Which Way is Your Profit Headed?

Many new investors select properties and locations based only on (low) purchase price and ROI. In this article I will talk about the short-sightedness and the potential dangers of this approach.

What Defines a Good Investment Property?

I believe a good investment property must meet all three of the following criteria:

To meet the above criteria you need a combination of the right location and the right property. The most critical of the two is the location because as long as you buy property in a good location, all but the worst mistakes will be corrected over time through appreciation, inflation and rent increases. If you buy in a rising location, everything is great. Your operating costs are largely fixed and rents and property value will rise so your return increases. So, life is good for the investors in these locations. What happens if you buy in a declining location? Just like in a rising market, your operating costs are largely fixed. However, as rents and property prices fall, you are caught in a financial trap. At some point, rents will not even meet your operating costs and you are caught in a very difficult situation where you can't afford to rent the property and there is no way to sell it because there are few, if any, home buyers who can qualify for a loan and investors will not touch it. If you would like to see a sample list of declining markets, check out this list of the 100 most dangerous cities in the US by NeighborhoodScout.. This is certainly not a comprehensive list but it is a good start of a location elimination list. Still, despite all the signs, people continue to buy investment properties in these locations for two reasons:

High Return and Low Prices

Some of the highest return properties you can find are ones in declining locations. The main reason for the high returns is that rents tend to lag property prices by 2 to 10 years. Effectively, you are getting the level of rent from years past at the current eroded property price. See the illustration below.

However, ROI and cash flow are only a snapshot in time; a prediction of how the property is likely to perform today. ROI and cash flow tell you nothing about how the property is likely to perform in the future. And, much as some investors hope that the location will remain constant, it will not. The Greek philosopher Heraclitus (535 BC to 475 BC) stated it very well.

"Change is the only constant in life"

Restating the above in real estate terms, every location is either rising or falling; nothing stays the same. I want to mention one more problem with buying in declining markets and that is the changing tenant pool.

Tenant Pool Characteristics

Earlier in the article I defined the characteristics of a good investment property. Below is my definition of a good tenant:

Good tenants are not common, they are the exception. Plus, no matter the intent of the tenant if they are not employed, they can't pay the rent. An investment property is no better than the jobs around it. You need to meet the combination of a "good" tenant and a tenant that stays employed.

How do you find good tenants? Careful screening by a skilled property manager. However, no matter how good the property manager, unless they have historical tenant information, they have no way to make an informed decision. Based on economics, there are two basic categories of tenants.

See the illustration below of how tenant type can significantly increase your operating costs.

As an area declines and people with higher incomes leave, the tenant pool will shift from credit based tenants to cash based tenants. The increased cost due to cash based tenants can be huge. This is also why paper returns can be excellent but once skips, evictions, damage and turn costs are included, they can be financial disasters.

In a declining location, not only is your income decreasing, as your tenant pool changes to cash based tenants your operating costs increase. This is a double financial hit and not one many people can afford.

Buy in a Good Location

In the definition of a good property I listed earlier, several of the characteristics are location dependent. To me, a good location meets all of the following characteristics:

Urban sprawl is rarely talked about in investment circles but it is one of the major causes of declining markets. I've read many articles about urban sprawl but I've found no easy way to measure it. The best way I know is to look at an aerial view of a metro area over time. Below are links to a Google aerial time map page. Click on the various cities below and see the effects of urban sprawl. Note that you will likely have to zoom out to see the sprawl. Think about investors who purchased properties in the suburbs in 1984 (the starting year of the time lapse aerial views) and where the suburbs are now.

I included Las Vegas for two reasons. First, I live in Las Vegas. Second, it is one of the few metro areas in the US with limited or no urban sprawl. The only way for Las Vegas to grow is through redevelopment of existing areas. See the map below.

For more information on Las Vegas as an investment location, see "Why Las Vegas?"

Summary

In this article I focused on the impact of buying in a rising market and in a declining market. The image below summarizes what happens to investments in such markets.

The choice is simple. Buy in improving markets and your returns will continue to increase over time since your costs are relatively fixed. Or, buy in declining markets with high returns today and deal with declining rents and increased costs over time. Remember that once rents fall below your operating costs, there is almost no good way out of the situation. Taking the long view of a location before you invest is critical to your financial health.