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Why buying cheap rental units will turn you into a slumlord (advice for new investors)

(title is slightly exaggerated for effect)

I see a lot of new/prospective landlords on this subreddit, and also a lot of established/existing agents and investors, and sometimes there is a disconnect between what people don't know to ask, so to speak. So a couple of lessons from someone in-between (specifically, a small-time landlord who hasn't quit his day job yet). Take it for what it's worth...

  • The easiest way to get started as a landlord/investor, by far, is make your first home purchase be an investment home, such as a small multi-family. There are a million books, guides, web-forums on the details, but your first purchase is usually the easiest one to get favorable financing, and, for a bunch of reasons, it is much easier to build on a small portfolio of income-generating or flippable properties than to leverage your primary residence.

  • For this reason and others, a lot of new landlords are starting with cheap "starter" rental units. Which is fine, in fact it might be the best way for people with little cash to get on a path to being "rich", or at least a member of the investor-class.

But here is a thing to be aware of (and it's neither a good thing nor a bad thing, just a thing): Cheap rental units have a tendency to lock you into cheap rental units. Let me explain:

  • Let's say you buy a 4-unit apartment house in a marginal neighborhood for, say, $100,000 (all examples will assume adequate state of repair, etc-- big assumptions, but eye on the ball please). Let's say the units rent for $500/mo each. So $2,000 x 12 = $24,000 potential income on a $100k purchase-- that's some damn good returns, especially leveraged! Call that scenario X, where the gross rent is 24% of the purchase-price.

  • Let's compare this to, say, a $1M 4-unit in a desirable location where the apartments rent for, say, $3,000/mo, or $120,000 annually, or 12% of the purchase-price. Call that scenario A

Now, either one of those will "work" in a strict cash-flow analysis of income minus PITI minus reasonable assumptions for vacancy etc. But why is one so much more expensive than other, on a percentage basis?

  • A lot of real-estate agents don't really know what they are talking about when it comes to rental properties, and will tell you something hazy and unhelpful about equity or desirability or location or whatever. Some kind of gauzy fluff that sounds like wisdom handed down from on high to cover up the fact that they have no idea.

  • A lot of landlord forums and websites will tell you that you need to make 2% of purchase price per month or something to make any money, and are short on details but long on personal experience and appeals to authority, with a healthy dose of ranting about tenants or something.

Let's unpack some of this, and see if we can figure out why the market is willing to tolerate much lower percentage income on higher-end properties and locations (and I'm going to leave out speculative/emotional "desirability" stuff, because the institutional and commercial investors are not generally following the advice of web-forums or local realtors...)

  • In scenario X (the cheap one), you are, statistically, going to be renting to lower-income people with shakier credit, inferior job-history, less education and career prospects, etc. They are less stable, likely to have higher rates of turnover and nonpayment, they will have more people per bedroom, and more socio-economic factors that will lead to more complexities related to maintenance, evictions, police activity, etc etc. But you can and should minimize that stuff by screening tenants carefully, and there are good people and good tenants who don't have much money. So that's part of it, but not really the biggest thing.

  • The big thing, and the hard-edged, simple-math thing that rarely gets talked about, and that realtors and most investment books I've read seem to gloss over completely is this:

There are significant and ongoing fixed costs per unit that don't scale with purchase-price or rental income.

  • It costs a certain amount of money per year to own a sink, or a toilet, or a refrigerator, or a driveway, or a door, etc, etc... those things break and wear out and need to be maintained and replaced.

  • Maybe the high-end unit has nicer appliances and fixtures, but it doesn't cost anything close to 6x as much to own a stainless fridge as the cheap one (in fact, the better stuff may have a comparable or even lower total cost of ownership, especially if you have better tenants).

  • The roofing company doesn't charge less to work in the ghetto than they charge on Doctor's Hill, and neither does the plumber, the water-company, the landscaper, or anyone else. It costs about the same to replace a toilet or paint a unit in Beverly Hills as it costs in East L.A., and those are fixed cash expenses, not a percentage-adjusted scale.

What happens is that, over time, your $24,000 income stream that leaves, say, $14,000 per year after PITI, still has to cover a bunch of fixed cash costs that are not that much different on an apples-to-apples basis than, say, the $40,000 left over in Scenario A (the expensive one). This has a huge effect on your actual net, and accounts for most of the reason why low-end landlords will tell you things like the aforementioned 2% rule.

The net consequence of this is that, if you are making payments on cheap apartments, you are effectively forced to become a cheapskate: you buy the cheapest fixtures, you do the cheapest landscaping, you cover up old shingle construction with cheap vinyl siding, you let the driveway crack and crumble, etc, etc, because there simply isn't money left over to pay for "pride of ownership".

(N.B., of course there are always ways to wrangle the numbers and do things yourself and seek out rehab grants and etc and so on-- I'm talking apples-to-apples here).

Alternately, in Scenario A, on an actual cash basis, you have a lot more flexibility to exercise judgement about how much you want to pocket, versus re-investing towards making or keeping your units desirable and attractive to the most stable and desirable tenants.

I hope it is easy to see how scenario X, by comparison, can become a sort of cycle that is hard to break out of-- the lower your maintenance and appearance standards, the harder it is to be selective about tenants, and the more vacancy and non-payments you have to deal with.

Last but definitely not least, is the cash-basis effect of equity growth on both scenarios. Even if you invest purely for income and not for equity, it is reasonable to assume that, long-term, rents and equity should roughly keep pace at least with inflation (notwithstanding a whole bunch of things that can be discussed elsewhere in great detail).

