I’m making a massive change in my search for my next rental house.
I’ve spent the past year searching for another rental house within walking distance of Atlanta’s most vibrant city park.
It’s one of the most desirable neighborhoods in Atlanta, especially among young professionals who want to live in walking distance to martini bars and yoga studios.
We bought a great rental house in this neighborhood once; surely we could do it again, right?
It seems the answer is “no.” Every house I’ve looked at for the past year has a negative cash flow. This neighborhood is too desirable; the value of the underlying land is too high.
For Example …
One 4-plex in this area just came on the market for $400,000. If I put 10 percent down and locked in a 4 percent interest rate with 1 percent primary mortgage insurance, the mortgage would be $2,200 per month.
Each unit is a small one-bedroom with low ceilings, so I could collect roughly $750 in rent per unit, or $3,000 per month.
I hope you can already see that this is a losing deal. After insurance, water, trash, management, repairs, maintenance and vacancies, I’d be bleeding money every month.
The prices in this neighborhood simply haven’t fallen enough to make the rental income outshine the cost of ownership. The underlying land value is too strong. The house we bought, clearly, was the exception to the rule — the diamond in the rough.
Flipping a House vs. Holding a Rental House
When you’re “flipping” a house — buying for the sake of selling — a high land value is your strongest asset.
When you’re “holding” a house — buying for the sake of collecting rent — you want cheap land value plus a great building in a tenant-friendly zone.
It sounds like a subtle difference, but trust me: this distinction is HUGE. It can spell the difference between success and failure in real estate.
That’s why it’s essential to know why you’re buying.
That’s why I cringe when I hear someone say, “I’d like to collect rent, but I also want the price to rise so I can sell it. And maybe I also want to live there someday.”
They’re really saying: “I don’t have a strategy. I want it all.”
If you’re buying a rental, you need to know:
- Do people rent in this neighborhood?
- What type of renters does this attract? (Students, families, etc.)
- How many bedrooms are there? What can I collect “per bedroom”?
- What are the monthly expenses? (Water, trash, taxes, etc.)
- How does that compare to the average rental income in the area?
- How soon do the appliances need to be replaced?
- What repairs does this building need?
- The focus is on the BUILDING, the number of BEDROOMS, and the TENANTS.
If you’re buying for the sake of price appreciation, you want to know:
- Are people and businesses buying property in this area?
- How quickly is this area growing?
- Does this location have a competitive advantage that can’t be replicated? (Maybe it’s close to the city’s flagship park, or it’s in the best school district in the state.)
- The focus is on the LOCATION.
You might get lucky and find the best of both worlds. I certainly did with my first house.
But when you’re evaluating a property, you need sharply-defined criteria. “I want it all” is not a business plan.
Looking at Cheaper Locations
In the past few weeks, I’ve expanded my search to other areas. I’m searching neighborhoods, frankly, that I would never want to live in: Far-flung suburban areas with long commutes. Cookie-cutter houses. Cul-de-sacs.
The houses are cheap because the value of the underlying land is next-to-nothing. You’re paying for the building, not the land.
At the same time, there’s strong economic vitality. There are fast-food restaurants, gas stations and beauty salons. There’s a shopping mall with a Macy’s department store.
In the particular area that I toured last night, every commercial shopping center boasts full occupancy — a promising sign.
Many of the houses in the area are “new construction” homes, indicating that other property developers are investing there.
In short: people want to live there, but they can’t all afford to buy. The rental market there is ripe.
This reminds me — again! — of that famous quote from Roman emperor Cicero: “Refusing to set aside trivial preferences” is one of the mankind’s most common mistakes.
In other words: Just because I don’t want to live in a particular neighborhood doesn’t mean I shouldn’t buy a house there. 🙂
*****
UPDATE 2013: Now I have 4 houses, totaling $30,000 a year in net passive income. Here’s the story of House #1, House #2, House #3 and House #4.
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The 4plex is way overpriced relative to the income generated. Looking for cheaper real estate may or may not work. I think the pricing of the properties must be realistic or you are upside down.
‘They’re really saying: “I don’t have a strategy. I want it all.”’ – I think you nailed it with this statement!
Your breakdown on what to look for depending on your goals is great. It is so important to have a realistic set of goals, and a plan of how to best accomplish them.
I read an article the other day on Wealth Informatics talking about the benefit of falling home prices, when you’re looking to hold long-term (forever).
I think if we condition ourselves to evaluate each situation – and ignore our emotions – then we can avoid these types of mistakes.
@Khaleef — Wealth Informatics is great!
And I agree — when the media says, “Oh no, house prices are falling, this is awful news!,” I simply think: “Awful for whom? Why isn’t anyone talking about how this is a GREAT time to be a buyer?”
I know many people who bought homes at the peak of the bubble. Some of them are depressed because their house price plummeted. And some of them are hopeful because they see such fantastic opportunities in front of them — opportunities that will compensate for their loss, plus more. It’s all a matter of perspective.
Great advice about the planning. Without a knowledge of the market in the area and a concrete plan about the resale or rental, a buyer can overspend.
Yeah, you’ve got to pass on that one. All you need is one unit to go un-rented and your already thin margin of error becomes razor thin that month – assuming no maintenance or other expense (property tax, anyone?).
Is that unit on the MLS? Are all 4 units rented right now?
