Approaches to Investing out of State

If you live in San Francisco, LA, or NYC, the first challenge most new investors have (myself included) is that they feel their market is too expensive to buy rental properties. If you're feeling that, this post is for you!

Investing in real estate outside of your local market adds a lot of complexity. Let's first explore why or why not to invest out of state, and then, review several approaches to doing it.

WHY BUY OUT OF STATE

If smart investors are buying rentals in your local market, buy in your local market. Stop, and please read that again. Okay, now re-read it again. Making a mistake on where to buy is an extremely costly error, but you really only need to follow this rule of thumb to decide whether to buy locally.

You have a personal network in your market, can attend local REIA meet ups, drive properties, check in on properties you own, meet other invests, and much more. Investing out of state adds a lot of complexity, so only do it if your local market is significantly disadvantaged.

However, a handful of markets, especially on the coasts, are seriously disadvantaged for rental buying, usually because:

• The price to rent ratio is really low. I.e., your monthly rent check won’t cover your mortgage, property taxes, insurance, and other costs.
• The law favors tenants to the extreme. You can’t raise rent or evict a tenant who damages your property.

This is the case right now with the SF Bay Area where I currently live. For example, within an hour drive of SF, a very good deal would have a price to rent ratio of about 0.5%. That means a $1M home would rent for about $5,000/month. However, the mortgage, property taxes, and insurance will be about $5,000/month too. That's not counting HOA fees, home repairs, and any vacancies, so actual monthly costs will be higher. And this is a good deal in SF!

In Indianapolis (where I invest), finding a 1.0% deal is easy, and you can find deals in the 1.3% - 1.4% in good locations (not the slums) if you look hard enough.

HOW TO BUY OUT OF STATE

There are a few common approaches for out of state investing, which I’ve listed below from most to least hands on, and consequently, highest to lowest potential ROI. They all have pro’s and con’s.

1) DIY

Don’t do it. Just don’t do it. Managing construction projects and property management remotely by yourself requires a deep knowledge of both activities, and even then, it has the potential to go horribly wrong. If you’re new, don’t even think about it.

2) Partnership

Find “boots on the ground” that will handle all local activities. Typically this person earns a fee or a percentage of the home (often called “sweat equity”) You can find deals with super high returns this way without needing to be on the ground. You’ll also learn a lot more along the way than more hands off approaches described below.

The downsides are that you need to place a ton of trust in your partner. Even if you do everything by the book, your partner will be able to find ways to steal from you. At the end of the day, you have to trust that your partner will be honest and put systems in place to identify theft.

And even in a partnership with a high level of trust, you and your partner need to have aligned interests. What types of properties do you prefer and why? How long do you plan to hold? How do you exit the partnership if interests become unaligned? These all take time to figure out and can change over time.

Last but not least, you will need to profit share your partner, but that cost, in a lot of cases, will be lower than the options below.

3) Turnkey

In every market, there are companies that sell properties that are rent ready to investors. They also usually provide property management services for an ongoing percentage of the rent. They’ve done all of the hard work. Now, you just pay market price for the home and start generating income immediately.

The downsides are that you need to trust your turnkey provider. Did they put lipstick on a pig, or did they find you a great deal? If you go this route, you need to vet the turnkey provider very deeply. Look at their listings. Drive by their properties if possible. Call other investors who use them. Dig into their property management service.

4) Syndication

Some investors, typically more experienced investors, will raise small funds to buy and improve properties. After a set period of time, typically five years, they’ll exit the properties and return your share of the fund. The most common playbook is to buy a mismanaged apartment building and add value to it. For example, they may modify the utilities so that the tenants pay the utilities instead of the landlord, renovate units, add units, and laundry or storage, or put better processes in place for filling vacancies. They may also add improvements that justify higher rent prices.

Syndication is super hands off. You just write a check, but you need to trust that the investor knows what she’s doing. Similar to turnkey, you need to really vet the partner buying and improving the property. Call her other investors, look at her past deals, and see if she’s published anything insightful. This person should have a long track record of generating strong returns on similar assets.

5) REITs

REITs, Real Estate Investment Trusts, are publicly traded funds that hold real estate assets. You can buy them similarly to any stock or ETF. They are completely passive.

MY CHOICE

I chose option #2, partnership, and this blog will focus primarily on that approach. I prefer partnership because it allows for the highest potential returns without DIY and the most creativity to juice those returns. It does require a fair amount of work to get started and is definitely riskier than options #3 - #5.

I’ll describe how I set up my partnership in future posts.