The Great American Fire Sale
By Alan Mallach Posted on December 24, 2010
h6. What Do Investors Want?
Investors want to make money. That is neither good nor bad in and of itself, but how they make money will determine whether they have a positive or negative impact on a community. That, in turn, depends far less on the investor’s personality than on the dynamics of the local housing market. Some markets will reward responsible investor activity, while others, unfortunately, reward more predatory behavior. How investors behave is influenced by the market, but is not foreordained; their behavior can be influenced by public sector regulation and incentives.
Although it is an oversimplification, distressed property investors can be divided into four broad categories. Rehabbers and holders gravitate toward areas where market prices for distressed properties, while low enough to enable the investment to be profitable, are still high enough to discourage scavengers. For a serious rehabber to make a profit, the market price of an adequately fixed-up house in the area must be greater than the sum of the property’s acquisition and rehab costs. This is true in some markets but not in others. In many parts of Detroit, for example, a house that may cost $10,000 to buy and might need another $40,000 in rehab may not appraise higher than $30,000 after rehab. A responsible rehabber would soon go broke working without public subsidies in that market.
The same is true of holders. For an investor to maintain a property on a long-term basis while realizing a decent but unspectacular cash flow, there must be a realistic expectation that the property will at a minimum maintain its value, and be likely to start appreciating in the next few years. The property must also fall within a narrow price range—it must be inexpensive enough so that the investor will see a positive cash flow at market rent, but expensive enough so that the purchase price cannot be quickly amortized through cash flow alone. This is often true in an area like Phoenix, where investors are buying single-family houses for $60,000 or higher, and renting them out at $800 to $900 per month. Since many people believe the Phoenix market is close to bottoming out, they expect their houses will gain value over the next five years.
Detroit is very different. There, from a pure investment standpoint, it’s hard to justify a long-term holding strategy. Properties can be bought for less than $10,000, have little upside potential, but can be rented—even in poor condition—for $600 to $700 per month. Such properties attract flippers, who prey on the ignorance of others, including out-of-town investors who think that spending $25,000 on a house worth $10,000 is a good deal.
Those properties also attract milkers, who spend little on maintenance, ignore property tax bills, recoup their investment quickly through rents, and walk away from the property after a year or two with a tidy profit. While an investor who keeps properties in good shape and pays property taxes on time might be able to make money, the rents in Detroit are still high relative to the cost of buying distressed properties. Investors who milk their properties can make much more money, with far less hassle and effort. The economic environment motivates them to behave irresponsibly.
Alan Mallach, senior fellow at the Center for Community Progress, is the author of many works on housing and planning, including Bringing Buildings Back, A Decent Home, and Inclusionary Housing in International Perspective. He has served as director of housing and economic development for Trenton, N.J. from 1990 to 1999, and teaches in the City and Regional Planning program at Pratt Institute. He is also a fellow at the National Housing Institute.