Rentals in the middle/upper burbs?

Question

Answer

This is a question that comes up often. Do I trade what I perceive to be more tenant headaches and less appreciation for cash flow today? Or do I deal with "nicer" properties, and presumably "better" tenants, and sacrifice cash flow for less hassle and more upside appreciation? And if one assumed that the second plan would really pan out as expected, I think many people might sacrifice that short term cash flow to near break-even, if we thought we'd end up with nice house fully paid for by someone else, at which time we're just collecting rents. (And in some markets, that's almost your only option. The 2% rentals just aren't anywhere to be found.) For me, I think you have two things figured out before you decide which route to go are these: (1) Know your exit strategy before you buy a property. If you have no plans to sell, ever, why focus on appreciation? Appreciation just means higher property taxes. If you plan to sell at some point, though, you need to know what kind of buyer that is, and then ask yourself if your property will have appeal to that kind of buyer. (2) Become a master at tenant selection. This is where you'll determine whether you're going to have a headache or not, regardless of the property's value, location, condition, etc. I've had tenants in "sketchy" neighborhoods that pay on the 1st of the month like a Swiss watch, without bothering me for anything. They are out there if you know how to find them. I have a "nicer" rental that is as close to hassle-free as it can get. The tenant never bothers me for anything. He pays five days early each month. And even on that rental, over the last 29 months (since it became a rental), my expenses, including a capital expenditure for replacement of an A/C unit) are running at 30% of my rent. If I add in 8% for vacancy and 10% for property management, BOOM, I'm right at the magic 50% number that is talked about here -- and I'm telling you, this is the easiest rental property I have ever had. It sounds like you're going to be highly leveraged (you're borrowing the down payment), so your strategy is likely, "Try to keep this sucker cash-flow neutral while I pay off the loans, then enjoy the property debt-free later." I don't know what your cost of funds is, but you might be able to do that if you choose the right tenant. Figure you're renting it for 12% of its value each year. Back out a vacancy expense equal to 1% of its value, taxes equal to 1% of its value, insurance at 1/2% of its value, and repairs and maintenance at, say, 2% of its value, and you have a 7.5% ROI. As long as your cost of funds is less than that, you should be able to break even cash-flow wise when you add in principal amortization. I know there are those who will think this is a loser, but if you can get good tenants in and manage your expenses, you could be sitting on a house that is fully paid for in 15-20 years using someone else's money. And that ain't all bad.

Answer

To follow on some other points that have been made, I wouldn't see it as you are "walking into equity". While on the surface it may seem that way (and it could be) many people were burned thinking property values were going up or they assumed they were worth more than they in fact were. I know this may not be a consideration you are worried about for many years, but i have exactly what you described in a Memphis suburb that i bought in 2001 for $150k, it would sell today for $130k and will doubtfully in the next ten years touch $160k. It pays for itself, maintenance has been minimal, it was a good personal home, but equity is nonexistant.

Answer

My market is small enough that if this neighborhood tanked it would mean the whole town tanked in what is consistently listed as one of the most stable/ undervalued markets in the country. We have not seen any reduction in price throughout the whole real estate issue. If we took that kind of dive all of us would likely have much bigger problems. Not to say it couldnâ€™t happen though with the way things are today. I guess when I think about it one of the things that I am looking at as motivation in this thought is that with a property like this in 15 years I could own a 20 year old $210,00-250,000 house with minimum headache and a little money out of pocket or I could buy a 30 year old fixer upper, spend a month rehabbing it, spend free time fixing petty crap, profit $200 a month after cost, and after 15 years I have a 45 year old property that may be worth $100,000 if the neighborhood didnâ€™t go to crap in the mean time. Initial cost for the fixer upper wouldnâ€™t be much different after down payment and rehab cost. The diversifier in me also sees having properties in multiple mini-markets as much better than having a bunch of one type of property renting to the same people in the same hood. Maybe I am stretching a little too far and trying to do something that should simply not be done.

Answer

Just because you raise rent doesn't mean there is less possibility of drama. With a larger property comes the possibility of short term renters who are remodeling their home, just wanting a few months. You can also get 3 singles with boy or girlfriends and in general a population that may be on the move. Are there a lot of properties for rent in this price range? In my area some very expensive properties are renting at prices that don't make sense from an investment point of view. A lease option is maybe the way to go but again, the market dictates here too. My neighborhood has gone from $225k to $140k. Just an adjustment in values.

Answer

I wouldnt be willing to drop below rent being 1% of sales price. I manage myself and do about 75% of the maintenace and repairs myself. I understand that I could lose money on the cash flow end of things on some months but thought the long term capital gain could be worth it. In my market there are no nicer neighborhoods where you can cash flow after all cost considered. Most of the houses in nice neighborhoods are going to rent for about .8-.85% of sales price making them terrible rentals. There are cash flowing properties but they are in neighborhoods that may or may not do well for long term capital appreciation. I currently own a few of those. I plan to work my salaried job for about 10 more years so immediate profit isnt an absolute must.

Answer

While there's nothing wrong with buying in nicer neighborhoods, if you're going to be buying properties at $180K to generate $1700/month in rental income, you better be prepared to come out of pocket a good bit of money until the property is paid off. While the rent might cover the debt service, you'll end up paying for vacancies, maintenance, capital repairs, utilities, management (if you use it), etc. This could end up averaging several thousand dollars per year in out-of-pocket expenses until the property is paid off. Most here would recommend that -- unless you have sizable reserves that you don't mind tapping into -- you instead focus on finding properties that will cash flow on their own. For the most part (with a couple specific exceptions), I agree with that line of reasoning...