A Word of Caution Regarding Cheap Real Estate

[JustAskBenWhy]

I’ve been a member of the fastlane forum for only a short time, and thus do not necessarily have the stature in this community to stick my neck out and offer advice contrary to the attitudes on the forum.

This said, however, I’ve noticed some virtual “high-fiving” going on in the real estate segment here regarding cheap property, and this disturbing indeed because it is dangerous! In the spirit of this community, which I’ve gathered even in the short time that I’ve been here, to add value, I feel validated expressing the following perspective…if you just bought a house for $9,000 and are increasingly proud of yourself – hang on to your knickers, and you just might learn something…J

Some Assets are Worth Less than $0.

The first thing you must understand is that just because something is affordable, or in this case cheap, doesn’t make it good. There are some assets, believe it or not, that are worth less than $0 relative to the value they add to your life (much as some relationships are worth less than $0, but let’s leave that for another time..)

About ROI

What determines value of any investment is ROI – Return On Investment. Unfortunately, in real estate this return can be measured in a multitude of ways, and while some metrics are increasingly honest, other metrics are virtually meaningless. This is all matter of perspective.

For example, most people are familiar with Cash on Cash Return (CCR, or COC). CCR juxtaposes the total investment of capital to the total return of capital. Thus, is you spend $9,000 cash to buy a house at the court house steps, spend $15,000 more to put lipstick on that PIG (get it?), and spend another $1,000 for closing costs, then the total cash investment is $26,000.

Let us assume that you can rent that house for $600, which is a stretch, but for shits and giggles… $7,200 of Gross revenue per annum. Let’s just say that property taxes, insurance, R&M (repairs and maintenance), etc . total $250/month, or $3,000/annum. Seemingly, $4,200 of Annualized Cash Flow on an investment of $26,000 constitutes 16% return relative to CCR.

You have to understand that houses don’t sell for $9,000 for no good reason. The marketplace has decided that this house – what it is, and where it is – this house is only worth $9,000.

This means a lot of different things, and I could take this on a lot of tangents, however, let’s focus on vacancy for today – follow this logic:

· House is cheap; why?

· Because people don’t think it’s worth more; what does this mean?

· It means no owners want to live there; what does this mean?

· If the owners don’t want to live there, why should the tenants want to live there? They won’t want to live there…

In other words, the only tenants you’ll get into the house are people without better options. Everyone who can afford to, and qualify for will go somewhere else. What does this mean?

Physical Vacancy

Those cash flow numbers from above do not include vacancy, which is simply understood as the time a unit sits empty. In my town, vacancy may be 3%-5% in better assets classes, a $9,000 might sit vacant 20% of the time by the time it’s all said and done.

In dollar terms, you would account for this by subtracting $1,440 from the Gross Potential of $7,200 (which is 20%). This, in turn, will compress the cash flow number to $2,760, which now will constitute a 10.6% CCR… I hope you can do better, but we are not done L

Economic Vacancy

Economic vacancy accounts for all of the losses associated with vacancy that are not vacancy itself. Things like bad debt (this is people stiffing you), or concessions (these are discounts you give just to get people in), and many others. In a $9,000 house, because of what it is and where it is, you’d be lucky to run economic losses of 15% - they will be higher!

Subtract another 15% from gross potential and your CF now looks like $1,680 – 6.4% CCR.

Let’s Talk About CapEx

Let me ask you – people who stiff you for rent, are they going to be too concerns about taking good care of your property?

You got it – the rest of the cash flow that you think you have will be spent fixing holes in the walls…

Conclusion

This barely scratches the surface of that which is property. My intent was to undersore the point that not everything is as it seems in real estate – in fact, most things are not!

PIGs are dangerous indeed because people feel that since they are cheap, it’s impossible to lose. Wrong – it’s not only possible, it is the most likely outcome! In this case, your $9,000 house might be worth less than $0

Hope this helps.

 

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[jon.a]

Note to the forum:

I've been pestering @JustAskBenWhy for over a week to speak up about cheap houses. This is my fault. You're welcome.

 

[BrandonS85]

All depends on the neighborhood.

