Buying rental properties is a great way to invest your money, but there are many opinions on what type and what price rental properties are the best. I prefer single family rental properties that are slightly below the median sales price in my area. Other investors make money buying multifamily rentals or cheap rentals. There is not a best way to invest for everyone, but there may be a best way to invest for you based on your market, goals, money available and many other factors.
What is a cheap rental property?
In my market in Northern Colorado the median price is just under $200,000. I have bought my rental properties from $80,000 to $135,000. I buy my rental properties below market value so even though I bought them below the median value, they are worth from $150,000 to $200,000. I would not consider these cheap rentals, because they aren’t the bottom of my market. In my market the lowest priced homes are $70,000 to $90,000, but prices have gone up significantly over the last three years.
Even though some of my properties were purchased for under $90,000, it is almost impossible for me to buy properties that fit my criteria for under $110,000 today. When I was buying my first rental properties I could have purchased a number of properties for under $50,000 and as low as $30,000. I did not buy these cheap properties for rentals at the time, but I wish I would have bought a couple looking at prices now! The definition of cheap rental properties varies in every market, but if I had to define it I would say properties under $50,000 are generally considered cheap rentals. Here is a great article on how to buy rentals below market value.
Why are there returns different for different priced rentals?
Rental properties that cost $50,000 will have vastly different returns than properties that cost $200,000. The returns vary due to obvious factors like higher rent, but also due to different levels of maintenance and turnover. Typically the lower priced rental will have more maintenance and more turnover, as well as lower appreciation over time. There are exceptions to this rule, which can be seen in my market. If I would have bought $30,000 rentals in my market a few years ago I would have made a killing today. Those properties are now worth two or three times what they were just three or four years ago.
My market had not seen prices as low as they were four years ago since well before 2000. I would not expect every market with $30,000 homes to see the appreciation we did. Many places that have $30,000 homes for sale have seen low or stagnant prices for years. They most likely will not see the huge price increases my market saw. When buying cheap rentals properties you are usually not betting on appreciation, but investing for cash flow. Many times the rent to value ratio on lower priced rentals properties is better than on more expensive rental properties. That high rent to price ratio is what makes low-priced rental properties attractive to buyers even with more maintenance and turnover.
Why is the rent to value ratio higher on less expensive rentals?
Rent rates are determined by the supply and demand for rentals properties in a given market. Rental rates are not determined by housing prices or the cost to build houses. The lowest rent rates are usually seen in large apartment buildings. If there is a shortage of apartment buildings in a given market you will usually see rental rates increase. Eventually when rental rates get high enough new apartment buildings pop up very quickly to meet demand, because investors see the need for more units and will make money if they build more. However, no matter how many apartments are for rent, there will always be people who want to rent a single family home.
When there is a shortage of single family homes for rent, builders usually do not build more homes to meet that demand, especially in the low-end of the market. Builders simply cannot build cheap enough in most markets to make new construction rental properties a viable business. Builders target owner occupant buyers when they build new homes. When there is a shortage of single family rental properties in an area the rent rates will increase, but unlike apartment buildings new construction does not ease the supply shortage.
Most markets with low-priced rental properties are found in the Midwest and you may see properties sell for $30,000 that can be rented for $600 to $700 a month. The properties would meet the 2 percent rule, which is very hard to do in most markets. $700 rent on a $30,000 house is a great margin when you consider my properties rent for $1,200 to $1,500 a month. Here is a great article on the advantages of single family homes versus multifamily.
What is the cash flow on low-priced rentals?
The rent to value ratio may be higher on low-priced rentals, but that does not mean the cash flow is higher. The expenses on a lower priced rental are most likely going to be a higher percentage of the value of the property. Here is an example of how an investor might figure the costs on a higher versus lower priced rental property. These numbers were generated from my cash flow calculator. I am using these numbers based on a higher priced rental property I could buy in my area and a lower priced rental that could be bought as a turn-key rental property in another state.
Higher priced rental bought for $130,000
Property Man $120
Total expenses $615
Cash flow $885
Lower priced rental bought for $35,000
Property Man. $56
Total expenses $356
Cash flow $344
The cash flow on a more expensive rental property is much higher, but that is because I assumed both houses were bought for cash. That isn’t fair because the high-priced rental takes four times as much money to buy! Looking at these number the low-priced rental blows away the high-priced rental when bought for cash. If I were to get a loan on the high-priced rental property I would have a mortgage payment around $500 a month. That would drop my cash flow to below $400 a month on the high-priced rental property and if I had to make repairs to this house before I bought it, my cash investment would be similar to the $35,000 the low-priced rental property costs. The returns are not that different between the two properties, but slightly higher with the high-priced rental property. We do need to look at the numbers closer to see why low-priced rentals have different expense ratios than high-priced rentals.
- Age: In my cash flow calculator I devote a higher percentage for maintenance costs on older homes. It is likely the older house will need more maintenance due to it being an older home. However, with lower quality tenants you may need to factor in an even higher maintenance allocation.
- Lower expenses due to lower rent: The rent is much lower on the cheap property, which makes the expenses much lower for vacancies and maintenance. The entire maintenance allowance for the year on the cheap property is $1,680, while it is $2,700 on the more expensive property. If the properties were the same size it would make no sense to have the maintenance that much higher on a more expensive home, but the cheaper rental is much smaller so I think those figures are a decent representation.
