Hard Truths about Hard Neighborhoods: Why Low-End Housing Is Not for Most Investors
Ever thought about trying to go into a low-income neighborhood, buy a vacant shell and renovate it to provide livable housing? Earn a return and make a difference at the same time? Think long and hard before jumping into low-income real estate.
The truth is that the oversimplified “2% Rule” completely distorts the investing picture on low-end housing. It’s easy to find properties in lower-end neighborhoods that will rent for at least 2% of the purchase price, which is why so many new investors are drawn to them. Besides, when properties are cheap to buy, it’s easy to diversify your real estate portfolio, right?
Wrong. Diversification is only relevant if you start with the assumption that every individual investment is inherently sound in its own right. But most landlords (especially new landlords) are simply not prepared for the challenges of low-end real estate.
One such challenge is the higher turnover rates in lower socio-economic neighborhoods. Statistically, poorer Americans have a far higher “mobility rate” than their middle- and upper-income counterparts. Turnovers are extremely expensive for landlords, between lost rents, repairs such as new flooring and painting, advertising and other costs associated with placing new tenants in a vacant unit. Higher turnover rates = lower return on investment.
A related challenge: higher vacancy rates in low-end neighborhoods. More vacant properties generally means more supply, making it more difficult to lease out vacant rental units. While a "shortage of affordable housing" is often bemoaned, the fact is that there is a shortage of qualified renters of affordable housing: the average credit score for households earning less than $30,000 is 619 (chart below). That means longer vacancies in addition to their higher frequency… once again leading to lower returns.
Then there are the frightening statistics correlating vacant properties with crime. A 2012 study by the University of Pennsylvania found not only a strong correlation between the number of vacant properties on a given block and the number of assaults, but also a correlation with gun assaults. And then there’s the property crime, which often means damage to your rental property. Think broken windows, kicked-in doors, stolen appliances, squatters, graffiti and the like – all of which comes out of your pocket. If you think insurance will save you, think again: the deductible is usually high, and if you do make a claim, expect much higher premiums in the years to come.
Who lives in low-income neighborhoods, with high vacancy rates, high crime rates and high turnover rates? To generalize, residents who have often have trouble making their rent payments on time. Rents often go unpaid, which means more eviction filings, which are in turn time-consuming and expensive. Once again, this translates to lower ROI in the real world.
Nor is it only about financial returns. It is a lot more work to chase down tenants who routinely fail to pay their rent, which is time you could have spent with your family and friends. Going to rent court means time taken off of work, or it means hiring someone to appear in your place. Higher turnovers means much more work, as you coordinate with contractors on cleaning out the trash left behind by your last tenants, repainting the entire house, replacing the ruined carpets, and so on. Advertising the property, meeting prospective tenants there, collecting rental applications, screening tenants, signing lease agreements… sure, there’s a certain helpful website for this (ahem), but it still takes time away from your family.
Perhaps your next idea is to hire a property manager to take these time-consuming headaches off your hands. But lower-end properties mean lower-end property managers, too. After all, as a property manager paid on commission, would you rather take on $2,000/month properties with stable renters who usually pay on time, or a $700/month property with tenants who make more excuses than rent payments? It’s a no-brainer for property managers: the only reason to take on the extra work and lower commissions of low-end properties is if they don’t have a choice.
Lastly, it’s worth considering the political and legal reasons not to invest here. Many states, provinces and municipalities have a lengthy and difficult eviction process, and extremely tenant-friendly laws. You don’t get any brownie points for trying to renovate a dilapidated home and provide decent housing for low-income renters; rather you get called a slumlord for filing eviction and "putting hard-working folk out on the street". Tenants call the local news station, and tell them their slumlord is turning them out on the street, that they live in abject conditions. (I saw this happen to an old colleague, and the news station jumped on the story, never mind that the cockroaches and squalor in the house were there because the tenant left food and garbage lying all over the house.)
If you want to make a difference in lower-income communities, I commend you for it, but do it as a volunteer at a local non-profit, or by donating goods to local charities, not as an investor. I have found that donating my time, money and goods has been rewarding spiritually, while my attempts to simultaneously earn a return while making a difference have left me poorer both spiritually and financially.
Are there any reasons to invest in low-end rental properties? While most investors simply don’t have the skills or stomach necessary to succeed in such a challenging market, it is a niche. Some investors thrive here, and can even earn strong returns. But the ugly sides of this market can be hardening; the frequent late rents and evictions, the sad stories of truly desperate people, the crime. There is a cost to managing and investing in poor neighborhoods, and it goes deeper than financial losses and extra management hours each month.