Do lower end / cheaper rentals do better in a downturn?

Question

Question for those who have been around a while, I haven't been able to figure this out myself from research. I'm referring mainly to larger markets, say over 1 million people at least, during a housing crash / downturn where house prices go down and rental vacancy rates go up would houses in the cheapest parts of the city be less affected than the more expensive homes? My assumption was that the people in the lower end neighborhoods would have less mobility so would stay put while people that are moving out of the more expensive areas may be moving away to other cities, etc but maybe I'm completely off base. Would appreciate any input from anyone who has been around a while in real estate.

Michael K Gallagher · Answer

My hypothesis on this subject is that the safest rental place to be in is the median/high middle rent prices.  So for me in Columbus OH my units are in the 1200-1400 range.  My theory is that in goods times, people are moving up and will want to move into a town house with a back yard, and updated fixtures...but also in a time of economic down turn, if someone is currently paying over 2K a month or had to sell their home...they will drop down to my range as well.  So in either economic situation I have a large tenant pool to choose from.

Again just my theory using no data whatsoever...just some yankee logic.

Erik W. · Answer

Low end has been my bread and butter for 16 years.  It weathered the housing crash and the recent "Rona slump" just fine.  In fact, demand has never been greater, but that's due to a shortage of rental in general.

To be clear, I don't rent in war zones.  I have to feel safe going to the neighborhood at any time, day or night, without carrying a weapon.  That said, my houses I define as "clean, safe, and functional."  They are not updated with the trendiest colors and appliances.  The fact that I PAINT my walls once every 5 years with touch ups in between puts me miles ahead of the competition, most of whom still have stained and/or peeling paint...or maybe gross wallpaper from the 1970s.

My experience is that there will always be good tenants who don't make a lot of money that can always afford my houses.  My job is to find those and screen to avoid the walking disasters.  Section 8 fails to qualify for my properties because they are always too slow.  My houses get rented within a week of coming vacant most times.  Section 8 takes weeks to do their inspections and process their paperwork.  I won't lose money sitting vacant when I have market-rate tenants ready to go quickly.  Also, on those rare occasions I do have to evict someone, Section 8 would not cover damages or late fees, and the cost of going to court plus cleaning plus lost rent more than consumes the deposit.  I do not want to take that kind of risk.

My advice if you want to do low end is find properties that need some work, but are otherwise in decent neighborhoods.  Screen diligently.  You'll get 100 responses, out of that 10-20 will tour, out of that 3-5 will apply, out of that 1 will actually rent.  Set up systems to automated self-guided tours and online pre-screening that quickly weeds out anyone who is obviously unqualified.  It's a numbers game, but can be done profitably.

No one is building more low income housing these days.  It's a niche market and therefore always in high demand.  Your job is to find the good people who simply don't have a lot of money.

Mario Garcia · Answer

Lower end housing will always have a demand but you have more difficult to deal with tenants in my experience.  I would recommend using Section 8 if you want to dip your toe in the low end housing pool.  And be ready to constantly repaint and re-carpet.  I will add those repair cost into my cap rate every 2 years.

Joe Splitrock · Answer

In most cities, C class is average and not really the worst part of town. As a general rule, the lower the class property, the higher the rent return versus purchase price. That is because risk is priced into rent. This is true of any investment. The safest investments have the lowest return, riskier investments have higher return.

Anything will rent faster if you use lower screening standards. Generally speaking, owners of higher end properties probably do hold higher standards, because they purchased higher end properties.

All I meant was I would prefer to own a B class property over D class property. I can rent B class to C class tenants. D class is D class and in a recession these are the people who struggle to hold jobs. In my experience buying B or C class is probably best, because you are not at the top or bottom of the market.

Chris Davidson · Answer

@James Elden This is a macro question with microfocus. When you say cheaper homes be less affected, are you referring to value loss or vacancy and loss of rental income? And are you trying to set up a portfolio that is more resistant to housing values or vacancies? If you look at the 08' mess, blue-collar jobs not related to construction were not as affected as white-collar jobs in sales and finance. If you look at the current economic situation many white-collar jobs just went to working remotely and some sectors of blue-collar jobs were affected dramatically.

In summary, a property in a more expensive area during the 08' mess would have had a hit on value and possible loss of collections depending on the tenants' source of income. Where a cheaper home would not have a large hit in value and likely had little effect on collections. Where in today's market a home in a more expensive area would have seen an increase in value and likely little issue with collections if the tenants were in an industry still working. Where the cheaper homes would have seen an increase in value the collections boils down to the source of income. All that being said it is driven by macroeconomic policies. In 08' there was a squeeze on available capital where currently it's very available and they are injecting as much capital into the economy as possible.

As for the mobility of the lower end and higher end, I believe that is more on an individual level. If you look at the Fracking boom many individuals from lower-end housing dropped everything and moved across the country looking for opportunity. Then on the opposite side, you hear of many high earners that were renting in large cities that could work remotely leaving during the pandemic.

Hopefully didn't cause more confusion, but help show there are many factors in play during crashes and downturns than first seen on the surface.

Joe Splitrock · Answer

In a down turn bad neighborhoods get worse. If there is lower demand in a market, higher end housing can discount to attract tenants.

Chris Davidson · Answer

@James Elden I would work on building a portfolio with different types of renters. The best explanation I have heard was on one of the BP podcast maybe #448 pretty much spread your units out a little where the tenants will most likely be in different fields. Ex if you have 3 have one near a hospital, one near a major factory, and one near an office park. That way if a hospital(factory, or ETC) shuts down and you had 3 tenants that worked there you are out all 3 just 1 out of 3. not foolproof but you get the idea.

Brian Ploszay · Answer

Section 8 is about the only way to go for true lower income neighborhoods.  The true costs of evictions are staggering.

Cody L. · Answer

Our cheaper stuff did better.  But mostly because our more expensive stuff is in hip / trendy areas by schools, restaurants, bars, clubs, etc.  When all that shut down, there was no reason to pay more to be there.In a more general / common downturn I think it'd be the same.  People always want to live in a better area even if it costs more.  But when money is tight, you can't get what you want.  So you 'settle' for the cheap stuff.And in good times, there is still always poor (per bible, the poor will always be among us)I'm a big fan of lower end / class C / workforce housing.  It's been good to me.

Alexander Szikla · Answer

Typically, the high end can compress quite a bit while the low end simply does not have that much room. Luxury is not a necessity while the demand for basic housing is relatively inelastic.

People don't need 3 bedroom / 2 baths and an office with granite countertops if money is tight, but they will at least need to have one bathroom, a basic kitchen and a couple of bedrooms for the family.

Not to mention, at some point (gov't programs) you have Uncle Sam backstopping you!

Do lower end / cheaper rentals do better in a downturn?

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