Is Rental Property Investing in Austin Still Profitable?

Is Rental Property Investing in Austin Still Profitable?

As someone who’s bought and sold a bunch of rentals, and helped other investors buy, sell and manage investment property in Austin for a number of years, I’m about to ask a question that might seem counter to my professional mission of being in service to real estate investors.

Is rental property investing in Austin still a good way to build long term wealth?

My answer, for a lot of people, is “probably not”.

Let me rephrase the question.

Is rental property investing in Austin a good way to lose money and create financial stress in one’s life?

Absolutely. More so than ever.

So, am I saying you shouldn’t invest in real estate in Austin, or elsewhere? No, I think everyone should consider doing so. But I do think, after careful consideration, a much higher percentage of people should decide against it than would have been the case 15 years ago. The opportunity for mistakes, bad decisions and cash flow disruption for the real estate investor today is much greater than in past years.

In other words, your margin of error is very thin. You better know what you’re doing, or have a good adviser. Success is harder to achieve than if you started in the 1980s or 1990s simply because today’s ratios are thinner. The financial and psychological profile of a good candidate real estate investor today has a much higher bar to clear than in years past. Let’s take a look at why that is.

Positive Cash Flow Harder to Achieve
The very first rental property Sylvia and I bought in Austin was a 959 sqft, 2 bedroom house on Avenue G in Hyde Park. We paid $58K. Then we immediately spent $7K to redo the kitchen and bath and rented it out for $825/mo, which provided $300/mo positive cash flow. This was in 1994.

18 months later we sold that home for $95K. We took the equity proceeds and bought another fixer-upper house for $60K in South Austin 78704, which we completely rehabbed and sold 4 months later for $129K.

We then took the proceeds from that sale and bought another home in South Austin 78745, and so on. We continued to “ladder up” as years passed, buying, selling, keeping homes. Making some mistakes but hitting more home runs than strikeouts. Such were the opportunities. Success was not dependent on bubble appreciation or low probability luck.

In 1999 I sold one of our investment properties in South Austin 78745, which I like to use as an example when discussing the erosion of our rent/value ratios over the past decade. At that time, the home was rented for $950/mo and it sold for $92,500.That means an investor could buy a home like that with 20% down payment on a 15 year loan at 6.5% interest and, because taxes and insurance were lower relative to rent value back then, have a total PITI payment of about $850/mo. on a house that rents for $950/mo.

That same 1400 sqft brick home in Cherry Creek would sell today for about $170K but would only rent for about $1195. In 1999, it took about 2.5 month’s rent to pay the annual taxes and insurance. Today it would take 3.8 month’s rent. That’s over a month’s rent each year, down the drain in higher taxes/insurance.

Appreciation Potential
In the old days, we didn’t worry so much about appreciation potential. It wasn’t ignored, but it wasn’t a “must have” to make the numbers work. After all, the property was paying for itself and would be free and clear in 15 years. Solid value appreciation was just a bonus, sometimes even a windfall, but never expected or taken for granted.

Today, if you don’t carefully consider the long-term viability and demand of the rental property you purchase, you will be failing to properly factor in appreciation potential. You have to ask yourself if the property is one that has a good chance of enjoying increasing demand because of location, and thus greater value appreciation than less desirable areas.

Failure to ask this question is the mistake so many dummy investors made during the bubble years. These wannabe investors and seminar buyers with low down payments and the easy-to-obtain loans assumed, for no good reason, that the price of all real estate would rise, no matter what and no matter where.

In a strange way, these “appreciation” buyers were partially right in desiring appreciation, but were unrealistic in their underlying analysis, primary location selection. If you are not willing to pick a quality location, and sacrifice a bit on cash flow, then all your extra cash flow could easily be lost in value slippage as has happened to the investors who bought further outside Austin from 2005-2007.

Is it a good idea to bet on appreciation only? No, obviously not. But you can’t ignore the fact that the tighter ratio numbers of today require some value appreciation to make things work out over time. That means sticking to quality product in good locations.

