?Building a Junker Portfolio

[John Chapman]

In the last few months, I have met a few retiring landlords who were looking to unload their properties. When I looked at the properties, I was really surprised at just how junky they were. They were a bunch of 2/1s and 3/1s woodframes in m’eh areas. (In my area, investors prefer brick and anything less than a 2 bath is functionally obsolete.) They did not have decent ARVs or decent comps, so even financing or refinancing would be tough. Basically, they appeared to have been picked up some time ago because they were "cheap" and now, many years later, they are still "cheap". (Hilariously, with the passage of time, these landlords had come to delude themselves that these were quality properties.)

I think @Jeff Brown harps on this, but it really got me thinking a lot about the importance of buying quality homes in quality areas for your long term portfolio. (Or at least properties that everyone else wants).

In my area, the highest quality rentals are 3 or 4 bedrooms with at least 2 bedrooms and a 2 car garage (brick, not wood) with ARVs between $80,000 and $150,000. The rents are commensurate with the ARV, and they are super easy to rent because they rent between $900 and $1500, which is what the bulk of tenants seek. They are also a great price point for first time home buyers. They are also very easy to finance, even after you get 10 mortgages. They are also (unsurprisingly) the homes with the highest demand and most competition.

When you are building an SFR portfolio, I think it's easy to become frustrated and compromise on the criteria of properties you add to your portfolio. Having done this awhile now (and seen where a junker portfolio gets you), I think this is really short-sighted for most investors. (I use the term "most investors" to describe people who want to balance ease of management with cash flow.)

First, you will end up with a portfolio of properties that is illiquid. It will be harder to sell or refinance, which is huge. You don’t know where you’ll be in 5 or 10 years, and if you want to move to the “next step” of real estate investing, whatever that may mean to you personally, you’ve got to be able to get to the equity in the properties you own.

Second, your chances for appreciation are limited. (yes, I know we shouldn’t buy for appreciation, but it’s sure nice when it happens). Heck, even just keeping up with inflation is important, particularly when you start to get a large enough portfolio. Junker properties stagnate (or decrease) in value.

Third, your chances of having a more difficult portfolio to manage becomes greater. (Not saying this guaranteed, but in my area the functionally obsolete tend to be in less nice neighborhoods with lower income tenants.)

I’m sure there are other reasons, these are just ones off the top of my head. I think most investors would be better served by (1) putting in more time to seek out quality properties (e.g. marketing); or (2) just pay more for them. In the long run, they’re likely to be better served.

I should throw out a couple of qualifications. First, I’m not bashing people who invest in functionally obsolete, nonconforming properties or in rougher areas (or both). You can make a killing on the cash flow, no doubt, but the headaches and difficulties are not for everyone. Second, I’m not saying there is no place in your portfolio for what I would call junker properties but you have got to buy them super cheap and as part of a larger strategy. I once bought a functionally obsolete property 2/1 for my portfolio in an almost-rough area. I bought it super cheap and understood it would be for cash flow purposes only, that is, that it would be difficult to refinance or grab the equity. I bought it only because I had enough quality properties that it didn’t matter. I wouldn’t. Third, I’m speaking in generalities in this post. These are just principles and there are obviously exceptions. Fourth, I’m probably being a little harsh in my use of the term “junker” to generally describe functionally obsolete, non-liquid properties. That’s more just my knee jerk reaction to the properties I saw recently.

I’m quite certain there’s nothing really novel in this post, but it’s just something I’ve been thinking about lately. Kind of curious if other people feel the same way.