicitly: and that is the value of your time and energy.
    Everyone basically has 3 macro resources: Money, Time, and Energy. Utilization of those resource can be converted into just about any other resource, including more money, time and energy.
    The post talks in depth about the money component, but what you failed to quantify in the original analysis of the Francis house was the time and energy required to manage such a property.
    So, I don’t think the take-away from this post should be “don’t invest in low-end housing.” I think there real take-away is that one should properly include the value of the time and energy required to own such a home when doing a cost/benefit analysis.
    Put simply, there is probably some amount of cash-flow you that would make you willing to incur such headaches, but 1K in gross rents probably doesn’t meet that threshold!

  12. Mike Buckley

    Ya from lots of experience low income rentals never actually attain those pie in the sky returns on paper. I specialize in these types of rentals and they can do well. I have found that by buying them cheap enough and leaving enough room to “good proof” them financially it can work. Taking measures to add 4” waste lines and having stacked plumbing to reduce clogg issues, even going as far as to add floor drains in some areas where physically and financially possible, using vinyl floor tiles instead of carpet so if one gets worn you can simply just pull it up and replace it, using electric range stoves to prevent gas leak issues, using one paint color for everything or use paneling, putting in durable countertops, using only deadbolt locks to illiminate locking themselves out, installing security cameras in common areas, etc.

  13. Karl B.

    The 2% rule has been good to me, mainly because I buy in low-crime, working-class areas I’m familiar with.

    A good rule of thumb is “If you don’t feel safe walking around the neighborhood at night then it’s probably not a good place to own.” Granted, I wouldn’t walk around my neighborhood in Los Angeles at night, so I suppose there are exceptions to every rule. Though for ‘living in the hood’ home prices are amazingly high and I look forward to 1031ing my house when I figure out where I want to live.

  14. Curt Smith

    I was very fortunate from day one having married a school teacher who instinctively knew that high appreciation, low turn over, low effort to manage all track greatschools dot org ratings. 5 or higher, good, 6 or higher better, hard to afford 8 and above, so look for 5-7 great schools high school ratings.

    BTW, nothing to sell, but I wrote a presentation on how to buy a bullet proof rental portfolio. I uploaded this file off my profile, lower right, way down. All my buying and managing secrets on how I self manage 38 rentals and only spend a few hours a month. True my wife spends a few hours tracking rent roles, but little effort is the bottom line.

    I recommend taking David Tilney’s landlord training. davidtilney dot com …

  15. Works great for me. I don’t buy war-zone, but fully half of my properties have been broken into at one time or another. I screen very carefully and rent to stable tenants who are hard-working but can’t afford to live anywhere nicer. Zero evictions, zero issues with the home being trashed, just occasional issues with a late payment now and then. I’m getting 2% consistently and average a vacancy rate of less than 3%.

  16. Nick Eckemoff

    As a new real estate investor (though fairly seasoned in stocks), I have stumbled on this very dilemma…

    Do I buy cheap properties with cash in bad neighborhoods; or do I use traditional financing to buy quality properties in good neighborhoods? The cheaper properties seem to cash flow better on the surface.

    The conclusion I came to is that the real value in buying real estate is long term, where using leverage allows your tenants to pay off a property after many years. All you pay is the down payment and closing costs…the rent pays all the other expenses and then positive cash flow nets you a small return to pay you for dealing with it.

    Estimating expenses is not as clear as the 50% rule. A higher quality property has less expenses/risks and a lower quality has more expenses/risks. When buying lower quality, there are many costs overlooked by novice investors. This is why it always looks good on paper and why rents are higher…YOU are underestimating expenses of the lower end property and over estimating the expenses of the higher end property. Perhaps you are missing that the cheap property will be a depreciating maintenance money sink and the expensive property will rent for more later or even appreciate considerably. These things need to be accounted for and I think some are just too caught up simple mathematical cash flow.

    Just like the stock market, some get delusions of grandeur and their judgment gets clouded with quick gains. They end up thinking too short term and make bad decisions leading to losses. Sometimes all they had to do is put the short term loss in perceptive with the longterm by zooming out on charts or looking at other data. But all they cared about is CASH NOW (FEAR of lose otherwise) and then emotions took over so they bought or sold at the wrong time…worse yet they compound this, where the initial loss sets deep into their psychology then it spirals to other poor decisions.

    I think low end rental properties are similar. A novice investor will see them and get excited by all the cash flow. They’ll ignore the bigger picture or refuse to believe it. They will try to justify themselves all the way down to eventually they net a loss. Then a smarter investor glady comes in and buys their failure dirt cheap and turns it around. Turnkey providers prey on novices.

    I’m sure plenty make good money off cheap properties, but these people do it smart and work their arse off or are good at managing an excellent team. Its more of a job than passively owning few expensive properties. The latter is more of a benefit of owning real estate in my mind. If you want quick money, wholesaling or flipping is a better pursuit than being a slumlord.

  17. John Murray

    My rules for BRRR Portland Oregon investment. I use the 10% rule and then clear another $50K or better in the first year. Camden NJ would not be tops on my list.
    !. Would I live there? Would not buy a house I would not live in.
    2. Sidewalks
    3. Central A/C
    4. Will return at least 10% of my investment in 1 year.
    5. Worst house on the block.
    6. Within 5 mile radius of my house.
    7. Appreciation of 5-8% per year
    8. Purchase 20-30% below market value
    9. Refinance when clearing at least $50K
    10. Good tenants will come if you would live there.

  18. Tyler Parish

    This is a great article. I have this constant battle in my head as the properties I am buying are around $500k with rent at 2700-2900 / month. I always this of how easy it would be to come up with the money to buy these cheaper properties, sub 100k. This is a great reality check! I have also been so lucky to have great property appreciation in the past 5 years, which I wouldn’t have gotten with lower end housing!
    Thanks!

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