@PKamp3 — Yeah, it’s a shame because the location is top-notch. But … well … that’s the problem. 🙂 The location is just too good. 🙂
@PKamp3 — I found the building on Zillow.com, so yes, it’s listed on the MLS. I don’t know if all 4 units are rented right now or not. I’m sure I could find out if they’re rented, but it’s not worth my time — the asking price is far too high.
I love your last statement about putting personal preferences aside. Being in the construction business, I see that mistake happen a lot. Owners will spend a lot of money making a property something they would want to live in, but the average renters in the market could give a damn about those things.
Great tips in general. Thanks for sharing.
@Lindy — Most tenants overlook those small “finishing details,” but the “wow factor” pieces — like granite countertops / stainless steel / crown molding — go a LONG way towards creating the “look of nice”.
Of course, you only want the “look of nice” where it’s appropriate. In our triplex, for example, there are two one-bedroom units. One of these units has the “bones” of a “luxury living downtown” type of space — 9 ft ceilings, enormous kitchen, huge bedroom, etc. The other unit, however, will never be a “luxury” unit — the kitchen is cramped, and it’s laid out in a way in which we can’t really ever expand that.
So in the opposite way of the squeaky wheel getting the grease, we’re renovating the already-nice space — to make it ultra-nice — while allowing the smaller space to remain mediocre (laminate, white appliances, etc.) The big space will be marketed as “luxury living,” the small space will be marketed as “just a place to live.”
You’d hate my neighborhood then! And I’d hate living in the city. To each his own, and exactly why when you are buying to rent you can’t judge the house based on what YOU would want. It’s a business decision.
@Ashley — Exactly! Separating my “personal preferences” from housing decisions has been one of the toughest things about investing, because “personal preferences” come across in subtle ways that I’m not always consciously aware of …
Best of luck in your search. Real estate is the way to go.
@KC — Thanks!!
Am I the only fool who thinks even breaking even on cash flow is good deal as you’ve got a property with just the down payment money?
@SB — In theory, that’s fine. But in practice, that’s a narrow margin of error.
I normally run a spreadsheet with 3 scenarios: best-case, mid-range and worst-case. My best case scenarios are “amplified best” — highest rent, zero vacancies, lowest expenses. My worst-case scenarios are “amplified worst” — lowest rent, highest costs, huge vacancies.
If the spreadsheet says I can break-even, even in a worst-case scenario, I’ll buy it. But if my “best case” is simply breaking even, then the risk of it turning into a negative-cash-flow property is too high.
I find that the housing prices in Canada haven’t fluctuated as drastically as the ones down south. This is most likely the reason why so many family members are flocking state side and purchasing either vacation homes or second properties to rent out.
It certainly is a buyers market- yet most buyers don’t take the time to analyze and come up with a strategy.
@Marissa — It’s amazing, to me, to see how much money I can make for each hour I spend with real estate, as compared to how little I earn each hour I trade my time for cash through a traditional job. The main difference is that the money I make through real estate is “deferred,” whereas a standard job pays immediately. A little delayed gratification goes a long way!
The other beauty of buying in a cheaper locale is that you’ll pay less for a property manager and repairs. I’m finding that with my college real estate purchase. We can get skilled trades for like $30/hr and unskilled for under $10. Where I live, I can’t get an electrician for less than like $100/hr and I’ve gone through multiple quotes. It’s crazy – mix of demand and going rate I suppose.
@Darwin — Ah, that’s a good point! I don’t have that experience (in Atlanta, an “expensive area” vs. a “cheap area” can be within the same half-mile radius), but I can certainly see how some cities might be like that!
At what purchase price would the numbers work for you? Have you discussed an offer with the seller or assumed since the asking price is too high, the deal isn’t worth the time and effort and can’t be made? Perhaps there’s ‘middle ground’ where the house can be acquired at a price suitable for your needs and plan.
Keep these posts coming! Thanks.
Curtis
I had been reading your blog for a while and had not realized you were also an Atlanta investor, good deal!
Atlanta is a weird place specially if you are inside the perimeter. You can have a $400k property sitting right next to a $75k property. So comparables can be a challenge.
For rental property cash flow considerations are king. Appreciation is nice but not the ultimate determinant. I have both flipped and rented houses in Atlanta and find that for rentals the numbers for properties located in subdivisions works best. I have rentals north of the Perimeter and have been able to rent them out quickly and with good cash flow (knock on wood).
Really liked this article; very good info. Quite a promotion you gave Cicero, though!
Just curious, how are you managing to purchase an income property with only 10% down? In California lenders will not qualify you for a loan on an investment property without at least 25% down. Am I missing something?
@vmongo – Banks are only one of many, many lending options. There are also private lenders, cash-out refis, HELOCs … the list goes on and on. Check out this post – http://affordanything.com/2012/11/20/rental-property-passive-income/ especially the comments.
My friend has recently shared with me your website. I have literally spent the last three hours reading all the articles you have written and find a lot of your perspectives intriguing. My husband and I are going to be diving into the real estate world soon but before we do we want to take in as much advice as possible. Here is a few questions I have.
1. Why in a neighborhood that is booming with rentals would someone want to sell their house/investment if they know they can rent it out and pay the mortgage?
2. Do you really think the best deals are the ones that are on their way to foreclosures?
3. Where would you recommend to find these great deals?