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

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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.

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.

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.

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.

We’re republishing this article to help out our newer readers.

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!

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.