which investment course of action?

Question

Long time read, first time post.  After reading too many articles on this site, lots of books, and saving money over the past year, and looking at many properties, I am trying to find a first deal to complete but keep running into this scenario:

Property type A:  around $40k, needs $5k reno, rent for $650, not a great neighborhood, higher crime, terrible schools, no room for growth, I would be paying cash for this type property

Property type B; around $75k-85k, rent for $1k, great neighborhoods, very good schools, lots of growth in the areas, easy ability to resale and much better appreciation.  I would be financing these properties.

My initial goal was to invest in the lower income areas, pay cash, get good cash flow, and repeat the process.  After talking with a property manager, I am leaning towards sacrificing cash flow for a better property, easier to manage tenants with more stable incomes, better schools and resale value.  However property type B would not meet the 2%, it is pretty difficult even getting a 1.5% rule, but there are other benefits of these properties as well.  Any thoughts or advice would be appreciated.  Thanks for the information.

Robert Leonard · Answer

@Joshua Campbell I'll introduce a different perspective to this conversation - cash on cash rate of return.  If you buy the lower price properties for all cash here's how it calculates:

45k cash outlay/7800(gross rent)= ~17.3% ;If you apply 50% (rule) to ball park expenses, you get 3900 estimated net = ~8.7%.

VS.

85k *20% DP = 17k cash outlay

68k loan balance @6%@20yrs=487.17/mo + 250 (tax&Insur, just for illustrative purposes, you can easily get actual numbers to figure this out) = 737.17/mo

1000 -737.17=262.83 *12= 3153.96 (gross rent) = ~18.6%; If you apply 50% (rule) to ball park expenses, you get 1576.98 estimated net = ~9.3%.

It's your decision which you prefer.  Personally, I would buy two of what you labeled as type b and keep the balance as a cash reserve.  The rules of thumb like the 2% rule serves a purpose, but people misapply them way too often and get hung up on whether or not they fit a deal.

Ned Carey · Answer

@Jonny Lambert

Part of my answer had to do with the context of the question. The  original poster was trying to compare low end houses where he pays cash,  vs higher end properties he finances. That is like comparing 2  different business models. The 2% rule does nothing to help evaluate  that.

The 2% rule says the monthly rent should be 2% or more of the purchase  price. This is simply a ratio of rent to sales price. This is known in  the business as a gross rent multiplier. Often when it is used in  commercial properties, it simply the price divided by the annual rent  (typically generating a number like 4.5 to 7) . This is the most crude  of evaluation tools and should only be used as a quick screening tool or  as a double check to make sure something isn't way off.

A GRM can be used as a screening tool; but the number 2% can vary  considerably for the market, type of property, personal financial  situation, and personal goals. Generally for SFHs a 2% rent vs price  will be profitable but I sure won't buy one at that price. I need to do  better and I can in my market.

Back to your original question. Whether 2% works for you, or you need to  use a different number, will depend on whether you are getting financed  or paying cash. For the same property you cash on cash return can vary  considerably cash vs financed.

Once you know your number (2% or whatever) You can use it to screen any  deal. Then when you get down to evaluating the specific deal, whether  you pay cash or finance would be made on a case by case basis.

Jonny Lambert · Answer

@Ned Carey can you expound on your last statement?

"You can't use the 2% rule to compare a financed deal vs an all cash deal. It is a form of gross rent multiplier that does not take financing into account."

Ned Carey · Answer

I go the higher cash flow route, but I am closer to rents being 3% of price.

Forget the 2%. Run the actual numbers on your returns and decide if that works for you.  In today's low interest rate environment deals work at less than 2%.

You can't use the 2% rule to compare a financed deal vs an all cash deal. It is a form of gross rent multiplier that does not take financing into account.