Types of US Residential Properties
Different types of properties are suited to different business strategy depending on whether the investor rental income or capital gains. I propose the following four profiles in increasing order of rental yield. You will be able to identify the kind of property you are dealing with based on their rental yield.
Pricey Fashionable Areas
Here is an example: a three bedroom in Cambridge (MA) is currently up to rent for $2400 per month while its value is estimated at 1.4mln. In this case, an owner accepts a gross yield of 2% only in exchange for the pride and privilege of owning a house near Harvard and MIT far beyond what is to be rationally expected to be the rent collected on this home.
Prime and exclusive locations are expensive not because those areas are particularly nice, the reasons are invariably social. Some areas have a brand that is associated with success. People will buy that brand so that they can signal their success by owning an overpriced house, and meet other successful people. While this social reinforcement mechanism is similar to that of a bubble, prices in these areas are very resilient. Prices did not go down in Manhattan in 2009, although this was the biggest financial crisis ever, and the only instance of nationwide real estate downturns ever. This tells a lot about the solvency of these owners. Transaction volumes do slow down, but there are fewer foreclosures in these cities than anywhere else in the US, and the prices remained high. In fact, such properties appear to be most safe in case of a downturn. This does not mean that these houses are necessarily a great investment: these house prices are likely to keep up with the inflation, but there is an opportunity cost, as investing in houses with 10% higher yield will double one's investment every seven years.
Parallel to that influx of success seeking individuals, properties with multi-million prices experience a drain from people cashing out on their house and leaving for a cheaper place. If the proud owner of this three bedroom Cambridge house paid off his mortgage by the time he retires, he might consider using the money to buy a nice $300k house with everything he wants, and use the extra $1.1mln to generate $11k of gross monthly rental income. While short-term prices are safest in areas such as Cambridge, buying there at current prices requires the belief that the best society will continue to choose this place to congregate.
In an area where nice houses can be bought for $300k or $400k, there should be no problem with the price increase to continue given the demographic tailwind.
Investing for Capital Gain
Here is a typical example: in Cary (NC), a 2200 sqft home four bedrooms four bath home, with hardwood floors, granite counter tops, fireplace, stainless appliances, in a pleasant leafy suburban location.
The house would rent for an estimated $1900 per month and thus return 7% gross. Most people who can afford this will see that the mortgage would cost only $1200 per month. Unless there are special circumstances, we can expect the occupier to buy in that area instead of renting.
A capital gain property will typically appeal to mass affluent home buyers. The school district is an important indicator of the neighborhood quality. You target buyers does not care how much the house would rent for, they want a fireplace, hardwood floors, a kitchen with granite counter tops and stainless appliances, and all the contemporary fixtures that would invite invidious comparison. The HOA will be expected to offer convenient sports facilities and a swimming pool. This property will be anything but frugal.
A common strategy for real estate professionals in the US is to fix and flip. Typically, the house is purchased at a 30% discount to its potential value, say less than 10% of the price is spent on improving the property, which is then sold within 6 months leaving a 20% profit in 6 months. Getting the estimates right and the work done on time and on budget involves working on such deals full time. A less lucky investor will find that the property is harder to sell than anticipated, and the investor is stuck with a house that can neither be sold or rented for a profit.
There are many areas where indeed, buying only makes sense for capital gain. One would think about many up and coming areas of the of the US, such as the Cary (NC), Austin (TX), Portland (OR) or Gilbert (AZ). In these areas, houses have already gone beyond what rental investors can offer, due to an influx of affluent home buyers who will buy with low mortgage rates at such prices for lifestyle reasons.
Home appreciation has been very unevenly distributed in the US. Real estate professionals usually consider short-term deals that close within 3 to six month. Buying for long-term appreciation requires an understanding of what long-term changes are occurring in an area.
Investing for Rental Income
Here is a typical example: a house built after 1980 with very basic fixture: carpet floors, linoleum floor in bathrooms may be found for 90k-140k in an area where it pays $900-$1400 per month. The house will not have the formidable qualities of the capital gain house, but its price is so low that nothing much can go wrong with it. The rent can compensate for depreciation.
With a median annual salary of $51000, rents lower than $1400 are affordable for the majority of the US population. At such prices, it is possible to find investments with month rent at 1% of the property price (that's 12% gross yield).
Investing for rental income is easier than for gain, as one just needs to find a property with affordable rent, in an area with a healthy job market to be able to rent it, there is no need to find a property below market price as in the capital gain business model.
At $900-$1400 per month, most tenants rent by choice as they could save to buy a better house. Perhaps they do not want to deal with calling contractors for home emergencies. Such safe income properties in this price range make sense when annual rent is 10%-12% of the property price.
High Cashflow Investments
Here is an example: a wooden frame house built in the 70's, selling for $35k and rented $650 per month.
You should be aware that there is a qualitative gap in tenant sociological category when rents are lower than $900 per month. When you buy a property value below 90k, this is far below the replacement value of most houses and implies that the house is not generally desirable (it might be too ancient or in a bad neighborhood). At such prices, you see an increasing number of tenants who struggle through life, even if they pay the rent, they may have too many problems to take good care of the property where they live.
The term of trashflow property is the colloquialism for such houses sold below $70k with yields above 14%. While houses between 70k and 90k value would be a crossover between trashflow and cashflow properties. These investments are the most profitable of all when all works well, but with higher yields come higher risks. Anything paying more than 12% will require an exceptional property manager to keep the rent coming, you need to monitor your property manager carefully if you get into that business.
You will also need to consider whether the state has landlord friendly or tenant-friendly laws, and whether to buy such houses through an LLC to avoid big problems.