“San Diego apartment buildings are outrageously expensive! The cash flow is wretched. What do you think about going to the 40 other states with dramatically higher cash flow and lower prices?”

The experienced landlady was asking me whether her son should use his $80,000 and buy a fourplex in Arizona or somewhere else where the cost of units is so much cheaper. Before I tell you how I answered, let’s review a few facts.

The experienced landlady was right about the cost. Apartments in Texas, Arizona and other Western states can be 25% to 50% of the price of San Diego multifamily. So, do only idiots invest in the San Diego while smart people take their money to higher cash flow locations?

If that were true, then next year coastal cities will sell for relatively less and the 40 “fly over states” would sell for relatively more. But in the last generation the opposite is been true. The supply constrained markets, like San Diego, have gone up in value faster than the cities that don’t touch saltwater.

Why is that?

In supply constrained markets, there is a steady demand for new and improved rental housing, but government or topography or both significantly restrict new construction. In such markets it can take more than two years to get the permits to build apartments, even when the land is already zoned for multi-family. In contrast in builder friendly markets it’s sometimes possible to have brand-new, rent-ready apartments six months after the developer buys the dirt.

Consider this. Houston has built more condos and apartments in the last decade than the entire state of California even though California has four times the population. Rents and apartments are cheap in Houston. In contrast rents and apartments are relatively expensive in San Diego.

Most of nation’s markets do not have significant governmental, ecological, or topographical limits to new construction. Scores of markets are like Texas, Arizona and other Western states – miles and miles of flat land and a Chamber of Commerce eager for more people to come to town.

Alternatively, in many of the already expensive cities, people who describe themselves as environmentalists want to limit the impact of growth, perceive suburbs as inefficient, and want developers to “pay their fair share.” In San Diego County the development impact fees can range from $30,000-$80,000 per apartment. In many markets, apartments can be bought for less than $80,000 per unit.

So, the landlady asked whether her son should use his $80,000 and buy a fourplex in Arizona where the cost of units is so much cheaper than San Diego. Here’s my answer.

It might be great for him. Or maybe not.

In the first few years if he’s able to raise the rents and improve the property and have superior cash flow he might feel like king of the world. Yet within the next decade something bad could easily happen.

There’s a pretty good chance that developers will build more units than the market can absorb. When there is excess supply most owners will give concessions or cut the rents or suffer higher vacancy. If her son has vacancy for two extra days, it’s not a big deal. What happens if the young rental owner goes six months with a vacancy?

Recessions happen. Lenders know that and build in a cushion for their loans. Lenders call it debt coverage ratio. The lender will insist that the borrower begin with $120 of cash flow after all costs for every $100 of mortgage payment. Debt coverage ratio (DCR) is 1.2 :1. Repairs, taxes, utilities etc. may take 35% -50% of the total income. The mortgage takes almost all the rest. In markets with little vacancy that 20% cushion after costs protects almost all borrowers.

However, what about the market with a lot of vacancy? When the collections drop 10%, the taxes, insurance, mortgage and most other cost stay about the same. Thus the net cash flow shrinks, by a bigger percentage than the change in gross collections. That can mean that there may not be enough to make the mortgage payment!

Suppose that owners were on the financial edge before the recession or the market glut. When owners can’t make the mortgage payments then lenders will foreclose and sell property for whatever they can get, in other words at a substantial discount. Suppose 10 buildings in that zip code are foreclosed. That will push values down for the entire market. Every owner in the market will have trouble obtaining loans because the values are down. It could take from 2 to 7 years for values to return to what they had been before the foreclosures hit.

One more thing. In a supply constrained market, there’s much more potential for capital growth, but there’s a consequence. Banks always want a DCR cushion, regardless of how much the investor pays for the asset. High prices mean not just more per unit but also more in relation to income. In some markets in “fly over states,” apartments can be bought for less than ten times the annual gross income. In prestige metros investors might pay 15- 20 times a year’s income. Lenders loan on NET income. Buyer can and do pay premium for lower risk or more prestige, but that does not mean they can finance the same percentage, regardless of the price. When buyers pay more than the lenders loan then the buyers make bigger down payments to cover the wider gap between price and loan. In some low-cost markets buyers might put 25% down; in fancy markets buyers have down payments greater than 50%.

If the young man were your son, what would you advise?

What, if anything, would need to be different for you to advise him to do the opposite?

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Terry Moore, CCIM, is the author of Building Legacy Wealth: How to Build Wealth and Live a Life Worth Imitating. Read his “Welcome to My Blog.