It's very true that there are places/locations/scenarios where a house has negative value. One prime example is Detroit where houses routinely go for under $1,000. After you include vacancy (Upwards of 35%) , taxes, high M&R budgets and the like, you end up with something that's a very poor choice.

HOWEVER, there are areas where the investor demand simply isn't there. Maybe Lima has investors, but I'm seeing many areas here in Southern Ohio have very few if any investors, and when that happens prices plummet because few owner-occupants want multi family properties.

Around 50% of my portfolio is cheaper properties in poorer neighborhoods, and our average vacancy + legal fees is still relatively low due to low supply of available market rentals.

You also can not assume the market responds to perfect knowledge about properties. Properties are unique and often times marketed differently. A online-auction where the only form of advertising for a property is a sign in the yard is quite different than something on the MLS with a realtor marketing it and exposure to 90%+ of the market. This is why alot of real estate investors love direct leads and direct marketing, it can cut out a great deal of the marketing value and decrease cost.

 

[MKHB]

I’ve been a member of the fastlane forum for only a short time, and thus do not necessarily have the stature in this community to stick my neck out and offer advice contrary to the attitudes on the forum.

This said, however, I’ve noticed some virtual “high-fiving” going on in the real estate segment here regarding cheap property, and this disturbing indeed because it is dangerous! In the spirit of this community, which I’ve gathered even in the short time that I’ve been here, to add value, I feel validated expressing the following perspective…if you just bought a house for $9,000 and are increasingly proud of yourself – hang on to your knickers, and you just might learn something…J

Some Assets are Worth Less than $0.

The first thing you must understand is that just because something is affordable, or in this case cheap, doesn’t make it good. There are some assets, believe it or not, that are worth less than $0 relative to the value they add to your life (much as some relationships are worth less than $0, but let’s leave that for another time..)

About ROI

What determines value of any investment is ROI – Return On Investment. Unfortunately, in real estate this return can be measured in a multitude of ways, and while some metrics are increasingly honest, other metrics are virtually meaningless. This is all matter of perspective.

For example, most people are familiar with Cash on Cash Return (CCR, or COC). CCR juxtaposes the total investment of capital to the total return of capital. Thus, is you spend $9,000 cash to buy a house at the court house steps, spend $15,000 more to put lipstick on that PIG (get it?), and spend another $1,000 for closing costs, then the total cash investment is $26,000.

Let us assume that you can rent that house for $600, which is a stretch, but for shits and giggles… $7,200 of Gross revenue per annum. Let’s just say that property taxes, insurance, R&M (repairs and maintenance), etc . total $250/month, or $3,000/annum. Seemingly, $4,200 of Annualized Cash Flow on an investment of $26,000 constitutes 16% return relative to CCR.

You have to understand that houses don’t sell for $9,000 for no good reason. The marketplace has decided that this house – what it is, and where it is – this house is only worth $9,000.

This means a lot of different things, and I could take this on a lot of tangents, however, let’s focus on vacancy for today – follow this logic:

· House is cheap; why?

· Because people don’t think it’s worth more; what does this mean?

· It means no owners want to live there; what does this mean?

· If the owners don’t want to live there, why should the tenants want to live there? They won’t want to live there…

In other words, the only tenants you’ll get into the house are people without better options. Everyone who can afford to, and qualify for will go somewhere else. What does this mean?

Physical Vacancy

Those cash flow numbers from above do not include vacancy, which is simply understood as the time a unit sits empty. In my town, vacancy may be 3%-5% in better assets classes, a $9,000 might sit vacant 20% of the time by the time it’s all said and done.

In dollar terms, you would account for this by subtracting $1,440 from the Gross Potential of $7,200 (which is 20%). This, in turn, will compress the cash flow number to $2,760, which now will constitute a 10.6% CCR… I hope you can do better, but we are not done L

Economic Vacancy

Economic vacancy accounts for all of the losses associated with vacancy that are not vacancy itself. Things like bad debt (this is people stiffing you), or concessions (these are discounts you give just to get people in), and many others. In a $9,000 house, because of what it is and where it is, you’d be lucky to run economic losses of 15% - they will be higher!

Subtract another 15% from gross potential and your CF now looks like $1,680 – 6.4% CCR.

