Investing in Declining Markets

Declining markets can appear very attractive to investors: low prices with good returns. In this article I will look at the short and long-term considerations of investing in declining markets.

The Attraction of Declining Markets

In a recent blog post I read, an investor told of how she purchased a 3-bedroom home for $50,000, spent $10,000 in rehab and was renting it for $650/Mo. Based on my emails with her I put together the following.

Amount/Rate
Purchase Price $50,000
Rent (Mo.) $650
Interest rate 5.5%
Down Payment % 20%
Down Payment $10,000
Loan Term (Ys.) 30
Closing Cost % 4.5%
Debt Service (Mo.) $227
Property Tax % 2.5%
State Income Tax % 4%
Management Fee % 8%
Rehab Cost $10,000
Insurance (Yr.) $800
Debt Service (Mo.) $227

Calculation ROI: ROI = ((Rent - Debt Service - Management Fee - Insurance - Real Estate Tax - Periodic Fees) x (1 - State Income Tax))/(Down Payment + Closing Costs + Estimated Rehab Cost)

ROI = (($650 x 12 - 227 x 12 - .08 x 650 x 12 - 800 - .025 50000 - 0) x (1 - .04))/(10000 + 50000 .045 + 10000) ROI = 10.4%

Based on ROI alone this appears to be an outstanding property! However, when researching the location in which the property is located I found the following:

Decreasing Demand

Declining demand can be cause by many events. Below are the three of the most common causes.

Declining Population

If people are moving out of an area, rents and sales prices are likely to fall due to decreasing demand. If people are moving into an area, rents and sales prices are likely to increase. This is a simple supply and demand situation.

Declining Job Quality And Quantity

The value of a property is no better than the jobs around it. In many parts of the US, manufacturing and similar jobs are going away (or have already left) and what remains are service sector jobs. Service sector jobs tend to pay less than manufacturing jobs so the families of these workers have less disposable income today than they did in the past. Less disposable income means that they cannot afford to pay the level of rent they did in the past.

Urban Sprawl

Urban sprawl is a major factor to consider. In every major city I've seen there are areas which were once the best places to live and over time have become distressed areas. The major cause of such a change is urban sprawl. People want newer floor plans, newer homes, less crime, better schools, etc. If people have the income, they will choose to move to a location that better meets their current needs. As people with sufficient income move out of an area and those left behind will, on average, have lower incomes. One result of the outward migration of people with income is that property prices (and rents) will tend to fall because the remaining residents have less disposable income. As property prices fall, property tax revenues will fall. City services, which primarily depend on tax revenues, will be reduced. This creates a downward spiral which few locations ever recovered.

Declining Market Characteristics

According to studies I've read, rents lag sale prices by 2 to 10 years. What this means in the short term is that you can purchase low cost properties with comparatively high rents, resulting in high returns. However, over time rents and the market values of the property will both decline. See the graphic below.

What is likely to be a disaster for investors is that while your mortgage payment is fixed the rent will decline. At some point the rent will not even cover expenses. In many locations, the owner is forced to choose between renting at a loss, a short sale or default on the mortgage. I talked to an investor who owns many properties in Indianapolis who is in this unenviable position. He would like to sell his properties and buy in Las Vegas. However, the market value of the properties is so far below what he paid so he can't. He is trying a lease to own approach but is finding very few people who are willing to live in this distressed area that can qualify for a loan or who are willing to buy. So, he is stuck in a downward spiral.

There is another problem in addition to declining rents and property prices and that is the tenant pool. As the median income of people living in such areas declines, largely due to people with higher incomes leaving the area, the percentage of cash based tenants increases. While the specific price points will vary depending on the market, below a certain monthly rent the majority of the people will be cash based. Cash based people have little or no dependency on credit. Some will not even have bank accounts. If a person carries no "financial history" then actions in the past have little or no impact on their future. Because of this, cash based people have little concern about leases, eviction, skips or property damage judgments.

Cash based people tend to have fewer possessions than credit based people. This means that cash based people can load and go much easier and faster than their credit based counterparts. So, if a property targets cash based tenants you are going to have more evictions, skips, damage and turn costs. And, while properties that target cash based tenants appear to have high returns, once all the additional cash based costs are included, your cash flow will be lower.

In times of financial turbulence, low skilled cash based tenants are the first to get laid off the last to be reemployed. In Las Vegas after the 2008 crash, some C class properties had vacancy rates so high that owners just boarded them up.

Lastly, with little financial history, or bad financial history, it is externally difficult to screen out the bad actors. As one property manager who specializes in low end properties told me, "If they have a heart beat, a months rent and a job, they are in."

Cash based tenants will result in a much higher operating cost due to skips, vacancies, damage, evictions, crime factors, etc. The impact on the owner is illustrated below.

Over time you are likely to find yourself in a position where you can't afford to rent the property due to the operating costs exceeding rents, you can't sell the property since there are no buyers and you can't walk away because you still have the mortgage.

Why do people buy properties in declining markets? After talking to many people who own such properties the answers generally include:

Summary

Declining markets appear to be extremely attractive due to low purchase prices and comparatively high return. However, over the long run can be a financial disaster.