Buy Several Cheap or a Few Pricier Houses? An Investor’s Analysis

I get this question all the time: “Should I buy cheap property somewhere else with higher cap rates or more expensive property where I live?”

I wanted to buy cheap property once. It’s very tempting. So is it a good idea? Let’s run some numbers and find out.

Most investors turn to cap rates to decide which property to buy, almost like a magic wand. But cap rates can be deceiving and should be used with caution because there is a lot they don’t take into account.

What is a cap rate exactly?

Cap Rate = Net operating income/sales price

• Net operating income is simply the yearly gross income minus operating expenses (i.e. property manager, yard maintenance, vacancies, repairs).
• Sales price is what you will pay for the property.

Real World Example

We’ll use two very different different homes for this example.

Expensive Property

• You make $29,000 a year in rental income
• Property costs you $270,000
• Manage property yourself
• Yard maintenance is $1,200 a year
• Vacancy loss is about $200 a year
• A typical year in repairs costs you $1,000 (not replacing major components)
• NOI: ($29,000 – $1,200 – $200 – $1,000)/$270,000 = 0.099 or 9.9% cap rate (very good for a single family home)

Dirt Cheap Property

• You make $6,000 a year in rental income
• Property costs you $30,000
• Manage property yourself
• Yard maintenance is $1,200 a year
• Vacancy loss is about $100 a year
• A typical year in repairs costs you $600 (not replacing major components)
• NOI: ($6,000 – $600 – $100 – $1200)/$30,000=0.14 or 14% cap rate (unrealistically excellent cap rate to prove a point)

Based on the analysis, the cheaper property has a lot better return on the income invested. What most people don’t put into cap rates is the cost of major repairs which tend to be similar between really cheap and more expensive houses. Let’s see how that changes things.

Here is an example of prices for different components of a house and how fast they wear out.

More expensive property:

• Monthly income = $2,400 – mortgage ($1,600) = $800 a month left over
• Average operating expenses are $200 a month
• Average costs to repair major systems in the house over time are $157 a month
• Monthly profit $800 – $200 – $157 = $443

Less expensive property:

• Monthly income = $600 – mortgage ($142) = $458 a month left over
• Average operating expenses are $158 a month
• Average monthly costs for major systems in the house $157 a month
• Monthly profit $458 – $158 – $157 = $143

So, to make the same monthly profit while paying off the loan as a $270,000 house, you will need three $30,000 homes. That might not be bad. Considering that you are putting 20% down on each investment, you will make more monthly profit per dollar invested when buying the cheaper homes. It doesn’t end here. There is so much more to consider.

Appreciation

What about appreciation (increase in home value over time) if you want to sell one day? Let’s say appreciation is 5% for the more expensive home (that’s why homes are more expensive in those areas) and 3% for the cheaper home (that’s why prices are cheaper in those areas).

If you wanted to sell in 20 years, the cheaper home would be worth about $54,000 and the more expensive home about $720,000. A little after year three, you will have made more in just appreciation (not including profit or pay down) on the more expensive house than the cost, appreciation and profit of the cheaper house. By year 18 you will make more in appreciation every year than the cheaper house costs. To get the same appreciation return using cheaper homes, you will need to buy and manage 13 ($390,000 in cheaper homes) of them.

Let’s look at how much your time spent managing was worth in just appreciation assuming three hours a month per house over 20 years. The cheaper house will be worth $75/hour and the more expensive home $995/hour. 

Management Time

Let’s say you pay the houses off and want to retire on that income. If you manage the more expensive property, you will make $2,400 a month (assuming the value of money never changes over time). You will need 5 cheaper properties to get the same amount of cash flow. In other words, you make 5 times more per hour of work with the more expensive house.

Going the more expensive route gives you a lot more time to do things that truly make you happy. That’s why we invest in the first place, right?

Economy of Scale

At the front end, cheaper properties are very tempting because they can bring in more money per dollar. At the back end, the more expensive properties bring in a lot more per amount of work and per year from appreciation. Whichever you choose is up to you.

I’m sure some of you are thinking, “Well, I can’t afford an expensive property.” My advice to you is to buy what you can afford as long as there is cash flow. Over time you will be able to gain equity and save up money so you can buy something that will increases your income per hour.

Things to keep in mind:

• Costs for long term and short term repairs are similar between cheap and more expensive properties because of the cost of materials and labor. This usually isn’t taken into account when using cap rates.
• High end homes will tend to have much lower cap rates, but the income per effort will be much higher.
• Low end homes cash flow better, but you are more likely you will end up with tenants who don’t take care of your property and end up costing you more in repairs. The time you spend finding tenants and dealing with problems goes way up. They won’t be the same between cheap and expensive properties.
• Don’t go too high end. It’s easier to find tenants and keep vacancies low if you buy properties in the price range most people in your area can afford. Higher demand properties are going to be easier than higher end properties.

Read more at biggerpockets.com

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