Rental property risk?

[jason]

I'm thinking about taking a large percentage of my overall net worth and buying rental properties (single family homes).  These homes would be on the lower end of the spectrum - working class neighborhoods, but not in poor, high crime neighborhoods.  I'm thinking of buying several homes priced at around $80,000 each.  I am paying cash (no leverage/mortgages) and I should be able to net 9% after normal expenses.  My question is, how much risk am I really taking on?  I know the values of the homes may go down, but has there ever been a period in the US where I would have taken a major cash-flow hit, such as a huge number of vacancies or being forced to lower rents a lot?  From my perspective, I think the odds of having these types of problems are extremely remote.  Am I underestimating the risk?

[barrett]

You'll get some good feedback here but I think the place you really want to take this question is the real estate section on the Mr. Money Mustache site. There are tons of folks on there and quite a few of them are seriously into land lording.

But I think most would say to start small and see if you have the temperament for it. Many folks make this work better by being skilled at fixing stuff, which means that with a lot of properties they become full-time handymen. I do know a guy here in CT who has made this work even by hiring people to do all the repairs, but he had the advantage of buying really low in 2010 after so many people got crushed financially and many properties were in foreclosure. Multi-family places seem to be better than single-family, but now I am wading into territory that I am only vaguely knowledgeable about!

[l82start]

the other important aspect is temperament, the ability to deal calmly and professionally with with the (lying idiot who is trashing your place) tenant behind on rent or moving pets/people etc. in to your property...

i would warn people to think of it as a career and a job first not an investment, if you can see yourself working in this field then you have a chance to make nice returns on your time and money..

[jason]

Thanks for the feedback!  I'm definitely not handy, so virtually all repairs would have to be done by a handyman/professional.  My plan is not to buy distressed properties and then fix them up, though.  My plan is to buy houses that are in good condition that I can just fill with a tenant immediately.  What about buying properties and also hiring a property manager to handle the day-to-day issues and rent collection?  Then, I could pretty much do this more like a passive investment than taking on a career, no? 

[l82start]

property management companies are a fine way to go, they often take care of the maintenance the sales/finding renters and background checks on tenants etc but you run the risk of breaking rule # 9 and #8 * and could easily end up being way over charged for maintenance stuck with bad tenants because the management company wanted the place full, charged an unreasonably big cut of your profit margin etc.
  i would recommend using a management company as a transition while  you learn the trade, take the local rental association classes to learn rental law and tactics for dealing with tenet issues, follow maintenance guys and repair men around and learn what they do by watching, wander through home depot and price the parts being used on jobs so you know what the DYS cost would be compared to a jacked up pro rate..  there is also a skill involved in picking out the properties and not getting blind sided by big dollar repairs that got missed in inspections..

don't let all this scare you off... its actually not a bad field to work in, but there is some knowledge you have to acquire along the way, (even if it is only going to be used to keep an eye on the people you hire to do the work) its just not the easy, plunk your money down and collect returns/rent proposition, it may appear to be from the outside..





*(letting somebody make your derisions and investing in something you don't understand) important rules for self employment as well as for investing

[Libertarian666]

Whenever I think of (or hear of) an apparently highly profitable venture, my first question is "If this is so profitable, why aren't a lot of other people doing it?".

The answer almost always turns out to be "Because it's not that profitable; it just seems that it is.".

Of course, sometimes that isn't the reason. Maybe no one has thought of it before. Clearly that isn't the case with rental property. Many people have thought of it and some people do it.

Thus I conclude that it can't be overly profitable after you account for the effort and risk.

[Pointedstick]

Whenever I think of (or hear of) an apparently highly profitable venture, my first question is "If this is so profitable, why aren't a lot of other people doing it?".

The answer almost always turns out to be "Because it's not that profitable; it just seems that it is.".

A different answer might also be "Because it requires a very large investment of time, starting capital, and skills, and most people don't have those things available to them."

That would pretty much describe rental property.

[Libertarian666]

Whenever I think of (or hear of) an apparently highly profitable venture, my first question is "If this is so profitable, why aren't a lot of other people doing it?".

The answer almost always turns out to be "Because it's not that profitable; it just seems that it is.".

A different answer might also be "Because it requires a very large investment of time, starting capital, and skills, and most people don't have those things available to them."

That would pretty much describe rental property.

Again, if the risk-adjusted return were that good, someone (or group of people, e.g., a company) would be taking advantage of it. The amount of capital that can be raised for an outsized return is very large, and you can always hire people with the right skills.

So the answer still is that the risk-adjusted return isn't that fabulous.

[jason]

Whenever I think of (or hear of) an apparently highly profitable venture, my first question is "If this is so profitable, why aren't a lot of other people doing it?".

The answer almost always turns out to be "Because it's not that profitable; it just seems that it is.".

A different answer might also be "Because it requires a very large investment of time, starting capital, and skills, and most people don't have those things available to them."

That would pretty much describe rental property.

Again, if the risk-adjusted return were that good, someone (or group of people, e.g., a company) would be taking advantage of it. The amount of capital that can be raised for an outsized return is very large, and you can always hire people with the right skills.

