A student came up to me recently and asked me a very pointed question regarding rental strategies…
YOU NEED TO HEAR THIS….
Should she buy one rental property in a very good neighborhood? Or should she buy two or three properties in a lower income neighborhood?
What do you think I said to her?
It’s actually a very good question, especially when you look at all the factors involved…
My student told me that the rental income on the property in the more wealthy area would be about the same (or slightly less) than the total rental income from two lower income properties.
But if she bought a third, which is possible, then her income advantage would be with the lower income rental strategy.
So on just a straight gross income basis, the lower income rental strategy wins, doesn’t it?
I reminded her that PASSIVE INCOME IS WHY YOU BUY RENTAL PROPERTY!
Ah, but there’s a bit more to the plot, as they say, isn’t there?
For instance, just buying three properties means three sets of transaction costs, such as Stamp Duty, conveyance fees and so forth. Then there’s the tax, insurance costs, titling fees and all the rest…
Whereas if she bought just the one upscale property, she would have to deal with those transaction costs only once.
Now granted, they would be higher than any individual property due to the higher value, but there is definitely an advantage in terms of convenience.
Another factor to think about is the condition of the properties. I don’t have to tell you that rehab or reno costs figure directly into your bottom line.
The lower income properties were not the most attractive properties, but everything worked.
Sure there was a bit of paint and cabinetry repair in two of the properties and some new flooring and a window replacement in the third was needed. And the grass needed cutting and trimming, but otherwise, the reno costs were minimal.
The single property in the nicer area, however, needed new appliances as well as new paint. And the exterior of the property was noticeably less well kept than the surrounding houses. The property had been rented prior and had not been well cared for.
On the plus side of things, the more expensive property was priced about eight per cent under market value, so there is immediate equity in it.
So far, it is higher cost, more reno costs and less rental income for the suburban property…
And for the lower income properties, she’s looking at three transaction costs, less reno costs and higher rental income.
When I went through this analysis with her, it was clear that the lower income property deals were the better opportunity for her in terms of passive income, which is her financial objective.
But there was one other issue that she was a bit concerned about…
The lower income properties were located in, well…a lower income neighborhood. No surprise there, that’s for sure. But she was not so comfortable with the idea of renting to tenants that might not take care of the properties.
But I quickly pointed out that the home in the nicer area was in much worse shape than the lower income properties. Also, I told her that a good property management company would go a long way toward screening potential tenants, handling repairs and collecting the rental checks.
Sure, it would cost her a bit every month and eat into her passive income, but it would be worth every penny.
Also, the fact that she could buy three properties for the price of one meant a lower risk if a tenant leaves. If her nice suburban tenant leaves, it might take a while to replace him. In the meantime, her passive income would stop.
If one of her lower income properties were vacant for a while, she would still have passive income from the other two. That’s a very important factor for stable passive income, because…
You should BUY PROPERTY WHERE 80 PER CENT OF YOUR TENANTS CAN AFFORD TO RENT!
This is the old, time-proven 80-20 Rule that applies to most things in life…
Like 20 per cent of the people own 80 per cent of the wealth…The trick is to be a 20 per cent person and lease to the 80 per cent.
And the simple fact is that those lower income rental properties represent the biggest chunk of the rental market. Believe it or not, that’s where 80 per cent of the demand is.
And don’t forget my property purchase rule…
Finally, I reminded her my rule for property purchases:
Always have the first property purchase set you up for your next one, and that one for the next, and so on.
In the case of the suburban rental property, yes, there was instant equity. But there were also costly repairs. Still, the eventual equity and income would, in less than a year, allow her to buy another property.
But with the lower income properties, she was already getting two or even three income streams. The equity play would not be significant, but the income streams meant that she could rapidly pay down debt on one and then remortgage it to access the equity for her next property purchase.
From that point of view, she figured she could actually buy a fourth lower income rental property within four to six months.
I also asked her about the possibility of manufacturing value by adding on an extra bedroom and bath to all of the properties. That, however, was not in her immediate plans. She was much more comfortable with her current strategy.
That’s all well and good. She might change her mind on that one after a little while.
In the meantime, she now sees that a fat rental market strategy means a fatter wallet!