So again assuming apples-to-apples, a 10% rise in equity gives you $10,000 in scenario X (which might cover a driveway re-surfacing for a four-unit), or $120k in Scenario A, which could afford a new driveway plus quite a bit of improvement (and maybe even a good chunk of the downstroke on another million-dollar property...)

None of this is to say that buying cheap rental units is a bad idea. It might be the best decision you ever make, and it's often the only way to enter the game in the first place. And plenty of people have gotten very rich in lower-income rentals.

But it's important and helpful to understand the ways in which real-estate is not like stocks. A house is not a "substance" like precious metal, it's a thing , and buying one million-dollar thing is not the same as ten $100k things.

Just make sure, when you run your numbers, that your assumptions reflect the ownership costs of all the toilets and windows and roofs and driveways and sinks and hinges and water heaters and so on. It may be that the cheaper units are still better than the premium ones, maybe much better. But only by using realistic fixed costs will you be able to compare apples to apples.

Hope that helps.

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"A lot of real-estate agents don't really know what they are talking about when it comes to rental properties, and will tell you something hazy and unhelpful about equity or desirability or location or whatever. Some kind of gauzy fluff that sounds like wisdom handed down from on high to cover up the fact that they have no idea."

I would suggest that any prospective buyer ask an experienced property manager/real estate agent who has worked in the local area for advice. I do this for investors all the time. I do not ask for any payment, contract or commitment. Usually I don't want a contract since the property is unrentable as it is and work will be required to make it a viable property. I would be wasting time trying to rent a property which is substandard. I can only suggest that recognized management procedures be adhered to. This is usually news to the investor(s). Whether the investor listens or not is up to the investor. Normally, investors call me after they have gotten into a situation which is difficult or impossible to remedy. This comes under the category of getting advice before ever considering investment in any property.


As a property manager in Ohio, I have to be licensed in order to manage properties for investors. I have to be familiar with state law and a variety of federal laws regarding rental. Litigation results from a lack of interest in laws or a deliberate violation of law. Each state has different laws regarding rental. Rent assisted housing is also governed by agency regulations which must be followed. Section 8 housing can be a wonderful and financially rewarding investment if law and regulations are followed. That program produces some of the best tenants to be found anywhere. On the other hand, some of the worst tenants have been in market rate, high end rentals. This is common experience for professional managers. Some of these tenants simply refuse to abide by their lease contracts or have any consideration of any kind for other...

"A lot of real-estate agents don't really know what they are talking about when it comes to rental properties, and will tell you something hazy and unhelpful about equity or desirability or location or whatever. Some kind of gauzy fluff that sounds like wisdom handed down from on high to cover up the fact that they have no idea."

I would suggest that any prospective buyer ask an experienced property manager/real estate agent who has worked in the local area for advice. I do this for investors all the time. I do not ask for any payment, contract or commitment. Usually I don't want a contract since the property is unrentable as it is and work will be required to make it a viable property. I would be wasting time trying to rent a property which is substandard. I can only suggest that recognized management procedures be adhered to. This is usually news to the investor(s). Whether the investor listens or not is up to the investor. Normally, investors call me after they have gotten into a situation which is difficult or impossible to remedy. This comes under the category of getting advice before ever considering investment in any property.


As a property manager in Ohio, I have to be licensed in order to manage properties for investors. I have to be familiar with state law and a variety of federal laws regarding rental. Litigation results from a lack of interest in laws or a deliberate violation of law. Each state has different laws regarding rental. Rent assisted housing is also governed by agency regulations which must be followed. Section 8 housing can be a wonderful and financially rewarding investment if law and regulations are followed. That program produces some of the best tenants to be found anywhere. On the other hand, some of the worst tenants have been in market rate, high end rentals. This is common experience for professional managers. Some of these tenants simply refuse to abide by their lease contracts or have any consideration of any kind for other residents. The property may be very expensive to buy yet the performance can suffer due to poor quality management. When an inexperienced investor decides to launch into management with little formal preparation, the investment can become the financial and legal burden it was not intended to be.


The aim of managing any property is to bring it up to standard and therefore, see realistic returns. If the manager is permitted to get the work done and to do his/her job, the investor does well over the long term, no matter what the property is. If the manager is not allowed to do his/her job, the property will fail, no matter the type of property.


After some years spent in management (before licensing and after) and having seen the large numbers of failures which could have been prevented, I encourage all prospective investors to get multiple opinions before buying any property or signing any contract for management.


One comment: the initial cost of the property may prove to be prohibitive regarding doing needed improvements later. What is most common in investment property is the lack of planning by the buyer and the inability to pay for maintenance which allows the building to be rented. In a competitive market, renters have every choice within their rent ranges. This is still a market in which the renter can find deals. If the manager has little experience and has no budget to make units work, there is no chance for the investor to see the returns he wants over the life of the investment.


Investing is long term. There is not and never has been a short term real estate investment which magically produces returns. "Flipping" is a term with negative connotations in the real estate market. I hope we have seen the last of the "property flippers". Lenders still need enforcement regarding loans being made to investors with a habit of foreclosing on investment properties. Lenders need to sell and in this market, they certainly will.


I hope investors can be educated before buying. I also hope investors know to talk to a variety of qualified sources before risking any money in this recovering market. The best situation for everyone is when both the investor and the residents are pleased with their experiences. The licensed manager's job is to make sure that happens with as little expense as possible.

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  MP Clark

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