Repair Costs
In the 1990s, we had an abundance of $25-$35 hr vendors who could fix just about anything in a home. Not anymore. We paid $350 total to swap out a 40 gallon water heater in 1999, today it’s $750. Stoves and dishwashers had simple parts that were cheap to fix or replace, today everything has an expensive computer chip and/or control card. Older appliances and HVAC systems lasted 10+ years, sometimes 20+ years. Today’s stuff often breaks down during the first year, especially cheap foreign made A/C coils that develop freon leaks. Everything today costs at least twice as much to repair as it did a decade ago.

What this means to you as an investor, is that the number and type of repair events that can wipe out an entire month of rent, or more, is substantially greater than in years past. A good analogy would be the comparison between rising health care costs and wages. Wages have not kept up and we all pay a greater percentage of our income toward health insurance and medical costs than a decade ago. So too does the landlord pay a greater percentage of rental income toward repairs today than was the case a decade ago.

Ten or fifteen years ago, our repair costs across an entire portfolio of management properties ran at about 8% of annual rents, including major replacements such as roofs and HVAC systems. Today it’s about 12%. In 1999, it cost 2 month’s rent to replace a roof ($2,000). Today it would cost 5.4 month’s rent to replace the roof ($6500) in my Cherry Creek example above. Luckily, roof replacements are few and far between, and often covered by insurance due to hail damage, but still.

Conclusion
Despite all this, I still invest in real estate and I’m still a buyer. The S&P 500 ended 2009 at about the same point it started in the year 2000, so at least in that decade, real estate was the winner for those of us who didn’t get sucked into the bubble mentality and stuck with basic decision-making rules. But real estate investing is not for everyone, and it makes sense for far fewer people today than it did in the past. Mainly because the opportunity to experience financial stress as a result of your rental property ownership is greater than before. People without sufficient reserves are the most vulnerable and should simply stay out.

Is there a safe way to get started?

The best way, I think, for someone to start in real estate investing is to convert your existing home into a rental when you move up, provided it’s well located and has the attributes of a good rental property, which means it’s not too big or small and will attract quality tenants.

By converting your existing home, your financing is already in place, you know the home and its location well already, the new owner-occupied loan you obtain for your next house will be much easier to obtain than a new investment loan, and if you’ve lived in the property at least 2 years, you have a 3 year window during which you can still sell with zero capital gains tax if it doesn’t work out for you. Then start saving for your third home and just keep leaving a trail of accumulated rental homes behind as you go.

This will be even more effective for those able to improve a home in disrepair while living in it, thus increasing its value (appreciation) more than whatever the natural appreciation rate might be.

And there are a number of other strategies for those with higher risk tolerance, but for most, starting slow and having a long term strategy and sufficient financial staying power is going to be key to success. If you don’t have at least 6 month’s rent set back to cover turnovers or unexpected repair events, you are in a weak position as a real estate investor, and your lack of funds can start a cascading series of bad decisions that eventually drag you down.

Play it safe, be smart, don’t make wild optimistic assumptions. Put at least 20% down, more if you can. Always assume the worst and ask if you can handle that. If not, don’t do it.

Posted by Steve
6 years ago
Steve

Steve is a Real Estate Blogger, Husband and Dad, UT Austin Grad, Runner, Real Estate Broker and owner of Crossland Team and Crossland Real Estate in Austin TX.

Click Here to Leave a Comment Below

Todd - 6 years ago

Steve, another excellent article regarding the pro’s and con’s of investment rental real estate. I want to follow up on your point about rental property profitability being dependent upon capital gains. There are four primary financial advantages to rental real estate, cash flow, amortization, depreciation and appreciation (capital gains). When buying, the other three come first before appreciation in importance, with appreciation being the “wild card” that can turn a solid investment into a larger winner over time.

