Investing in Rental Properties for the 1% Rule – Good Idea?
This is somewhat of a loaded question so first let’s explain what investing for the 1% rule actually means.
The 1% rule means you are investing to receive a 1% gross monthly return on the principle amount invested. For example, if you purchase a house for $100,000 you expect to receive $1,000 per month in return. This could be in the form of a rent payment, private mortgage payment by financing the purchase for someone else, etc.
This form of investing has become popular for many out-of-state investors in the belief they are making a safe investment since many times they believe the houses they are purchasing are in good areas. These houses are portrayed by the seller as stable since they are middle to upper markets in a specific region. These areas are typically classified as A, B, or C areas. Let’s first look at the classifications of areas to better understand the truth rather than what is being said.
Classifications by Area
It is true that many areas that are classified as A, B, or Care better areas for many reasons. These areas typically offer higher values for Real Estate; Residential and Commercial, the school systems typically receive higher scores overall, unemployment is typically lower, and more people typically have some form of higher education.
At this point you must be thinking, great I knew I was on the right track. Hold on. These areas have all of the things mentioned above except the ability to sustain 1% rent amounts because the demand is not driven by people looking for a place to rent. These areas are driven by owners. That’s why they have all of the things mentioned above. The demand in these areas are driven by people looking for a house to buy and stay for 30+ years, raise their family, send their children to good schools, etc.
That’s why it is difficult to sustain 1% rent amounts in these areas. The people in these areas don’t want tenants living near them. If you’re honest, you don’t want a tenant living next door to you if you own your home. People don’t change just because you are investing in a different neighborhood, city, or state than where you live.
What Happens When Houses are Rented in These Areas?
The answer to this question depends on the number of houses that are rented in an area/city. If there are not many houses tenant-occupied it likely won’t have an effect on the value of a property in the immediate area or city. These are typically the A and B areas. The purchase prices will likely be too high to obtain 1% of a gross return. These areas will typically appreciate so if you are a long-term buy and hold investor it may not be a bad play. You will only see profit when you sell 10-20 years down the road but money can be made. It’s difficult to invest in these areas though due to the higher prices of the houses. A portfolio is likely out-of-reach for most of us in the A and B areas.
In contrast, there will be a lot of houses in C areas that are rented. It has a substantial impact on the value. How so? Just like above, you don’t want a renter living next door to you if you own your home. These areas do not change from owner-occupied to tenant-occupied areas overnight. It takes a while to make the transition. Unfortunately for many out-of-state investors they aren’t aware of what is going on in the area of the property that are purchasing. All they see are the returns promised and it looks attractive.
There is an area located adjacent to Birmingham known as Centerpoint. This area was once predominately owner-occupied. Over the last 5 years or so there have been many investors providing what is known as Turnkey Properties to investors. Over time I would estimate around 100 houses per month have been sold to investors as a way to make passive income. These Turnkey Providers combined with Hedge Funds have been buying every house they could to turn into a rental property. Some have been resold to out-of-state investors and some held by Hedge Funds. What it has created is a once owner-occupied area is now a tenant-occupied area. If you compound 100 per month for 5 years you change the usage from an owner to a renter for approximately 6,000 houses in a city with a population of about 16,000 people.
This is why Turnkey Providers and Hedge Funds focus on C areas. The values that can be stated on an appraisal look good but holes can be punched in the immediate market so Turnkey Providers can make money on resales while Hedge Funds are able to buy lower than what the market shows as the median value. This is a trailing waterfall.
A Trailing Waterfall as Appraised
When a property is appraised it is compared to similar properties that have sold, “in the past.” The past may be 3 month, 6 months, or1 year. When you compound sales in the past with repeated lower purchase prices the values begin to decline. Over time you see what was once $100,000 is now only $75,000. They are still able to be appraised for enough to get a loan since you still have retail sales of owners buying a house but you are trailing the value when you buy in these areas for the 1% rule. In 3 months a new set of comparable sales will be used. The same in 6 months and 1 year. By the time you get to 5 years what type of actual resale value do you have in a market that has been declining because the usage of so many houses changed?
Now you have 6,000 less houses that an owner-occupant could potentially purchase to keep the values in the area stable. Many of these owners begin to realize the area is changing and decide to sell while they still can and move somewhere else. Unfortunately, investors are the potential buyers now. This puts the area in to further decline. This is known as De-gentrification.
No matter when you buy a property to rent in area that is changing the usage from owner-occupied to tenant-occupied you are buying at the current peak of the market. In the near future the purchase price will be lower. This happens until the market implodes and Turnkey Providers can no longer sell houses in the area. This has happened in Centerpoint. Every Turnkey Provider and Hedge Fund has completely pulled out of buying houses in Centerpoint as of the date of this article. This is why it is so important to know what you are buying. Many Turnkey Providers and every Hedge Fund only cares about the money they are making not whether the investor purchasing the house will make any money. You can’t fault a business for making money. It’s the only way to keep the doors open of the business.
Red Flags When Investing for the 1% Rule
In Real Estate, if it’s easy you need to walk away. If it’s too difficult you need to walk away. There is a sweet spot that has a couple of bumps but not too difficult. This is where to invest if you plan on making money.
Something to keep in mind is a company offering to manage a house they are selling you likely isn’t a wise decision to allow both. The eggs in one basket scenario. This is giving someone absolute control of your investment. It’s not unheard of for companies to make repairs and not tell the owner since selling them more houses will make them more money than 10% of the rent each month. This is not to imply every Turnkey Provider does this but compare $1,200 a year to manage a property versus $50,000 profit from selling you another house. It’s easy to understand the attraction to make the management seem as though you purchased a good investment to keep you in the cycle to obtain the additional profits from selling you more houses.
Invest in properties and with companies that want you to make money instead of selling you an investment property at top dollar. That only makes the provider money. You make minimal profit, if any all, but hold all of the financial risk.
If you are investing for cash flow you should invest where rent drives demand. Your return will likely double if not triple. You’ll also likely find actual investors in these areas because investors that focus on their returns are buying in these areas. Investors that are solely focused on selling to out-of-state investors but have minimal holding themselves will be in areas where they can make the most profit from sales.
At LAS, we hold, sell, and help investors make wise decisions. We do not expect every investor to purchase from us but we do like to see investors be successful with their investments. We don’t have to sell our properties because they make money.
If you have questions about a property or area in Birmingham, we welcome you to contact us. We’re glad to help if we can. Our success is directly impacted by the success of the investors we help and work with that invest in Birmingham.