Let’s Talk About CapEx

Let me ask you – people who stiff you for rent, are they going to be too concerns about taking good care of your property?

You got it – the rest of the cash flow that you think you have will be spent fixing holes in the walls…

Conclusion

This barely scratches the surface of that which is property. My intent was to undersore the point that not everything is as it seems in real estate – in fact, most things are not!

PIGs are dangerous indeed because people feel that since they are cheap, it’s impossible to lose. Wrong – it’s not only possible, it is the most likely outcome! In this case, your $9,000 house might be worth less than $0

Hope this helps.

I have gotten bargains (cheap real estate) on many occasions and have lost my a$$ every time.

I have bought good, well located real estate at the wrong time and at the wrong price and
despite utter incompetency- still managed to somewhat look like I wasn't an idiot...somewhat.

That is why I am a commercial real estate investor/practitioner...longer term commitments 3-5-7 years (less economic vacancy issues),
pass thru expenses (net leases and full service leases with a stops and CPI protection) and built in rent escalators; and plenty of
opportunity to sell picks and shovels to the eager throngs of miners every time we hit that sweet spot in the CRE market...like now!

I'm just not smart enough to pull off the 1-4 unit residential play, god bless those who can, just not me.

 

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[JustAskBenWhy]

All depends on the neighborhood.

It's very true that there are places/locations/scenarios where a house has negative value. One prime example is Detroit where houses routinely go for under $1,000. After you include vacancy (Upwards of 35%) , taxes, high M&R budgets and the like, you end up with something that's a very poor choice.

HOWEVER, there are areas where the investor demand simply isn't there. Maybe Lima has investors, but I'm seeing many areas here in Southern Ohio have very few if any investors, and when that happens prices plummet because few owner-occupants want multi family properties.

Around 50% of my portfolio is cheaper properties in poorer neighborhoods, and our average vacancy + legal fees is still relatively low due to low supply of available market rentals.

You also can not assume the market responds to perfect knowledge about properties. Properties are unique and often times marketed differently. A online-auction where the only form of advertising for a property is a sign in the yard is quite different than something on the MLS with a realtor marketing it and exposure to 90%+ of the market. This is why alot of real estate investors love direct leads and direct marketing, it can cut out a great deal of the marketing value and decrease cost.

Fair enough - but there are things I can assume:

1. If there is not investor demand, most likely there is no appreciation - since demand drives appreciation. Thus, you've bought a cheap house, which was cheap 40 years ago, and 30, and 10, and it's cheap now, and will be that forever. And while the market, as you allude to, is inefficient, the numbers are very efficient. One - the IRR is impossible to drive simply on CF. Two - wealth on the balance sheet is a function not of CF but of equity growth, either organic or forced. Which brings us to this:

2. CapEx is a function of needing to replace elements in the physical asset which run out useful life. I've written a number of articles on the subject, but if you add up all of the physical components in an SFR and depreciate their useful life, capital reserve would need to grow by $300+ in order so that you have a float out of which to deploy capital for replacements. The older the house, the sooner you'll need to deploy...

If there is no appreciation, then there's no value being created to off-set future capital outlays which are guaranteed to occur. These are just the numbers that are fact of life.

Not to mention that every time you have to replace a furnace in a house which has not and will not appreciate, you'll be saying to yourself - damn...throwing good money after bad again.

Thoughts?

 

[JustAskBenWhy]

I have gotten bargains (cheap real estate) on many occasions and have lost my a$$ every time.

I have bought good, well located real estate at the wrong time and at the wrong price and
despite utter incompetency- still managed to somewhat look like I wasn't an idiot...somewhat.

That is why I am a commercial real estate investor/practitioner...longer term commitments 3-5-7 years (less economic vacancy issues),
pass thru expenses (net leases and full service leases with a stops and CPI protection) and built in rent escalators; and plenty of
opportunity to sell picks and shovels to the eager throngs of miners every time we hit that sweet spot in the CRE market...like now!

I'm just not smart enough to pull off the 1-4 unit residential play, god bless those who can, just not me.

Yes, but CapEx still happens, and physical vacancy can be years... No perfect solution, but quality always wins out...right?