First is cash flow. As an investor, I always want to buy a property with cash flow. If a property cash flows, then over any particular year or series of years where there is no appreciation in price or negative appreciation, my property still churns out a steady net cash return. Cash flow takes the first level of stress out of the property.

The second benefit is amortization. Your tenants pay down your mortgage over time, slowly building up your equity in the property. Today’s lower rates also help here, and to the extent you can afford a shorter term 15/20 year loan vs a 30 year loan, this will also boost your benefits from amortization. Personally, amortization is the most satisfying part of owning rental real estate. I am using other people’s money to build my equity.

Third is depreciation. Depreciation often shield the benefits from our first two attributes, cash flow and amortization from taxation in years in which they are earned. Depreciation can be doubly valuable for veteran investment real estate owners who use phantom losses from depreciation on newly acquired properties to offset taxable rental income from more mature properties which are throwing off larger amounts of cash flow and/or paying down larger chunks of principal on older mortgages.

Fourth is appreciation for capital gains. Like investing in stocks, long term appreciation is where real wealth building occurs with real estate. However, like stocks, in any particular year (or even decade in the most extreme cases) this attribute can be delayed or even be negative. Because of this, the ability to identify and own a property that cash flows, and to be able to see amortization at work over these flat to down cycles, becomes very important both financially and emotionally for the real estate investor. Capital gains can be very lumpy and come in spurts, but if one is modeling the value of a property based on a smooth progression of appreciation, then your spreadsheet can become a source of frustration.

Finding cash flow properties that you would want to own over the long haul is a challenge in today’s market. The biggest positive factors out there today are low financing rates and the looming lack of new housing supply on the near horizon, both from new homes and from new multifamily projects in the pipeline. With luck, these factors will provide a nice supply/demand balance towards increasing rents until the drivers of job and income growth return to the economy.

Reply
Steve - 6 years ago

Hi Todd,

As usually your comments add a lot of value and perspective to my articles. Thanks.

It does remain though, that someone with $20K laying around 12 years ago could purchase a positive cash flow property for $100K in Austin with 20% down on a 15 year loan.

Today, someone with $45K available to invest would have to buy a sub-$150K property with 30% and a 30 year loan to achieve the equivalent positive cash flow of 12 years ago. That means slower equity built-up, longer free-and-clear date, and still the higher repair costs.

The advantages of real estate investing have not changed, I agree. But the financial strength required to capitalize on those advantages has become greater, thus making real estate investing an option for fewer people than before.

Steve

Reply
Todd - 6 years ago

Steve – A follow up point or two since this is such a great discussion topic. First, the very difficult investment property financing standards today, coupled with limitations on numbers of properties owned, high down-payment requirements and the restrictions on cash-out refi’s on rental properties are real hurdles to the market outside of areas that are so depressed to where cash investors can make fire sale buys. Couple this with the 3% down government subsidized primary home programs, and you wonder why our homebuying market gets itself into such a mess (another topic of discussion).

The flip side of these investor “barriers” to entry in normal markets like Austin that did not see massive price declines, foreclosures and REO inventory, is that as the current inventory gets absorbed as primary residences, and as new multi-family construction financing remains tight, that the rental market should firm quite nicely assuming net in-migration and job creation that most see for the Austin metro area.

A final point is the lack of investment alternatives for long term wealth building. The stock market provides a highly volatile, non-leveraged alternative where overt and hidden fees skim a large percentage of the average investor’s returns over time. Bonds? Well, 3-4% before taxes is a pretty slim return without any inflation protection. CD’s? rofl. Gold/Silver? You start getting pretty exotic and taking on holding costs, also fairly volatile in price over the short term. Pay down your mortgage? Maybe not a bad choice, but most now have 5% and under mortgages, so when you take out the tax advantage of the mortgage interest deduction, you are looking at 3.5% returns. If you have credit card or consumer debt above 7%, then that is a better alternative to pay down, but beyond that, someone will have to make the argument to me that investment real estate, prudently bought, financed and managed is not the best longer term choice for discretionary investment dollars.