- Maintenance: I used the same maintenance percentage for the cheap and expensive rental, but this may be misleading. It is true the more expensive rental is rented for more money and lost rent would be higher than the cheap property. However in my experience the more expensive rentals have more stable tenants. Evictions costs the same no matter what type of rental you have and the chances of an eviction are higher with the cheaper rental. The vacancy cost for the expensive rental comes to $1,800 a year and only $840 a year for the lower priced rental. I think the costs should be similar for both properties.
- Insurance: The insurance costs on a house are based on risk and replacement cost. The insurance cost on a smaller home will be less than a larger home, but it will be higher as a percentage on the less expensive home. If my insurance is $600 a year on my $130,000 house, it will not be $200 a year on the $30,000 house. It may be $400 or $500 a year, which is a higher percentage cost compared to the rent.
- Property Management: The property management fees should be similar on each property.
When looking at the percentage cost of the expenses on the two properties the cheap property expenses are over 50 percent of the rent and the expensive properties expenses are just over 40 percent. The expenses may not be high enough for the cheap property, because the vacancies and maintenance may be more than what an investor assumes they will be.
In my experience my expenses have not been as high as this scenario figures, because my vacancies and maintenance have been lower historically. While the cheap rental property may look like a slam dunk on the surface, it does have more expenses and may take more management. That doesn’t mean they still can’t make money or be a good investment. Here is an article on how to find a great property manager.
What are the disadvantages of buying low-priced rentals?
There must be a reason everyone doesn’t invest in low-priced rentals with ratios this good. In fact, there are many reasons many investors don’t like low-priced rentals.
- More turnover: when you are renting the lowest priced homes in a market you tend to get less than ideal tenants. There is a better chance of evictions, damage and problems when renting the lowest priced homes in a market.
- More maintenance: often times the lowest priced rentals in a market are older homes. The older a house the more maintenance a home will need and lower quality tenants can do more damage to a house.
- Less appreciation: I don’t like to invest for appreciation, but it doesn’t hurt to have houses go up in value. In most cases the lower the value on a home the less appreciation it will see.
- Buy below market value: I buy all my houses below market Value. It gives me instant equity, but 20 percent on a $30,000 house is only $6,000, while 20 percent on a $100,000 house is $20,000. You gain less equity when buying cheaper homes below market value.
- Getting a loan: most banks do not want to lend on cheap properties, because they see more risk and less profit. It is very hard to get an investor loan on a $30,000 house.
What are the advantages of buying low-priced rentals?
Buying cheaper properties is not all bad. Besides the higher rent to value ratio lower priced rentals have other advantages.
- Smaller homes: lower priced rentals are typically older, which means more maintenance. They are also typically smaller which means the maintenance will cost less. Painting a 700 square foot house will be a third the cost of painting 2,000 square foot house. There are less windows, smaller furnace, smaller roof, less floor space. Even though the home may need maintenance more often, that does not mean the total maintenance costs will be more than a larger rental.
- Can buy with cash: with the low price of inexpensive rentals you can spend the same money to buy the entire house with cash as you with a loan on a higher priced home. It is difficult for many investors to get loans who already own multiple rentals, are foreign investors, are investing with an IRA, or have low income on their taxes. Paying with cash is an easy way to buy rentals when you can’t get a loan.
- Less chance of loss: with less expensive homes there is usually less appreciation, but there is also a smaller loss with depreciation as well. Inexpensive homes can go down in value, but if the values drop 30 percent on a $30,000 house versus a $100,000 house, your losses will be much less.
- No loan needed: If you are unable to get a loan, you can pay cash for a cheap property. This may be perfect for those looking to invest with their IRA or 401K.
Is it better to buy low-priced rentals or higher priced rentals?
There is no right answer to this question for everyone. You have to figure out for yourself what type of property is right for you. I like higher priced rentals, because they have less maintenance, are not as old, less turnover and sometimes better appreciation. I have no problem getting loans on my rentals, even with over ten mortgages. That makes it easier for me to buy higher priced rental properties, because I can get a loan.
If you are in a position where it is harder to get a loan, then maybe lower priced rentals are a better option. I have been seriously considering buying a low-priced turn-key rental property over the last few months, because it is so hard to find good rentals in my area. I wrote about the advantages and disadvantages of buying a turn-key rental property here. I prefer to buy rentals locally that I can buy below market value, but if those aren’t available I think I would try buying an out-of-state cheap property. If you are having a hard time finding good rentals in your market, maybe buying a cheaper turn-key property would be a good option.
I think if you are looking at cheaper versus more expensive rentals in your market you have to look at many factors. Run the numbers on how much money you will make with both properties, look at historic values on both property types, which property can you get a better deal on, how much management will each property take. If you still can’t decide which type of property to buy; buy one of each and see which one you like better!
Some investors assume low-priced rentals are not a good way to make money, because to the horror stories they hear about tenants. Many investors assume low-priced rentals are a slam dunk because of the rent to value ratios. I think you can make money with low-priced rentals, but you have to screen your tenants very thoroughly and be realistic about the returns you will get with the increased maintenance and vacancies. For more information on turn-key rental properties check out this article.