 

[BrandonS85]

Fair enough - but there are things I can assume:

1. If there is not investor demand, most likely there is no appreciation - since demand drives appreciation. Thus, you've bought a cheap house, which was cheap 40 years ago, and 30, and 10, and it's cheap now, and will be that forever. And while the market, as you allude to, is inefficient, the numbers are very efficient. One - the IRR is impossible to drive simply on CF. Two - wealth on the balance sheet is a function not of CF but of equity growth, either organic or forced. Which brings us to this:

2. CapEx is a function of needing to replace elements in the physical asset which run out useful life. I've written a number of articles on the subject, but if you add up all of the physical components in an SFR and depreciate their useful life, capital reserve would need to grow by $300+ in order so that you have a float out of which to deploy capital for replacements. The older the house, the sooner you'll need to deploy...

If there is no appreciation, then there's no value being created to off-set future capital outlays which are guaranteed to occur. These are just the numbers that are fact of life.

Not to mention that every time you have to replace a furnace in a house which has not and will not appreciate, you'll be saying to yourself - damn...throwing good money after bad again.

Thoughts?

Your assumption is that any rehab/repairs are done to a property forgo capex, and that a investor/rehabber doesn't have access to lower priced materials or work. As it stands now, i'm paying roughly 1/3rd of the going rate that contractors charge on rehab and ongoing maintenance, so far I'm not seeing the capex issues associated with low end rentals, especially after we rehab them and fix everything that's needed to get it all to a 10-20 year shelflife before replacement is needed.

Appreciation certainly comes from increased rents, and even in poorer neighborhoods, there's plenty of rent increases, just in 2 years I've seen rents increase on many properties by 5%-10% which is fantastic. With no appreciation and standard rent increases of 2.5% to 3% a year, you're still increasing income. Even if by your definition, 20 years from now you have to offload it on a 'sucker who wants to play the low end game', your rents are very, very likely to be 2 to 3 times higher than they initially were, offsetting the perceived lack of appreciation. Granted there is some appreciation in the low end areas I look at, but it isn't nearly as much as the 'good' areas which see that can get 5%-10% a year. Now mind you, any of the good areas can suffer from gentrification and become the low end areas too. Then your nice $100k nest egg house becomes the nicest $45k house in the slum 20 years later. Look at all the vets in Hilltop in Columbus.

 

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[JustAskBenWhy]

Your assumption is that any rehab/repairs are done to a property forgo capex, and that a investor/rehabber doesn't have access to lower priced materials or work. As it stands now, i'm paying roughly 1/3rd of the going rate that contractors charge on rehab and ongoing maintenance, so far I'm not seeing the capex issues associated with low end rentals, especially after we rehab them and fix everything that's needed to get it all to a 10-20 year shelflife before replacement is needed.

Appreciation certainly comes from increased rents, and even in poorer neighborhoods, there's plenty of rent increases, just in 2 years I've seen rents increase on many properties by 5%-10% which is fantastic. With no appreciation and standard rent increases of 2.5% to 3% a year, you're still increasing income. Even if by your definition, 20 years from now you have to offload it on a 'sucker who wants to play the low end game', your rents are very, very likely to be 2 to 3 times higher than they initially were, offsetting the perceived lack of appreciation. Granted there is some appreciation in the low end areas I look at, but it isn't nearly as much as the 'good' areas which see that can get 5%-10% a year. Now mind you, any of the good areas can suffer from gentrification and become the low end areas too. Then your nice $100k nest egg house becomes the nicest $45k house in the slum 20 years later. Look at all the vets in Hilltop in Columbus.

Sure - if you do volume and you are your own contractor cheap SFRs make more sense. But, this is not an investment - it's a business for you, and there is a difference.

Also, not sure what you mean about rents driving valuation. They do in the commercial/multifamily space, but SFR valuation is via CMA and doesn't take income into consideration - only adjusted comp sales...

 

[Chazmania]

Not to mention that every time you have to replace a furnace in a house which has not and will not appreciate, you'll be saying to yourself - damn...throwing good money after bad again.

Thoughts?

