Why Investing In “High Cash Flow” Low End Houses Is The Wrong Direction

I started investing in single family houses in 2018 largely focused on the bottom end of the market.  I have purchased over half a dozen houses at under the $40,000 price point.  My initial appeal to these houses was a combination of the low barrier to entry and the high cash flow as a percentage of the investment that could be generated, at least theoretically.  After 7 years I am no longer interested in these bottom of the market homes and am willing to share what I have learned.

Low Income Housing In General Is Tough:

The tenants available in these neighborhoods tend to be people who are not in great financial positions. We routinely experience high turnover, high tenant damage, late/unpaid rent, and high drama. I have a house that has had 3 tenants in 3 years.  It normally is taking 2 months of vacancy to flip one of these houses after a tenant moves out. I instituted higher late fees in order to incentivize tenants to pay on time, and most still do not. Chasing rent is a pain in the butt and the eviction process in Michigan moves slowly. We recently had two long term tenants move out who each caused thousands of dollars of damage and left behind massive piles of trash.  All of the walls needed to be deep cleaned and repainted and the flooring needed replaced. Each house had at least 2 broken windows.  This level of damage is not sustainable with <$1,000 per month rents.  We originally only charged 1X rent in security deposits and have now moved to the max of 1.5X rent in Michigan.  1.5X rent is still way to low for the amount of damage we have been encountering.

Those Deals Don’t Exist Anymore:

For the most part those sub 40K deals have disappeared. My strategy was to look for bank owned listings, wait for them to hit 30 days, and sometimes 60 days on the market, then after a price drop offer around 70% of that number.  The bank repos largely don’t exist, and most properties that would have been $35,000 7 years ago are closer to $70,000 today. The value of houses has increased much faster than rents, so the numbers do not work well anymore for new purchases.  If rating deals on return on equity, it no longer works well for existing properties either.

Interest Rates Remove Cash Flow:

Interest rates increasing from 3.75% to 7%+ makes it really difficult to get cash flow, especially with the higher priced homes.  On 15 year notes a 3.75% loan for $40,000 is $291 while a 7% loan for $70,000 is $630. The property taxes in Benton Harbor for a home valued at $40,000 is $104 and for a $70,000 home is $183.  We have a $417 increase in monthly costs, while rents have increased $113 on average over the last 3 years in my market.

The inverse of this is that it also makes it difficult to give up the existing rentals precisely because the interest rates are so low. For the existing properties a big consideration has to be the return on equity.

Compared to more expensive housing:

If we look at 2 identical homes that the only thing that separates them is the location, with one being in a challenged neighborhood like Benton Harbor, MI and the other being in a more stable neighborhood like neighboring Sodus,  A move in ready house in Benton Harbor may cost $80,000, while the house in Sodus may cost $160,000.

Repairs cost the same: Replacing a roof is still going to cost $15,000 no matter the zip code.  The furnace will still cost $7,000.  The carpet installation will still be at $3/square foot.  Regardless of the home price these big capital expenses have the same cost.  This destroys the low income housing model because a large cap ex expense can be a major portion of the total value of the property, and it won’t sell for that much more in the future. Insurance also costs the same, as it is based on the rebuild cost of the home.

Future Appreciation: Although I benefited from strong appreciation during this 7 year period of time investing in these types of houses, I do not think that long term this appreciation will continue in this area. If the house in Sodus appreciates 5%, that is $8,000 in a year, if the house in Benton Harbor appreciates 2% that is only $1,600.  Compound across a decade and these are some real numbers.  After 10 years the $80,000 home would become worth $97,500, while the $160,000 home would become worth $260,000. This is $17K Vs. $100K.

Depreciation: With more expensive houses I can benefit more from the depreciation expense. As my income has increased, this has become more appealing.

