Which Way Is Your Profit Headed?

Many new investors select properties and locations based only on (low) purchase price and ROI. In this article I will talk about the shortsightedness and the potential dangers of this approach.

A Good Investment Property

So we are on the same page, I believe every investment property must meet all three of the following criteria:

  • Sustained profitability - The property must generate a positive cash flow today and into the foreseeable future.
  • Likely to appreciate over time - You would never buy a property just for appreciation but appreciation is very desirable. Especially when using a 1031 Exchange to reinvest equity or adapting to market changes.
  • Located in an area where you can make money and business risks are low. Key factors include state income tax, property tax, insurance cost and landlord favorable regulations. Regulations include property related laws like the time and cost of evictions, rent control, code compliance requirements, etc.

To meet the above criteria you need a combination of the right location and the right property. The most critical of the two is the location because as long as you buy property in a good location, all but the worst mistakes will be corrected over time through appreciation, inflation and rent increases. If you buy in a rising location, everything is great. Your operating costs are largely fixed and rents and property value will rise so your return increases. So, life is good for the investors in these locations. What happens if you buy in a declining location?

Just like in a rising market, your operating costs are largely fixed. However, as rents and property prices fall, you are caught in a financial trap. At some point, rents will not even meet your operating costs and you are caught in a very difficult situation where you can't afford to rent the property and there is no way to sell it because there are few, if any, home buyers who can qualify for a loan and investors will not touch it. If you would like to see a sample list of declining markets, check out this list of the 100 most dangerous cities in the US by NeighborhoodScout. This is certainly not a comprehensive list but it is a good start of a location elimination list. Still, despite all the signs, people continue to buy investment properties in these locations for two reasons:

  • High return
  • Low purchase price

High Return and Low Prices

Some of the highest return properties you can find are ones in declining locations. The main reason for the high returns is that rents tend to lag property prices by 2 to 10 years. Effectively, you are getting the level of rent from years past at the current eroded property price. See the illustration below.

However, ROI and cash flow are only a snapshot in time; a prediction of how the property is likely to perform today. ROI and cash flow tell you nothing about how the property is likely to perform in the future. And, much as some investors hope that the location will remain constant, it will not. The Greek philosopher Heraclitus (535 BC to 475 BC) stated it very well.

“Change is the only constant in life”

Restating the above in real estate terms, every location is either rising or falling; nothing stays the same.

I want to mention one more problem with buying in declining markets and that is the changing tenant pool.

Tenant Pool Characteristics

Earlier in the article I defined the characteristics of a good investment property. Below is my definition of a good tenant:

  • Pays all of the rent on schedule
  • Takes care of the property
  • Does not cause problems with neighbors
  • Does not engage in illegal activities while on the property
  • Stays for multiple years

Good tenants are not common, they are the exception. Plus, no matter the intent of the tenant if they are not employed they can’t pay the rent. An investment property is no better than the jobs around it. You need to meet the combination of a “good” tenant and a tenant that stays employed at similar income.

How do you find good tenants? Careful screening by a skilled property manager. However, no matter how good the property manager, unless they have historical tenant information, they have no way to make an informed decision. Based on economics, there are two basic categories of tenants.

  • Credit based tenants - These people carry a detailed credit history and know that any negative reporting to the credit bureau will have a significant impact on their future lives. Credit basted tenants tend to observe leases, will work hard to avoid evictions and know that if they damage the property they will pay for it in the long run. These people can be effectively screened through their credit history and are your best source for tenants. Credit based tenants also tend to have a lot of possessions, which are hard and expensive to move. The cost and effort of moving has a very positive impact on the length of time they stay in a property.
  • Cash based tenants - These people have little or bad credit. They tend to live cash based lives and an eviction, property damage judgments or skips have no significant impact on their future. Cash based tenants also tend to have fewer possessions so they can load and go any time they wish. Cash based tenants are almost impossible to screen so there is little the property manager can do to screen out the bad actors.

See the illustration below of how tenant type can significantly increase your operating costs.

As an area declines and people with higher incomes leave, the tenant pool will shift from credit based tenants to cash based tenants. The increased cost due to cash based tenants can be huge. This is also why paper returns can be excellent but once skips, evictions, damage and turn costs are included, they can be financial disasters.

In a declining location, not only is your income decreasing, as your tenant pool changes to cash based tenants your operating costs increase. This is a double financial hit and not one many people can afford.

Buy in a Good Location

In the definition of a good property I listed earlier, several of the characteristics are location dependent. To me, a good location meets all of the following characteristics:

  • Population is stable or increasing at a sustainable rate (never buy in boom towns).
  • Demographic stability (per-capita income is stable or increasing)
  • Job quality and job quantity are increasing.
  • Crime rate and type is stable or improving.
  • Limited or no urban sprawl.

Urban sprawl is rarely talked about in investment circles but it is one of the major causes of declining markets. I've read many articles about urban sprawl but I've found no easy way to measure it. The best way I know is to look at an aerial view of a metro area over time. Below are links to a Google aerial time map page. Click on the various cities below and see the effects of urban sprawl. Note that you will likely have to zoom out to see the sprawl. Think about investors who purchased properties in the suburbs in 1984 (the starting year of the time lapse aerial views) and where the suburbs are now.

I included Las Vegas for two reasons. First, I live in Las Vegas. Second, it is one of the few metro areas in the US with limited or no urban sprawl. The only way for Las Vegas to grow is through redevelopment of existing areas. See the map below.

For more information on Las Vegas as an investment location, see "Is Las Vegas For You?".

Summary

In this article I focused on the impact of buying in a rising market and in a declining market. The image below summarizes what happens to investments in such markets.

The choice is simple. Buy in improving markets and your returns will continue to increase over time since your costs are relatively fixed. Or, buy in declining markets with high returns today and deal with declining rents and increased costs over time. Remember that once rents fall below your operating costs, there is almost no good way out of the situation.

Taking the long view of a location before you invest is critical to your financial health.

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