Should You Buy Cheap Rentals?
There is a debate afoot and I’m dragging you in! The debate is whether you should own rentals in the low-priced areas of your town. I don’t buy houses valued less than 80,000 dollars once repaired to keep as rentals. Is that the right decision? Here are a few points to consider as you choose what’s right for you.
One metric in rental property ownership is the “one percent rule”. Now this one won’t employ your skills in advanced trigonometry. Sorry. It basically says that if the house rents for 1 percent of the purchase price, per month, it might be a good deal. For instance, if you pay 100,000 and think you can rent it for 1000 per month, you might want to dig a little deeper. While this metric is too vague for much more than a quick look, it is a decent starting point. You may even hear people who achieve the “two percent rule”. And these folks may actually have lower priced homes. Possibly even in “war zones” as they are affectionately known in the real estate circles.
You see, a general trend in pricing is that the higher prices climb, the less the rents keep up as a ratio. So if my 100,000 dollar house rents for 1%, my 500,000 dollar house may only rent for 2200 dollars. That makes it a 0.4% deal. Now, my 50,000 dollar house rents for 900 dollars. That is 1.8%!!!! Pretty cool, huh? I should just buy a bunch of cheap houses by this metric, right?
Warning: buzzkill coming. The numbers seem to work just fine but many people report not being able to keep these lower priced houses rented or being able to collect the rent. In other words, some of this tenant class is less than reliable. So if you have longer vacancy, your 1.8% starts to drop. How about an eviction? Drops even more as you are now spending money to get rid of tenants. What if they don’t have bank accounts? Now you spend time driving to collect rents. And repairs are about the same as for a nicer home of similar size. Toilets all cost very close to the same amount. And lenders don’t want to loan on these homes. Most conventional lenders don’t want to mess with these small balance mortgages. And these houses don’t tend to appreciate like nicer homes do.
Our Sweet Spot
So those are some of the reasons I haven’t jumped into this market segment. My houses are nicer than these “war zone” houses but not as nice as the 500,000 dollar home in the example. I find that at my price point, I can add value to a fixer-upper and get bank financing pretty easily. I can still cash flow some and see some appreciation in a strong market. I also find I can be very selective of the tenants so I have a good chance (no guarantee) of finding a great family that pays on time and can pay from an electronic form of payment to make chasing rents a non-issue. My tenants tend to stay put for multiple years and help my vacancy rate stay very low which increases my actual return.
My focus is cash flow and any appreciation is just an added bonus. I can’t make the luxury home make sense from any perspective so that leaves us with “my” kind of house and the “war zone” houses. My kind is a 2 or 3 bedroom house with 1 or 2 bathrooms in a good working class neighborhood that I’m comfortable for my wife to go to without me. Actually, she’s pretty tough so maybe I should change that to areas she’s comfortable for me to go without her. At this time in the market, the values of these houses are usually from 90,000 – 160,000 dollars ARV (after-repaired value). It’s a pretty big sweet spot! I really like that I can feel good about the houses we own. They are clean, safe, and comfortable. This is mainly a psychological aspect but it matters for me. I like when a family moves in and is really proud of their new home.
The Flip Side
Now after all this bashing of the cheaper houses, I have a confession: this topic was largely prompted by a conversation I had with a friend this week who only buys cheap houses and he is doing extremely well with them. I don’t know all of his systems but it’s working for him and he’s paying them off quickly too. Another very successful investor I know chooses different strategies based on the ARV (after-repaired value) of the home. He picks the ones under 80,000 to be owner-financed, above that are rentals up to about 120,000. Above 120k ARV he tries to flip. His reasoning was really solid for the sub 80k strategy, in my opinion. He says that this is not the tenant class he wants to manage. It’s also not an area he minds missing out on appreciation in (with O.F. you don’t benefit from appreciation because you are no longer the owner). And these areas don’t tend to appreciate as much anyway. Another cool aspect of owner financing these homes is due to that fact I mentioned earlier that banks don’t like to loan on these homes. If you can provide the financing, you can provide an opportunity for ownership where a buyer likely won’t find a bank who will finance it. This also allows you to charge a higher interest rate. And there is no tenant management at all because the new buyer is truly an owner. They are responsible for all upkeep. You only collect payments. The downside is that eventually you will be paid off and have to find another place to invest your money but this is a very popular technique that many people love.
Pick Your Niche
Lower-priced houses are not my niche but there are plenty of people who make money with them using different techniques. This is a reminder that there is no perfect niche. Find yours and get really good at it. We spoke recently to the Alamo REIA Wired group which is made up of all women investors. There were so many people there who were succeeding with different strategies. It is a reminder that just because we like rentals and the BRRRR strategy, this is but one of many strategies in real estate. Some other women did STRs (short term rentals), others did owner finance, some were flippers, and still others did rentals like us. I hope this blog helps you see that there are many options available to you. It can be overwhelming but once you find a niche it is fun to dig in and create systems to be successful.
Why We Do It
We are traveling a lot this summer and hosting family from out of town. Our focus on rentals along with personal budgeting is what has allowed us this freedom. It’s the freedom of time that matters more to us than the freedom of money. Veronica has been able to be self-employed for two years now and we aren’t looking back! Having her present more has been worth more than the money any business can provide. We joke that we buy houses to sleep in tents. And it’s pretty much true. We have focused a lot of energy to make this our reality. Focus is what will be our topic next week. I hope that you can use this blog to help you find your path to what is most important to you and continue to “keep the main thing, the main thing”!