Why I won’t invest in F-class properties again

[Arthur Wong]

I bought my first US investment property in an F-class neighbourhood that in essence showed a 25% cap rate. It cost me $23,500 all cash to purchase plus closing costs (honestly, I didn’t know anything about neighbourhood classes, I was just hypnotized by the cap rate). The property was “turnkey” and had what was advertised as a “long-term tenant”. In actuality, the tenant I inherited had signed a 1-year lease paying $850/month subsidized completely by Section 8 (with probably about 3- or 4-months left on that lease) and was definitely not what anyone would consider a great tenant.

After her 1-year lease, the tenant moved out and I needed to put in approximately $6,500 in rehab and extermination costs. My strategy was to get a tenant who had a voucher through Section 8 to maximize the subsidized rent. The house was a really large house with five bedrooms which would maximize rents but limit the number of people who would qualify for such a big house. After getting the house back up to Section 8 standards, it took almost half a year to get a new tenant in.

My first (and best ever) property manager explained to me that no matter how great the house is, my tenant will always want to move out of the house.

This was because the area was quite rough and anyone who is living there will want to move up to another house in a better neighbourhood. Makes sense but unfortunately I had already bought the place. My second tenant finally moved in and I received $826/month rent all subsidized through Section 8. Finally, the cashflow was flowing! Everything was fairly smooth with only a few random repairs along the way and of course, the dreaded annual Section 8 inspection. Every year it seemed like there were somewhat insignificant repairs needed that seemed like they were nit-picking. I get it now though as they needed to keep the properties up to a certain standard and I assume they were this nit-picky with the tenant’s responsibilities as well.

Everything was running smoothly until about the two-and-a-half-year mark when I found out that my tenant hadn’t paid her water and sewer bill for 24 months! Twenty-four months!!! How had they not shut down service after 24 months of not paying your utilities? It ended up working out to be about $100/month and even though it was stated on the lease that the tenant was responsible for the water and sewer, as the owner of the house, I’d be ultimately responsible for the grand sum. My property manager reached out to the tenant and it was basically getting blood from a stone. I had to weigh the $826/month I was receiving versus having her leave and very likely having to put in thousands of dollars back into the house to rehab it and find another tenant. Now when I think about it, I think this may have violated Section 8 rules but I was dreading the inevitable change of tenants and the amount of work that would be necessary.

Long story shorter than I usually go rambling on for but the tenant finally left this April after about four years as my tenant. She left me with about another one full year of sewer and water bills and skipped out on her responsibilities on the annual Section 8 inspection violations. According to my new property management company, it would cost me $11,500 to get it back up to Section 8 standards to start looking for another tenant. It took until close to the end of April before I was told that the tenant had actually left on April 1st and by the time my property manager sent their maintenance person to inspect the property, someone had broken in and stolen the hot water tank and possibly some parts of the furnace. By the time I decided I would try to sell the house, the lockbox was stolen. So I’m assuming that whoever stole the lockbox, had access to the house until the maintenance person was able to install new locks. By that point though, I was definitely looking to offload the property and actually was ready to accept a couple of lower offers that I would have considered when the tenant was actually in the house. Anyway, I’ve sold it now.

All told, I believe I was relatively close to breaking even after my second tenant left. Quick math says that $826 x four years but in actuality, it was probably more like $726 x four years since I’m left holding the utility payments. That’s still right around $35,000. I paid a whopping (but so worth it 12% PM rate for most of those years) so I’m left with about $30,500. Insurance was relatively high and ran around $800/year, property taxes were really low, usually around the $600/year range and you’d have to factor in repairs which after the inherited tenant left, let’s peg at $1000/year for about four years. So that’s $11,000 of expenses which coincidentally after commissions, will be right around the amount that I’ll receive from the sale proceeds. So I’ll have made a tiny bit of money on this property in the five years I’ve owned it.

Sometimes I hate the truth.

A few things I learned:

1) I know there are a lot of questions out there about Section 8 but yes, accept Section 8 tenant. I have other properties with Section 8 tenants and they are fine. And with the Covid situation (hopefully this type of scenario doesn’t happen again though we are far from being out of the woods yet) and the worry about paid rent, it was nice to know that at least some portion of your rent would definitely be coming in.

2) The Section 8 annual (or now possibly every 2 years depending on your county) can be a bit of a pain with the amount of “violations” that are on there and the way they affect your cashflow but they are probably for the better.

3) While I’m going to leave F-class properties alone from now on, I’m sure others can make it work. I wish the current owner the best of luck and it sounds like that’s his niche and he’s probably local (which I’m sure will help immensely) but if you want to be a passive out of state/country investor, it’s probably best to stay away.