Some rental investments don't pay off

Neighborhood, local economy dictate profit potential

By Inman News Feed
Add Comment Add Comment | Comments: 0 | Posted Nov. 20, 2009

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Neighborhood, local economy dictate profit potential

Steve Bergsman
Inman News

Buying foreclosed, or otherwise inexpensive, residential units with the game plan of renting the property for as many years as it takes until real estate appreciation returns has proven to be a time-tested and generally successful investment strategy.

Unfortunately, it's not as easy as it appears. Just because a residence, whether a condominium or a single-family residence, can be acquired cheaply doesn't mean that a home-rental scheme can be operationally profitable.

It would seem that with so many foreclosures and REOs (bank-owned homes) on the market that now is certainly the time to make an investment in a rental property, and many experienced investors are plowing through bank auctions with vigor. Those folks I don't worry about. It's the novice investor and those new to the business to which I have these four words of caution: You are not alone!

There are so many investors buying up homes with busted mortgages, thinking they are going to transform the property into a rental, that a glut of houses for rent in your neighborhood is coming -- or might already have arrived.

New investors fall in love with a property. They see a house or visit a condominium and immediately want it, sparing no effort in making the acquisition. They become so entranced by the real estate that they don't do the research required to see if the property can, indeed, be a viable rental.

Let's say, for example, that you find a house you want to buy so you can turn it into a rental. It's in a good neighborhood and you can buy it fairly cheaply. However, you don't do any research so you fail to turn up the fact that a multifamily developer will be building a huge apartment complex one mile from your property, creating intense competition for renters. Or that most of the people in the neighborhood, where the object of your real estate desires can be found, work in a manufacturing plant that will be closing up in three months and putting everybody out of work.

Those are extreme situations. A more likely scenario is this: too many rental properties in your city, creating too much competition, driving down rental rates too severely to make investments operationally profitable.

As I mention often, I live in Mesa, Ariz., about 20 miles from downtown Phoenix. According to my local newspaper, the Arizona Republic, in my city alone there are almost 17,000 single-family home rentals; in Phoenix, there are 49,694 single-family home rentals; and in the metro area as a whole, 133,990 single-family home rentals.

I checked in with an associate and good news source, Alan Langston, executive director of the Arizona Real Estate Investors Association, about what this situation, which looked to me like a glut of homes, meant for single-family home investors.

What I got was a verbal wagging of the finger; There is no glut, he contended. There was enough demand -- at the moment -- so that home rentals in the Phoenix metro area still showed a low vacancy rate. However, even he admitted that the market was rapidly changing and there was a downward pressure on rental rates.

Phoenix isn't the only metro that might be facing a glut of home rentals. I got on a Denver home-rental blog that reported although rents were still on an upswing, the supply of home rentals was increasing as well, meaning that the upswing could easily reverse and become a downswing.

The problem in Denver was the same as in Arizona and elsewhere. Real estate investors were diving into the foreclosure market, picking up properties and then renting them out. In past years, these same homes might have been flipped, but the lack of credit and millions of workers picking up unemployment checks have combined to drastically narrow the pool of potential buyers.

When considering becoming a single-family residential landlord, use common sense. The basic law of supply and demand in regard to single-family rental properties is this: Try to avoid a neighborhood with a lot of foreclosed homes. It doesn't matter if these homes have been purchased and retain market appeal, because the owners are investors who will be renting out the property just as you hope to do. And, as in all industries, a surfeit of the same creates a glut, which will at minimum keep prices low, or at worse drive prices down hard.

If you want to invest in a single-family home that will be used as a rental property, it might make more sense to pay more for a property in a neighborhood that is not so beaten down with foreclosures. Without the intense competition you could probably set a rent that will make the property operationally profitable -- at least for near future.

"I'm still telling folks this is one of the best real estate investment markets ever," says Langston. "If you can acquire rental properties, buy and hold, it is a good strategy. You just have to be careful. Depending on how you structure your transaction will make the difference whether you will be in good shape or not."

Obviously, an all-cash investor has the flexibility to lower rents and still be in a profit position. That's not true for an investor who borrows capital to make the transaction. If there is a single-family home-rental glut in your target area, which is becoming increasingly likely, it's better to do the research and discover it before you buy.

Then tread carefully.

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