Case #1

Why Square Footage Matters

 by Noel Pulanco

This article is the first in a showcase series of articles focused on specific Arizona investment properties, and why they made a good or bad investment.

Successful real estate investing hinges on two primary factors: selection of the right property and effective property management after the purchase. While lukewarm management doesn’t necessarily kill all chances of profit, selecting the wrong property is guaranteed to hinder an investor from being profitable with their investment portfolio.

This particular investor had a goal of doubling his investment fund within three-to-five years through appreciation of his portfolio. When he came to HomeLovers, he had six properties in his portfolio purchased with the help of a local real estate agent.

While the areas the rental homes were located in were good neighborhoods in general, the properties had several challenges that blocked their profitability.

The first home in the portfolio is located in Goodyear, Arizona, an area with a median home price of  $165,100 in September of 2009 according to Trulia.com. Purchased as one of a bundle of homes, this particular investor paid $70,000 for the property. At the time of the purchase, homes under $100,000 were plentiful in the Phoenix metropolitan area.

After reviewing this portfolio with the new investor, it rapidly became apparent that the entire portfolio was purchased based on the sale price to acquire the properties, with no other criteria in place to ensure they were good potential investments. 

So what was the primary issue? Each home in the portfolio had a major barrier to cash flow.

In this particular case, the first home to be showcased is a three-bedroom investment property with only 1,300 square feet.

The impact of low square footage

Any three-bedroom house is considered a “starter home” whose only upgrade to a condo or townhouse is having a yard. With a home of small square footage, the amount of cash flow is limited.

Prospective tenants are limited to paying lower rent, most likely due to low income, otherwise they would obtain a bigger home. 

With a three-bedroom rental property, you are directly competing with apartments, townhomes and other small homes. The best you can hope for when purchasing this type of property is a home located in a fantastic neighborhood where tenants are willing to give up size for location.

You often end up with a tenant upgrading from an apartment who is not used to maintenance - a drawback for the home’s owner who wants a tenant able to maintain the home and treat it as their own. The bigger the home and the subsequent rent payment, the more likely you are to get a better tenant who has been an experienced homeowner.

This investment property is too small for the typical renter, which is a family coming from a short sale or foreclosure in their recent past who are used to larger homes but perhaps lived over their means. They are looking to downsize in price, but not in size.

HomeLovers fields a constant stream of calls all day long from prospective tenants. More than half of the calls are prospects requesting four-bedroom homes.  They need room for their furniture, cars, kids and belongings from the larger home that they just lost. Homes under 1,500 square feet are automatically eliminated from the market regardless of its great condition or location.

Because it appeals to only a fraction of the market, the pool of tenants is restricted and the property is prone to periods of vacancy. It just can’t compete with the abundant number of larger homes available at bargain rental prices because of the down market.

The compromise

For a home in average “rent ready” condition and a good area that is slow to rent because of its size, a price drop every two weeks is often necessitated until tenants are in place.

Despite solid investment advice, the investor who owned this particular property was difficult to convince that price breaks were necessary, and it took almost six months of incremental reductions to reach a marketable rent of $700/month before a tenant was secured.  

Even in the best neighborhoods, an investment property with less square foot is risky. For this home, it was a fair price but not a steal - an average price on an average home. Investors should always have a minimum square footage established before looking at potential properties, regardless of the price. HomeLovers would never have recommended the purchase of this property. Because it was a poor decision, the investor ended up losing six months worth of rent - a cash flow loss that can never be made up.

Was it a good choice for appreciation? The average purchase price also limits its ability to appreciate quickly. The property was located in a relatively good neighborhood, but one that had a high number of foreclosed homes. This lowered the purchase price, but also lowered the value of all homes in that neighborhood, thus severely impacting appreciation for years to come.

No two investors have exactly the same situation and needs.  Before making any investment, you should review your specific objectives with a qualified investment expert to make sure the investment has the potential to meet your objectives.  This is especially true in real estate investing, where buying the wrong property can be catastrophic.  For more information, please see the HomeLovers article on “How to Select a Property Management Company.”

011110  © Noel Pulanco, HomeLovers