Reply
sara - 6 years ago

I told my AC guy what you said about cheap Chinese coils leaking the first year. He said it was government pressure on AC manufacturers to push energy efficiency to the limit–the coils keep getting thinner to achieve the goal. He said coil warranties are now usually 10 years– to improve consumer buying confidence as a result of the bad reputation from the earlier bad coils, I think is what he said. Anyway, he said he quit selling his favorite brand a while back because of the coil failure rate, but is now recommending and selling them again.

Reply
Steve - 6 years ago

Hi Sara,
What is his favorite brand? My A/C guy likes Trane.
Steve

Reply
dick ryan - 6 years ago

My experience with rental property in Austin(since 1975) says it’s practically impossible to buy and rent out a single family home now and have it cash flow – or even a duplex. I would suggest having enough $ to do a 4-plex or more – before you take the plunge. This is serious business.

Reply
Steve - 6 years ago

Hi Dick,

We actually stay away from 4-plexes. The better “on paper” cash flow quickly evaporates due to high repair/maintenance costs and the fact that 4-plexes do not attract quality tenants.

I’ve written about this before:
http://crosslandteam.com/blog/2006/05/22/why-we-advise-against-buying-in-or-near-austin-4plex-neighborhoods/
and
http://crosslandteam.com/blog/2007/08/13/another-problem-with-investing-in-4-plexes-in-austin/

Steve

Reply
Dick Ryan - 6 years ago

I am talking Central Austin, 1920’s – 1960’s construction, and 30 something singles for renters, far easier on the units than families in terms of maintenance.

Reply
Steve - 6 years ago

Hi Dick,

Problem with the Central located 4-plexes is that the land values are so high the purchase price and ongoing property taxes kill any cash flow advantages.

Steve

Reply
Mark - 6 years ago

Steve,
As an alternate, would you recommend looking at rentals in nearby smaller cities that are not as overpriced as Austin? (i.e. Waco, Temple, San Marcos). It does make it more difficult to manage properties out of town, but I agree with your article and I am finding it difficult to find properties for sale in Austin that are a great bargain for an investor. Especially with the property taxes here in Travis County.
A colleague of mine has several duplexes and rentals in Waco and Temple that he bought for $30k to $50k they are all cash flowing nicely. Again the real disadvantage is managing the property from another city.

Reply
Sylvia - 6 years ago

Hi Mark,
Yes, the big problem especially in Waco and Temple is finding a good property manager. In San Marcos, I would think it is the high number of students and higher turn over and vacancy costs. My suggestion is Cedar Park or Leander. You can find a decent single family home in this area for $130-140k that rents for $1100-1200.

Reply
Steve - 6 years ago

> would you recommend looking at rentals in nearby smaller cities that are not as overpriced as Austin?

Hi Mark, for me, I wouldn’t. I agree with Sylvia. We like Leander for investors who seek better ratios.

Getting further away would require building an entire new vendor list of plumbers, a/c people, etc. who service that area. Or hiring a property manager. The problem with $30K-$50K properties, in my opinion, is that the repair expenses represent a disproportionately high percentage of the rent. Swapping a water heater out for $900 turnkey is 3/4 of a month’s rent on a $1200 rental, but its 2x a month’s rent on a $30K home renting for $450. Same with everything else.

I’ve been contemplating the idea of the “perfect” or “optimal” rental property but I haven’t come up with the answer yet. My intuition tells me it’s a $1250/mo rental though, at least in Austin. High enough rent to cover expenses but low enough to be in the sweet spot for good quality renters. I shudder at the thought of a 4-plex renting for $450 per unit, with 8 commodes, 4 HVAC systems, 4 fridges and 4 dishwashers to maintain. Uggghhh!

Steve

Reply
Sripal - last year

Thanks for the insightful write up. Do you suggest buying apartments or condos in communities that take care of things like external maintenance etc. over the others, for start up investors ?

Reply
Leave a Reply: