Low Income vs Moderate Income Tenants

[Adam Ulery]

Hi BP Team! I was chatting with a Tax Attorney this week and explaining my plans for beginning in real estate investment. He asked me if I plan to buy low end rentals with lower income tenants or mid or high end rentals with middle/high income tenants. I said the latter, but didn't elaborate on why. He made a comment about me being more interested in long term investment vs. higher cash flow. The conversation moved on, but I was a bit confused by the comment. I didn't get a chance to ask him before we ended the conversation. Does anyone understand why he surmised this? Why would cheaper units tend to generate higher cash flow than moderately priced properties? Why would moderate to high properties be considered more of a long term investment?

Thanks in advance for answering what may be a stupid question from a newb.

-Adam

[Michele Fischer]

It's a combination of lower entry cost and higher relative rents with low income.  With most properties, your exit strategy can be to investors or to homeowners, allowing for more leverage to the seller.  With low income properties, there aren't very many people buying them as primary residences, and investors are less interested in low income, so it is harder to get top dollar.

The rent for a two bedroom in a nice area compared to a two bedroom in a low income area also isn't as wide as it should or could be.  Low income housing could be much more affordable, except that landlords need to charge more to cover the  default and move out costs that the deposit doesn't cover and cannot be recovered after move out.  So you are getting more income per investment dollar, especially if one decides to slumlord and defer maintenance.

Some other considerations:

Advantages of low income:

Advantages of low income:

Lower property investment cost. $/square foot and square footage is lower, so purchase price and repair costs are lower. Our motto quickly became “safe and clean”, allowing us to stay focused on using the cheapest products available in rehab.

Higher occupancy rates. Applicants are often living with friends or family, so are often able to move in mid-month, as soon as the unit is ready. More stable tenants tend to need to give notice, and move near the first of the month.

Lower expectations. Low rent tenants are willing to live with more flaws, fewer extras, and won’t be as demanding about discretionary maintenance and improvements.

Fewer evictions. Low income tenants are more willing to move out when the situation gets bad. We have not had to deal with someone living in the unit rent free for months while we work through the eviction process.

Disadvantages of low income:

Disadvantages of low income:

More turnover. Low income tenants are not as stable, so they tend to move more often. Even some of our best tenants have become nightmares at move out. Dealing with move out, unit rehab between tenants, and prospective tenants is a huge time, energy, and cost drain.

Higher utilities cost. Water/ sewer/ garbage is about the same cost for a 500 square foot unit as it is for a 3,500 square foot house, so utilities become a bigger percentage of total rent and costs with smaller units.

Collecting rent is time consuming. Very few tenants mail us a check or deposit the funds in our bank account. Some bring the cash to our front door, more have us come get it at their front door, and both involve texts back and forth to coordinate schedules. We often have to initiate the conversation to find out where rent is, and we often have multiple trips to collect partial rent during the first two weeks of the month. We admit part of this is due to our desire to visit the properties more often and our willingness to be flexible for our tenants. It may be possible to set expectations and have low income tenants pay less hands-on, but it is a consideration.

More difficult to screen applicants. Most of our applicants have no bank accounts, have terrible credit, and it is difficult to know where they’ve really been living.

Lower loan amounts. It is more cost effective to mortgage and refinance one property worth $150,000 than two properties worth $75,000. The inspection and appraisal costs are about the same for a $30,000 house as a $300,000 one.

Easy to over improve. It is so easy to get into the trap of wanting to get the property to the standards you would want to live in. Such spending brings risk of being destroyed by tenants or never getting the value out at sale.