Inflation induced debt destruction: Higher dollar properties means higher value loans.  I have 3 properties that have 3 loans and combined have less than 100K in debt.  With a house in a more stable neighborhood my debt would easily be over $100K per house.  We are limited to 10 conforming loans, so more expensive properties allows us to borrow more money on 30 year notes, which is effectively shorting the dollar. Although this is the same regardless of home pricing, switching to 30 year notes vs. 15 makes a massive difference in the cash flow and in the ability to take advantage of depreciation because with a 15 year the mortgage payback amount largely offsets the depreciation.

Ease of Loans:  The lower end homes that I have been buying are not easy to get loans on.  In general they need a lot of rehab, which requires them to be bought with all cash.  On the off chance that they could qualify for a loan without repairs, the percentage of the total deal that is wrapped up in closing costs becomes really high.  With average closing costs of $6,000 on a $60,000 home this is 10%, but on a $180,000 home this is only 3%.

The larger price also makes future refinances make more sense.  Interest rates dropping 2% would save the $60,000 loan $78 per month, but would save the $120,000 loan $156 per month. A $5,000 refinance cost would take 64 months to pay for itself on the $60K loan, while it would only take 32 months to pay for itself on the $120K loan, leading to more long term cost savings.

Half The Drama: If every house costs twice as much, and the rent is almost twice as much, and the down payments are almost twice as much, I end up economically about the same having 1 house in a nice neighborhood vs 2 houses in a rough neighborhood.  1 tenant is typically less hassle than 2. In general a tenant who can afford $2,000 a month in rent is more likely to treat others civilly than a tenant who pays $1,000 a month in rent. In general then, going from two houses in Benton Harbor to 1 house in Sodus should result in similar cash flow with close to a quarter of the drama.

Actions Taken:

I have recently purchased 2 homes in my neighborhood which are currently short term rentals, and I am preparing to sell 2 of my houses in Benton Harbor. One of those houses I got back this month and am in the process of fixing up to sell. The next one we should get back in the spring and I should be able to sell next summer.

Does This Mean I Won’t Work In The Affordable Housing Space?

No. But I do plan to pivot.  Rather than scaling to more single family rentals in the low end market, I am looking at an investment model of buying homes that need more work than could qualify for a loan, then flipping them only to the point where they would qualify. This means taking care of the major systems, but likely not installing all new flooring, doors, trim, and countertops.  A rough deal might be something like paying $50,000 for a home, putting $15,000 and 6 weeks of work into it, and selling it for $95,000.  Another option would be to seller finance these homes instead of going the bank route, opening up the ability to profit off the sale price and the interest, without being a landlord. For owner financed properties you often charge a higher interest rate because of the increased risk.  This would also provide the opportunity for people to become home owners who don’t have perfect credit or the most stable long term job history.  On a 30 year note with a 9% interest rate 93% of the initial monthly payment is interest.  On a $100,000 loan $44,000 of interest would be paid in the first 5 years, while only $4,200 in principal would have been paid down.

I will also continue to work in the apartment spaces. The cost of apartments often can be much less expensive than the cost of single family housing, which is why it makes more sense to focus on apartments for rentals instead of single family houses if my goal is to try to provide low cost housing options. It isn’t possible to rent a single family house out for $800 a month, but I am able to do that on some of my apartments.

Compared To Multifamily:

The same concept can be applied to multifamily, but at a much higher effect.  Take the low end 7 unit building I purchased last summer for example.  I paid $36,000 for it while it was a money loser.  Now that it is stabilized I have increased it to have a net operating income of $30,000.  Due to its area, it will likely only sell for about a 10 cap, or 10X the NOI, which would be $300,000.

Repositioning a building in a nicer area would likely sell for a CAP rate closer to 6.  This would be 16.6X NOI and it would sell for $500,000. This means when buying a multifamily building in a nicer area and improving its cash flow, I stand to benefit far more on the upside for the new income I cause the property to generate.  On my Benton Harbor property I gain $10 in value for every $1 of net income generated, while for one in a different market I will gain $16.60 of value for every $1 of net income generated.

What do you think of this changing strategy? Are you still investing in low end single family houses?