Over the past few years, I've noticed an overwhelming number of social media posts advocating for out-of-state investing. The idea is simple: find a cheaper market, build your team, and make passive income. However, it's important to recognize that like any investment, there are risks involved that are often overlooked by so-called gurus.
Out-of-state investing can be a viable option for entering the real estate market, but it comes with its own set of risks compared to investing locally. Depending on the market you choose for out-of-state investing, you may be taking on unnecessary risks without reaping significant benefits compared to local investments.
Let's first explore the primary advantages of out-of-state investing. The two most common advantages I see are:
1. Investing in a market with lower costs: This is particularly attractive for investors residing in high-cost-of-living areas like Miami, LA, San Francisco, New York, and others.
2. Accessing markets with landlord-friendly laws: Some markets have regulations that are more favorable to landlords compared to your local market.
Firsthand Perspective From a Small Rental Investor
While these advantages hold merit, it's crucial to acknowledge the additional risks involved in out-of-state investing. However, before we dive into those risks, I want to share my experience with my own portfolio.
In 2011, I began purchasing rental properties in Cincinnati, my hometown. Every property I acquired was personally toured by me, and I currently manage the remaining few units myself. Initially, I built a portfolio of nine units before transitioning into flipping and passive investing.
Throughout my 12 years of active investing, I have collaborated with numerous real estate agents. However, none of them evaluated the opportunities and risks in the same way I did. Occasionally, they offered valuable insights on properties, but more often than not, their role was primarily to facilitate property access and encourage me to make a purchase to earn their commission.
During a 20-month period, I opted for third-party property management. Unfortunately, my experiences with managers during that time were less than satisfactory. I found myself spending more time overseeing the managers' work while generating lower profits compared to when I self-managed the properties.
While everyone's experiences in real estate may differ, I base my perspective on my firsthand involvement in the small rental market. With that in mind, let’s explore some of the additional risks involved in out-of-state investing:
1. Lack of Understanding About the Market
Everyone involved in real estate knows that it’s all about location, location, location. It’s the only truly unique characteristic of real estate; no two houses can be the same. They can be nearly identical, but since you can’t have two properties occupy the exact same space, they're never exactly the same.
You can learn a lot of nuances about a market by living there. There are natural and manmade divisions in areas — for example, a neighborhood may have an interstate cut through a corner of it. The area north of this interstate may be gentrifying quickly, while the area south of the interstate may be degrading. If you are out of state, you may only have heard that investing in that neighborhood is a good decision. If you saw a cheap property listed in the neighborhood, would you know it is on the south side of the interstate, or that the south side is not gentrifying like the rest of the area?
Of course, you can and should engage a real estate agent. Working with the right agent can help you better understand the nuances of the markets you're investing in. However, everyone comes with their own biases and may overplay or downplay some of the risks associated with any given neighborhood. Additionally, agents are meant to advise their clients. While they can often provide direct answers to questions, they're generally restricted from elaborating on their market perspectives due to ethical clauses and guidelines. Consequently, it's possible that an agent may not be able to provide you with their complete assessment of a market.
Plus, because agents primarily work with buyers and sellers, they may not understand what the renters in a given area are looking for, unless they also work as a leasing agent in the area.
The team-based approach extends to property managers as well. Similar to real estate agents, managers can also hold biases. Oftentimes, property managers have their own preferred contractors or in-house staff. When there's no competitive bidding process, there's potential for managers to inflate costs. Without anyone overseeing their work, subpar performance becomes easy to get away with.
2. Limited Ability to Verify Operations
Having the right team in place can compound your success. However, assembling the right team is no easy task, especially when you're venturing into a new business and are unaware of what you don't know.
At the end of the day, how can you be certain that your agent is guiding you toward the desired neighborhoods? How can you ensure that the painting job undertaken by your manager was executed well?
Often, when you're unable to directly oversee the work, you end up paying the price to learn valuable lessons. If your agent places you in the wrong neighborhood, you'll realize this when your returns don't align with your expectations. Some of this might be due to a lack of knowledge for newcomers, but I've witnessed numerous instances where "turnkey" rentals were marketed as "Class B properties" while actually being located in high-crime, low-income areas.
In terms of management repairs, a subpar paint job can limit the rental income and delay the occupancy of the house. Unfortunately, you may only discover this once the property remains vacant for a while or when you continuously have to reduce the advertised rent to attract tenants.
While these risks can potentially be resolved with more money, this brings us to the third point.
3. Higher Costs Associated with Out-of-State Investing
Overseeing a market firsthand and managing a property remotely can certainly be achieved by traveling to the market where you're investing. However, travel costs both time and money.
In most of my conversations with out-of-state investors, I've found that they rarely budget for recurring travel costs. These costs are fixed and can accumulate significantly depending on the effectiveness of your team.
Particularly when dealing with single-family homes up to fourplexes, the profit margins are typically not substantial. Let's assume you can generate $250 per month in cash flow from a single-family property, resulting in $3,000 per year. If you only own one property in a market and need to fly there for an annual check-in, you can easily spend around $1,000 per year on travel expenses, including airfare, a one-night hotel stay, a few meals, and either a rental car or Uber.
4. Not All Markets Are Actually Cheaper
I live in Cincinnati, Ohio, a market that consistently ranks high on out-of-state investing lists. Our city boasts a diverse economy with many large and small employers. We are home to NFL, MLB, and MLS teams. Additionally, we have two major universities, and another is located just a short 30-minute drive away.
Recently, I had a conversation with an investor from New Jersey who was seeking out-of-state investments due to intense competition and high prices in their local market. Although I'm unaware of the specific property types they were considering, it's worth noting that most major markets continue to experience a very strong demand for residential real estate, ranging from single-family rentals and Airbnb properties to larger fourplex units and beyond.
Depending on your desired price point, Cincinnati may not necessarily be significantly cheaper than certain coastal areas. The most sought-after neighborhoods in Cincinnati consistently see home sales in the $500,000+ range. While it is possible to find single-family properties for under $200,000 in higher crime areas, rents in such areas will also reflect the elevated crime rates, as will the characteristics of the "typical tenant." In my experience, higher crime areas tend to have higher turnover rates, longer vacancy periods to find quality tenants, and increased wear and tear during each turnover.
Returning to the initial point, you might not be acquiring a property with superior returns; rather, you could be obtaining a more affordable property with higher associated risks.
At the end of the day, out-of-state investing can be a viable option for some individuals, especially those residing in high-cost-of-living areas. But it doesn’t come without its own risks and costs. If you are considering investing out of state, my point is not to dissuade you, but to make sure you are assessing all the risks involved.
About the Author:
Evan is the Director of Investor Relations for Axia Partners, a diversified real estate fund operator, focused on recession-resilient assets. With over 16 years of real estate experience, Evan spends his days working with investors to better understand their investment goals and backgrounds. Please feel free to connect with Evan on LinkedIn, where he shares his insights into the syndication space.
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.