paying +80K a door instead of 25K? why?

Question

Hi guys,

Before finding this forum, I was so sure I was looking at good investment properties in the areas I was in (mostly populated downtowns in NE and NW).  Then just yesterday, I saw posts on this site about 50K duplexes and 100K 4plexes etc. that brought in almost as much rent as the 200K duplexes and 400K 4plexes I had been watching.

This got me thinking about why some still invest in what seems to be less profitable areas? Or at least, pay a lot higher for properties, when the rents arent that much higher?

And I was only able to come up with a couple of reasons:

1 - Not wanting to invest in states or cities too far from home.

2 - Vacancy rates? Not sure if 2X or 3X the price per door is worth it. Was hoping someone would chime in on this.

3 - A lot more stable markets. Im guessing properties in downtown Boston, Honolulu or Seattle have a higher chance of retaining value than in smaller areas. (not sure of this. Just guessing).

I was just hoping some would like to discuss this with me.

Im in a position where I would like start investing, but am hoping for some consult on where (physically) to start.

All the best

Paul B. · Answer

I tend to think that there is simply a little more work involved in owning and managing a property where the rent is 2% of the asset's value compared to a property that might rent for, say, 1% of its asset value.

For example, you'll see people who buy an $80,000 property, and they're getting, say, $1,600 a month in rent. Across town the $80,000 properties are generating only $800 in rent. So the question is, why would anyone buy the lesser-producing property?

One thing could be lack of knowledge. The other investor may simply not know that there are other properties out there with a better ROI. Or maybe they know about them, but they're under the impression that they're in war zones or that they other present challenges. (And that could very well be partially true.) Or it could be that the superior quality and location of the lower-producing property simply merits the lower ROI or ROE -- which, if you analyze it, is not exactly horrible.

Let's say the 1% income property chews up half its rent in expenses as many here will tell you it will. That means that you're earning 6% net on your asset each year. Not really bad by today's standards.

Then, when you factor in that the rent is going to go up each year, it gets even better. And when you factor in that the asset should appreciate even just a little each year (remember those days?), it gets better still. Add in depreciation (temporary, yes, unless you never sell, but still putting more money in your pocket today), and it gets even better.

Then you can magnify your return even more (ROE vs. ROI) by using leverage, although that will be less of a factor if you're earning 6% on the asset and the debt is costing you about that.

So, while I know there are people out there who think it's plum stupid to buy anything that generates such a modest return on investment, it can work over time. And if you're taking the long-term view (15-30 years), even if the asset breaks even from a cash-flow perspective all those years, one day it will be debt-free -- coincidentally, right around the time you'll be retiring.

I can think of worse things than being 40 to 55 years old and sitting on $5 million worth of debt-free real estate that's netting "only" 6%...

Steve L. · Answer

Jonathan,

Paul and Bryan made good posts.

I think the other important factor is most of the experienced and real investors here have exhausted or would never qualify for good financing.  That makes us unable to compete with people who can get 5% loans and trust fund babies who are okay with a 5% return on their funds.

If we need to raise private money, hard money, subject to existing financing we really have to chase better returns.

Every investment area has it's pros and cons.  Midwest has better cash-flow but rarely sees much appreciation.  Texas has great pricing, landlord friendly laws with huge property tax.  I invest in my backyard so I can go to my houses and manage them myself.

David Beard · Answer

I agree as well.  I think that the typicaly 1%-1.5% property probably has long term avg expenses of 40%, and 2%+ properties are more like 60%, due to higher vacancy and greater tenant turn costs, tenant damage, eviction/set-out expenses, more economically cyclical blue-collar tenant base, greater fixed costs as a % of rent, and the YOUR PERSONAL TIME to manage these types of properties versus engaging in greater value added activities.  And the nicer properties will retain their value better in tough times and be easier to resell to qualified O/O's.  (Potential buyers of the lower-end units will be disproportionately unable to qualify for mortgages and secure down payments).

That said, some of these lower end units are beaten down in price to such an extent that they still make a lot of sense in this market, but the expense ratio should be thought of as more dynamic.

Bryan Hancock · Answer

Yeap....I completely agree with you Paul.  "Cash Flow" is focused on far too much on BP at the expense of what each individual investor is trying to do.  3/4ths of the profit centers are generally completely ignored altogether.

There is a lot to be said for breaking even monthly and having SOMEONE ELSE pay off your note to build wealth.  The same is true for "speculation" based on modest appreciation and paper tax losses.

Jonathan H. · Answer

Thanks for the replies guys.

For me, this is all new.

For the areas I know, the cost per door is in the 60-80K and the returns are in the $50-60 a door. Certainly not the right numbers according to what Ive been reading on this site.

Im just trying to determine if I should just forget what I thought I knew, and start learning a whole new market where the returns are better?

Or start with something that makes me feel safe (lower vacancy rates, job growth in the area, potentially better tenants etc.) but costs A LOT more.

Im leaning towards purchasing something in an established area that I KNOW, and while I learn with this property, perhaps expand my research into areas that have lower costs per door.

So many options....

but its fun. Really fun!

Bryan Hancock · Answer

Assumptions for appreciation, vacancy, wanting to keep eyeballs on the property locally, etc. all play a role.

paying +80K a door instead of 25K? why?

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