So the answer still is that the risk-adjusted return isn't that fabulous.

I think the risk and headaches are typically accounted for in the cap rates.  Areas that are "hot" where people are speculating on a lot of property appreciation have tiny yields/cap rates.  Rural areas where minimal appreciate is expected have higher yields/cap rates.  More expensive homes that tend to have wealthier tenants with strong credit tend to have better cap rates than cheap homes with relatively poor tenants who often have bad credit.  Cheap homes have more defaults and tenant turnover, so there are more headaches and more vacancy risk.  So, I think the free market is working and the yields will typically be what they are for a reason.  But I think there are some inefficiencies in some areas.  For example, my brother-in-law lives in a small town in the Midwest, and he is able to get amazing yields.  He buys small houses for around $30,000 in cash, spends around $10,000 fixing them up, and then rents them out for around $800 per month, which gets him around a 24% yield.  After subtracting expenses, he is still at over 20%.  Of course, if a house needs a big repair like a new roof or heater, then he will take a hit.  He owns 10 houses and, overall, he is still netting a cap rate of around 20%.  I live in a much more densely populated area, and the yields are much lower.  My area runs at around a 11% yield (before expenses) and around 8% cap rate after expenses for cheap homes.  But the equivalent of a $40,000 house there costs around $100,000 here.  And the rents are obviously not high enough to get me a 20% yield.  He can't expect much appreciation, but his huge return more than covers that.  I would take cash flow over speculative appreciation any day.  I think one reason for the inefficiency is that if an area is extremely rural/low population, hedge funds and other non-local investors won't bother with it because there are probably not enough deals in the area to be worth their attention.  Another reason is that it is a blue collar area where a negligible fraction of residents have enough money to buy investment properties, so he has almost zero local competition.

[jason]

Also, getting back to the risk involved - in a SHTF scenario, could I take a huge hit?  Is anyone aware of a period, say, the past 100 years, in the US where owning a bunch of small rental homes would have done very poorly in regards to cash flow (I'm not worried if the values of the homes dip as long as my cash flow is steady)?  Obviously, there are situations where, for example, you own a bunch of houses near a manufacturing plant, for example, and the plant closes, and the town becomes a ghost town, and all your houses become vacant.  But I won't be owning houses in an area that relies on a particular company or industry.

[dragoncar]

Also, getting back to the risk involved - in a SHTF scenario, could I take a huge hit?  Is anyone aware of a period, say, the past 100 years, in the US where owning a bunch of small rental homes would have done very poorly in regards to cash flow (I'm not worried if the values of the homes dip as long as my cash flow is steady)?  Obviously, there are situations where, for example, you own a bunch of houses near a manufacturing plant, for example, and the plant closes, and the town becomes a ghost town, and all your houses become vacant.  But I won't be owning houses in an area that relies on a particular company or industry.

Does Detroit count?

[jason]

Also, getting back to the risk involved - in a SHTF scenario, could I take a huge hit?  Is anyone aware of a period, say, the past 100 years, in the US where owning a bunch of small rental homes would have done very poorly in regards to cash flow (I'm not worried if the values of the homes dip as long as my cash flow is steady)?  Obviously, there are situations where, for example, you own a bunch of houses near a manufacturing plant, for example, and the plant closes, and the town becomes a ghost town, and all your houses become vacant.  But I won't be owning houses in an area that relies on a particular company or industry.

Does Detroit count?

Did investors renting out single family homes in Detroit take a huge hit in regards to cash flow?  Were they forced to significantly reduce rents or were they seeing an increase in vacancies?  I know the value of homes went down in Detroit, but that is not necessarily a total debacle if cash flow is steady since you can just hold on to the properties.  If you are living off the cash flow, your lifestyle won't immediately be affected unless you are forced to drop rents or have an uptick in vacancies.

Besides that, my plan is to diversify and to buy real estate in several different cities around the US, which should help reduce risk.

[Libertarian666]

Also, getting back to the risk involved - in a SHTF scenario, could I take a huge hit?  Is anyone aware of a period, say, the past 100 years, in the US where owning a bunch of small rental homes would have done very poorly in regards to cash flow (I'm not worried if the values of the homes dip as long as my cash flow is steady)?  Obviously, there are situations where, for example, you own a bunch of houses near a manufacturing plant, for example, and the plant closes, and the town becomes a ghost town, and all your houses become vacant.  But I won't be owning houses in an area that relies on a particular company or industry.

Have you heard of the Great Depression? Maybe you should read up on it. 

[jason]

Also, getting back to the risk involved - in a SHTF scenario, could I take a huge hit?  Is anyone aware of a period, say, the past 100 years, in the US where owning a bunch of small rental homes would have done very poorly in regards to cash flow (I'm not worried if the values of the homes dip as long as my cash flow is steady)?  Obviously, there are situations where, for example, you own a bunch of houses near a manufacturing plant, for example, and the plant closes, and the town becomes a ghost town, and all your houses become vacant.  But I won't be owning houses in an area that relies on a particular company or industry.

Have you heard of the Great Depression? Maybe you should read up on it. 

How did single family rentals perform during the great depression? Did rents drop a lot? Did vacancies skyrocket?

[D1984]

Also, getting back to the risk involved - in a SHTF scenario, could I take a huge hit?  Is anyone aware of a period, say, the past 100 years, in the US where owning a bunch of small rental homes would have done very poorly in regards to cash flow (I'm not worried if the values of the homes dip as long as my cash flow is steady)?  Obviously, there are situations where, for example, you own a bunch of houses near a manufacturing plant, for example, and the plant closes, and the town becomes a ghost town, and all your houses become vacant.  But I won't be owning houses in an area that relies on a particular company or industry.

Have you heard of the Great Depression? Maybe you should read up on it. 

How did single family rentals perform during the great depression? Did rents drop a lot? Did vacancies skyrocket?

https://research.stlouisfed.org/fred2/graph/?g=9m1

The above has nothing to say about vacancy rates but shows that during the worst of the Depression (circa 1930-33) rents declined at around 10% to 13% a year and they didn't stop declining (albeit only in single digit declines per year by that point) until around 1935 or 1936. This sounds bad but consider that during 1930-1933 overall prices for everything (not just real estate)--as measured by the CPI--were also declining yearly by high single digit or low double digit percentages so even if you got 30% less in rental income then if prices a a whole were down 20 or 25% you really only got about 5% to 10% less in rental income in real purchasing power terms.

Rents (if indeed they did drop much) during Japan's lost decades might be instructive as well but I have no idea where to find info on those.

EDIT: In Japan from 1990 to 2014, apparently office rents fell sharply (especially in Tokyo) when the bubble burst but residential rents barely fell at all; see pgs 6, 7, and 29 of http://www.kdr-reit.com/english/ir/kdr_ ... data_E.pdf

[sophie]

I'd be more worried about the landlord-tenant laws in the area you're planning to invest in.  If a tenant stops paying rent, what's the process to get them evicted, and how long will you be stuck with them living in the apartment rent-free?  And, what's the average time a unit in the area sits empty (now, and going back to before 2008)?

I looked into renting my last apartment instead of selling it, since the building permits investor apartments.  With the high coop maintenance charges relative to expected rent (about half), I figured that at best I'd get a 5% return, including depreciation benefits - and not counting potential tenant-induced shenanigans with NYC's extreme landlord-unfriendly laws limiting recourse.  Honestly, after working the spreadsheet I really have no idea why anyone would want to become a NYC landlord.  You should definitely get estimates for all the variables you can and then go through this same exercise before making any decisions.

[l82start]

CA law..... thirty days if the tenant has been living there less than one year 60 days if over one year... then if they don't leave as ordered, expect anywhere from a few weeks to a few months to get a court date, set an eviction and arrange for the sheriff to do a lock out..  your mileage may very depending on how good your lawyer is and (as Sophie mentioned) will vary from state to state,

and of course you may not be getting rent for that entire time, or longer, especially if the eviction is due to not paying rent.    these costs have to be baked into the cake so that when it happens (it will happen) it can be weathered as a short term cost/loss.

it is definitely not a deal breaker that keeps people out of the landlord business but it is another whole area of job knowledge you need to be up on.. 

[jason]

Have you heard of the Great Depression? Maybe you should read up on it. 

How did single family rentals perform during the great depression? Did rents drop a lot? Did vacancies skyrocket?

https://research.stlouisfed.org/fred2/graph/?g=9m1

The above has nothing to say about vacancy rates but shows that during the worst of the Depression (circa 1930-33) rents declined at around 10% to 13% a year and they didn't stop declining (albeit only in single digit declines per year by that point) until around 1935 or 1936. This sounds bad but consider that during 1930-1933 overall prices for everything (not just real estate)--as measured by the CPI--were also declining yearly by high single digit or low double digit percentages so even if you got 30% less in rental income then if prices a a whole were down 20 or 25% you really only got about 5% to 10% less in rental income in real purchasing power terms.

Rents (if indeed they did drop much) during Japan's lost decades might be instructive as well but I have no idea where to find info on those.

EDIT: In Japan from 1990 to 2014, apparently office rents fell sharply (especially in Tokyo) when the bubble burst but residential rents barely fell at all; see pgs 6, 7, and 29 of http://www.kdr-reit.com/english/ir/kdr_ ... data_E.pdf

Thanks.  This is really helpful.  I guess landlords did get clobbered during the Great Depression.  I was also thinking about using leverage to get higher returns and also to avoid paying taxes (the depreciation deduction and the mortgage interest deduction typically put the net income in the negative), but I'm worried if another Great Depression plays out, I could end up bankrupt.  It's one thing to pay cash for real estate and have to cover taxes and insurance during bad times (some risk of financial ruin, but probably small).  It's another to have big mortgage payments to cover, as well, in an environment of high vacancies and falling rents.

[MachineGhost]

a large percentage of my overall net worth

A mistake right there.  Diversify, diversify, diversify.