Many new and aspiring real estate investors are drawn to lower-rent properties. There are a number of factors that can make low-rent (sometimes referred to as “Class C/D”) properties seem attractive:
- Lower purchase price
- Higher cap rates (advertised)
- Higher cash-on-cash return (predicted)
- More inventory to choose from
However, the reality of these properties is quite different. In the course of owning low-rent properties, many investors learn the hard way that they are terrible investments. In fact if you look at the transaction history of these types of properties, you will see that they tend to change hands quite often, sometimes as frequently as every 2 years or so. Conversely, higher-rent (Class A and B) properties have quite stable ownership history; rarely do they change hands. The reason is obvious: Why sell an income-producing asset?
There are several reasons that make lower-rent type properties perform poorly.
First, there is a minimum level of ongoing costs associated with owning and maintaining a dwelling. No matter how small the square footage, how cheaply purchased the property, how low the rent, and how many units in the building, there is a floor on how low ongoing costs can get. Every livable dwelling has things like HVAC, windows & doors, plumbing, electrical, walls, and many other systems. They are all slowly wearing out and have to be maintained and occasionally replaced. This idea is explored well in this article: Rents Will Only Go So Low, No Matter How Much We Build.
What does this mean for real estate investors? Don’t estimate your repair costs (or any costs, really) by using a percentage of rent. There is no correlation between rent and repair/maintenance costs. Instead, try using a dollar-per-square-foot figure or other means of estimation. The upshot is low-rent properties end up performing poorly because nearly all of the gross rents end up getting spent just to keep the property habitable. Plus, these properties are often old to begin with, exacerbating the problem.
The second reason low-rent properties don’t perform well is because the tenant base tends to be transient and rough on the rental units. High turnover rates and expensive turn costs are a disastrous combination for a rental property. No matter how good your tenant screening, there is no escaping these facts. Relative to a class A or B neighborhood, you are going to experience higher turnover and more wear-and-tear on the properties. Combined with lower rents, you just can’t make money.
I hope you have a good idea of why we recommend investors stay away from these types of properties – particularly if they are new or out-of-state. Seasoned investors who know the ins and outs of every block in the neighborhood and are willing to self-manage (and put in sweat equity) can and do turn a profit. All others should avoid.