If Given the Chance, Would you Run a Motel 6 Strategy, or a Marriott Strategy?
In our series of Investing Myth articles, we will be busting open some common buying and selling myths that affect real estate investors. Making an investment decision based on one of these common misconceptions could cost you thousands of dollars and a ton of headaches. We want to help make sure that does not happen to you. One myth we want to debunk is that buying a cheaper rental is always better. But is it?
Hidden Costs of Cheap Rentals
Bargain real estate prices are not going to get you a high quality property. You will end up with a property that is affected by extensive depreciation. It will be in need of substantial repairs and many of them will include major repairs such as expensive items like roof, foundation, heating, plumbing and electrical replacement. While a landlord can overlook a dated kitchen, scuzzy carpet or low quality siding, they cannot ignore a leaky roof or a failed heating system.
These costs can quickly add up into thousands of dollars which you have to come up with out-of-pocket. One high priced major repair or replacement can suck up your profit margin for many years. Whereas if the investor purchased a higher priced but already renovated property, the cost of those past repairs are now part of the mortgage and are paid over time.
According to this chart which reflects typical rent-to-price ratios along with average expense costs, the bargain property will only earn $3,900 per year – unless there is a big ticket replacement item. If the roof needed to be replaced at the average cost of $19,000, it is going to take four years until the investor sees a profit – and that is assuming that there are no mortgage payments on the property.
Cheap Investment Properties Attract Cheap Renters
Another factor to consider with cheap rental properties is that they are often found in less desirable locations. These cheap properties are offering a reduced price because no one wants to live there. You will find these properties in high crime areas. The problem here is that these types of properties attract sub-par renters leading to high vacancy rates and irregular income streams. Tenant damage is another important consideration which could also affect the net operating income.
Conventional Financing is Limited
Many new investors looking to get into the real estate market do not realize that there is a minimum finance amount for conventional mortgages. In order for a lender to sell the mortgage to the secondary market (i.e. how they make their money back), the loan must be $50,000 or more. With a 25% down payment requirement for investment properties, the minimum purchase price is $62,500.
An additional consideration is that mortgage terms are affected by the economic life of the property. If this dirt cheap property appraises with only 20 more years of economic life, do not be surprised if the lender does not require a 15 year mortgage – which could eliminate any profitability.
Cheap rentals can be a good first step into the income property market, but make sure you understand the risks before jumping in. Just because it is cheap does not mean that it will be profitable.