Picture this: a market with move-in ready homes priced at $40,000 that have a cash-on-cash return of nearly 25% after all expenses without needing to utilize leverage. The home values in the market are increasing 7-8% annually. Oh, did I mention that tenants here supply all their own appliances? Never again would you have to replace a fridge, range, dishwasher, or washer/dryer!
This sounds too good to be true, right? Welcome to Cleveland, Ohio, the “Diamond in the Rust.” Articles are consistently being published about the market here being one of the best Sale-to-Rent ratios in the country. To me, the math was saying I would have my initial investment back within 3-4 years and be playing with “house money” after that.
What could possibly go wrong?
Sometimes, it can be easy to look at financial projections, insert some conservative estimates, and make yourself feel comfortable with the expected outcome. After several successful real estate ventures, you may even take your given formula for granted—acting with the casual assurance of true confidence. This is exactly what I did over the last 12 months while acquiring a portfolio of 16 duplexes in Cleveland, OH.
I’ll be honest with you; it hasn’t exactly gone according to plan.
Many of the lessons in my home state of Minnesota haven’t transferred over to a portfolio of Class C properties in Cleveland, OH. I’m here to share 4 of the hard lessons I have learned so you have more to consider before stepping across a state line and into a different asset class.
Lesson 1: High Cap Rates Do Not Always Equal High Profits
Higher vacancy rates mean that tenants have more leverage in the market place. It is important to know the trends of the city where you are investing. In today’s market, it is possible to purchase an occupied and cash-flowing 4 bedroom Up/Down duplex for as low as $40,000 and expect to receive $1,200 in total monthly rents. With ratios like this, low taxes and reasonable labor rates for maintenance, it is not uncommon to see cap rates in the 25% range.
Of course, this in not always the full story.
Even though the Cleveland area may show good returns on paper, you sometimes need to zoom into the metro area to discover the trends of housing. For example, the Cleveland economy is improving and housing prices are making their first strong upward trend since the great depression—but most of that growth is happening in the suburbs. As people are making more money, they are moving out of the city and into the surrounding areas and as a result, the city’s population has actually been in decline in recent years. This is causing a reduction of pressure on the housing stock and vacancy rates are much higher than I had expected. This, in turn, leads to property owners being much more likely to accept tenants with less-than-desirable situations and negotiate on late payments and evictions due to the fear of having vacancies that would be more expensive than forgiving a late payment.
So, in the end, if you are able to maintain vacancies close to national average and secure tenants that are reliable, the math works out just as imagined. However, this would mean finding a metaphorical golden goose in a market that does not support these expectations. It is important to account for inconsistent rent payments, higher vacancies and property management that needs to be more hands on than needed in other areas.
Lesson 2: When Rents are Low, Small Changes in Operating Expenses Make Larger Impacts on Your Bottom Line
My baseline for labor expenses was created in the Minnesota housing market over the last 10 years. This means that I am used to paying skilled labor around $40-$60 per hour. So, when I see that replacing an old toilet in MN will cost around $250 and the same job in Cleveland will cost half as much, my gut reaction was that I was getting a great deal. However, profit margin gets eaten up significantly faster and these small expenses make up a higher percentage of the gross rent income. This also means that some expenses that are not as much on a sliding scale with the local market such as legal fees, utility expenses and administrative costs can eat away numbers faster if not calculated correctly. There are minimums that property managers need to charge to be able to operate effectively. In higher-rent markets, a large volume of properties may get you a discounted percentage, but I actually had to suggest a percentage increase to my property manager so she could make enough to be able to focus on my properties without looking for additional clients and being spread too thin.
It is important to note in low rent areas the way that any and all additional costs, even if they are less than they may be in high rent areas eat up the gross rent income quickly and must be allotted for in planning for the property. Even a simple $200 expense can be more than 1/3 of the unit’s monthly rent.
Lesson 3: Rent-to-Own Can Be a Great Strategy to Shift Risk from Investor to Tenant
When someone takes ownership of their space everything changes for the better. I had a few properties where the maintenance, management and vacancy expenses were eating us alive. It seemed like a futile game of “whack-a-mole” with repairs. As soon as one light fixture was fixed, another would mysteriously break.
So, we decided to advertise a couple of vacant properties as rent to own. This means we came up with a future price that the tenant agreed to pay for the home and would make partial payments toward equity while they were renting. How this looked was we would take a home we purchased for $30,000 and agreed to sell it for $50,000 two years later. The tenant would then put down a non-refundable $1000 deposit as well as make an additional non-refundable $50 payment each month that would go toward their future equity. They are then responsible for all repairs. We found that even a small amount of money was a strong motivator to keep them on track with payments and lock them into a home for longer than a year.
When a home is not producing, it is time to think about it differently. By changing the contract to rent-to-own, we were able to secure long-term renters who took care of the properties themselves.
Lesson 4: Low Purchase Price Homes Can Be Hard to Finance
I decided to purchase the first 16 properties with cash since the purchase prices were low. We could close quickly and beat out other buyer competition and then refinance once we stabilized.
Obtaining financing was a big concern of mine when I first started investing in real estate in the early 2010’s in Minnesota. But, after years of successful acquisitions and operations, banks seemed very eager to lend credit to an experienced investor with a healthy balance sheet and good credit. However, this confident attitude wasn’t enough to easily obtain financing on small-dollar out-of-state properties.
The “Fannie and Freddie” secondary market has loan limits of $50,000, so automatically all brokers and traditional residential mortgages are out as we would have needed values to be around $70,000 to be able to meet that requirement with 25%-down loans.
Every local community bank we spoke with was only interested in lending to new borrowers if there was a local resident as partial owner of the properties.
The large national banks with branches in both Minnesota and Ohio with which I had existing relationships all required at least 1 year of ownership in the properties.
The only easily viable option was private hard money lenders which would charge interest rates close to 12% annually. Obviously, this was not ideal either.
In the end, we were fortunate enough to find a local community bank in Minnesota that was willing to finance the properties in a “blanket loan”—meaning all 16 properties were encompassed in a single loan. The president of the bank had a daughter that was attending college in Cleveland and was familiar with the market enough to take the plunge with a fellow MN investor.
Part of the real estate investing journey is the learning and discovery you find through the process. Sometimes, trial and error are your best teachers. The lessons I learned above were discovered through action and have made me a much more acute and savvy investor both in-state and out of state. Out of state markets have huge potential to be lucrative investments. But, as I have learned, nothing is ever as black and white as it seems. Taking small steps and learning at a comfortable pace might be the way to go to make sure you can adjust to unforeseen circumstances. If you keep the right mindset and see challenges as opportunities, you will be fortunate enough to find your fortune in a market like Cleveland, OH.
I wish you all the experiences and challenges that will help you grow your confidence and career.