This is a repost from a great article on BiggerPockets.com by Mark Ainley
Which sounds better: three properties that bring in $700 a piece for $33,333 each or a property that costs $100,000 and brings in $1,350 ? Well, just judging from the numbers, it would be easy to say buy the three properties. Most new investors see the low cost of entry and the high price-to-rent ratio, and they assume this is a good property. But there is more to investing than just the numbers.
There is this whole subculture in real estate investing that invests in under $30k investment properties. Unfortunately, it most often is new investors who got sucked in by the numbers on paper. They haven’t owned the properties long enough to really appreciate what owning $30k properties actually entails.
Let’s analyze certain factors here. :
FOR ADVANCED INVESTORS ONLY
If you haven’t owned an investment property before, your first purchase should not be a property under $30K. These are for experienced investors only. I see it too frequently. An out of state investor is told that there is a neighborhood somewhere in the Midwest that has a price-to-rent ratio of greater than 2%. They decide that this is a tremendous opportunity because they just got done reading Rich Dad Poor Dad, so they need to start getting out of the rat race today. They purchase the property more times than not sight unseen and are ready for the checks to start rolling in. Little do they know that they have bought a property in a high crime neighborhood.
Does this story sound familiar? Have you seen this story told countless times on popular real estate forums? If you are going to start investing without any experience, start with something easier. If you are going to do it yourself, start with a property in a B-class neighborhood. The returns won’t be as good, but it will allow you to get comfortable with investing. If you are looking for someone else to guide you through the whole process, make sure you do your due diligence and get comfortable with the company selling you the property.
If you are a new or budding investor, try to start your research by looking at the properties locally. You can talk to real estate agents, investors and other experts to understand the market condition. Look for neighborhoods that have a potential of giving you good returns with high rental demand.
If you don’t want to get your hands dirty, you can look for the right turnkey investment company that could assist you in finding a good deal. It’s easy to meet them because they are in the same city.
If you don’t find any success locally, then you can start looking for properties or turnkey companies in different cities. You will have to make sure that you meet them in person and see the properties before investing in them.
There are many cities out there that can offer properties under $30K, but whether they are worth the price or not is debatable. Some of them won’t be able to generate enough income in the form of returns, whereas others will be in shady neighborhoods or require a lot of maintenance. You need to do your calculations properly before making any decision.
ECONOMICS OF A PROPERTY
Property management is a day to day process. It’s not solely about finding the tenant, renting out the property and collecting monthly rents. It is an everyday activity where you have to deal with all the problems faced by the property, tenant or you. It could be a leak in the faucets or getting rid of bad tenants. Any property requires a lot of care, including preventative maintenance, regular inspections, repairs, and improvements. So when you think about this, think about what you are charging.
The example property brings in $700 a month in rent. You pay your management company $70 per month to manage. No matter the price of the rent, these properties still require the same amount of time to manage, and I would argue that $30k properties require more time. Unfortunately as the property owner, you will have to find a property manager who may need to cut corners to stay profitable.
Also consider the leasing of the property. Typically, property managers charge one month’s rent to fill a vacancy. That is either kept all in house or split with a cooperative broker. At $700 a month, the property manager may try to keep it in house so he can get the whole amount as opposed to splitting it. The cooperative broker might not even show the property because making $350 takes the same amount of energy and time as it takes to rent a property that has twice as high rent. All of these activities take time, and if you are going to pay less for someone’s time, inevitably you are going to get less in return.
Continuing with this theme about the cost of things, what do you think the overall condition of that property is going to be? If you bought the property “turnkey,” how much work do you think was actually done to the property ? Our typical rehab cost for a property is around $30K. How do you expect someone to buy the property, rehab it and sell it for a profit if the sales price is $30K ?
There is no room for profit. Heck, there’s no room for a rehab budget. Too often, people buy “fully” rehabbed properties, where the seller came in and painted everything and called it “fully rehabbed.” The person who gets stuck with the “fully” rehabbed building is a newbie investor who just bought a money pit.
I don’t know about you, but when I got to the Home Depot when I am looking for materials, I have never seen the aisle for materials for $30k properties. That’s because it doesn’t exist. Replacing a furnace is going to cost at the minimum $1,500 regardless of whether it is a $30K or a $100K property. So when that furnace goes, it’s going to take a much bigger bite out your profits. Just because the price of the property is cheap doesn’t mean the repairs are going to be any less than they normally would be.
I’m not saying that people shouldn’t buy $30K properties. What I am saying is that to make it work, it requires you to most likely be a local. You’ll want to be able to manage the property yourself and be as hands-on as possible, so that you can squeeze every nickel out of your revenue. Because the actual dollars return is so small, you have to work harder to be extremely efficient.
Otherwise, those promised returns will not be there.If you are not local and not hands-on, you will end up performing the same–if not worse–than on that $100K property you avoided because you thought it was too expensive.
Have you had luck with “cheap” investment properties–or do you have a story of disaster ?