100% agree and I'm speaking from experience. Yes those houses throw off a healthy cashflow but your other points are spot on. We have a few of those and they are a different animal than the ones in the more middle class areas where the value slowly grows instead of dwindling. Yep big difference.

 

[Jon L]

This reminds me of a tax-lien investing program I bought 20 years ago. You could buy tax-liens against properties, and you were 'guaranteed to make a profit,' because either the tax lien would eventually be paid, plus interest, or you'd end up owning the property. I looked into it, and one of the properties I could end up owning for about $1000 in taxes was an old gas station in Bakersfield, CA. I'm guessing there was a reason that the owner abandoned the property. It might have taken $1M to clean up the old gasoline spills before you could do anything with the land.

I'm sure you can make money with tax liens, but the prospect of not knowing what I didn't know scared me too much.

 

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[MKHB]

Yes, but CapEx still happens, and physical vacancy can be years... No perfect solution, but quality always wins out...right?

So far as I can tell.

 

[H. Palmer]

Ben, do you yourself invest in RE?

 

[JustAskBenWhy]

Ben, do you yourself invest in RE?

Hmmm. Not sure, but my wife likes depositing those rents...

 

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[JustAskBenWhy]

Ben, do you yourself invest in RE?

@Ryan D. - What did that banker tell you last weekend; do I invest in RE?

 

[AllenCrawley]

Ben, do you yourself invest in RE?

https://www.thefastlaneforum.com/community/threads/pleased-to-join.62541/

 

[H. Palmer]

https://www.thefastlaneforum.com/community/threads/pleased-to-join.62541/

OK, good to know.

 

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[JustAskBenWhy]

This reminds me of a tax-lien investing program I bought 20 years ago. You could buy tax-liens against properties, and you were 'guaranteed to make a profit,' because either the tax lien would eventually be paid, plus interest, or you'd end up owning the property. I looked into it, and one of the properties I could end up owning for about $1000 in taxes was an old gas station in Bakersfield, CA. I'm guessing there was a reason that the owner abandoned the property. It might have taken $1M to clean up the old gasoline spills before you could do anything with the land.

I'm sure you can make money with tax liens, but the prospect of not knowing what I didn't know scared me too much.

Yep, and there is a name for that - financial obsolescence...

 

[Ecom man]

This reminds me of a tax-lien investing program I bought 20 years ago. You could buy tax-liens against properties, and you were 'guaranteed to make a profit,' because either the tax lien would eventually be paid, plus interest, or you'd end up owning the property. I looked into it, and one of the properties I could end up owning for about $1000 in taxes was an old gas station in Bakersfield, CA. I'm guessing there was a reason that the owner abandoned the property. It might have taken $1M to clean up the old gasoline spills before you could do anything with the land.

I'm sure you can make money with tax liens, but the prospect of not knowing what I didn't know scared me too much.

As with everything there are risks and rewards with tax lien investing. I have a couple family members that have invested in tax liens in Indiana for years. They invest for the regular returns but have recently foreclosed on a couple of properties worth hundreds of thousands. The amount they spent on the liens were pennies on the dollars vs what the properties are worth. They said they just invest in them for the high returns and the random property you actually foreclose on is just gravy. As with any investment do your homework before investing and you can alleviate a lot of the risk.

 

[Envision]

Ben I love your Biggerpockets interviews that you do. Gonna read through your posts now..

Welcome by the way!

 

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[JustAskBenWhy]

Ben I love your Biggerpockets interviews that you do. Gonna read through your posts now..

Welcome by the way!

Wow - get comfy - not sure if I've crossed 100 articles on BP blog yet, but got to be up there

 

[Jakawan]

In my market, it's kind of weird with those $9k houses. We have the NE side where those $9k houses are as you describe, worth less than $0 and an experienced investor would have to be PAID to take it off the sellers hands.

On another side of town we have a certain ethnic group occupying the majority of houses.. and they work construction jobs, painting, roofing, etc and they have CASH. So what I see people here doing.. is buying a fixer upper house for $9k, doing NO work to it.. or sometimes they'll throw on a second or third layer to the roof so it doesn't leak... and then they'll sell it for $25k-$30k with $3k-$5k down at 10%-12% interest.. I worked for a guy here who owned over 120 of these. He does well lol