In real estate, when you wholesale or flip a property you are in effect participating in a type of real estate arbitrage. However this is not the type of arbritrage I am referring to here. The type of arbritrage that I am referring to takes place in the rental market.
So how does the real estate arbritrage strategy work in the rental market?
With this strategy, you purchase a property for a certain amount. However, instead of renting out the entire property to one renter, you rent out different parts of the property to different renters. This allows you to generate a higher monthly cashflow because of economies to scale.
In any rental market, the smaller the size of the unit the more money you make per square unit when compared to similar units of larger sizes. A tenant renting out a 1 bedroom apartment is generally going to pay more per square unit than a tenant renting out a 2 bedroom apartment in the same market.
Here’s an example of how this works.
Suppose you are looking to purchase property in Forest Hills, New York, a good middle to upper middle class neighborhood in New York City. Here are what the average rents are for apartments in this area:
1BR - $1300 to $1400 a month
2BR - $1400 to $1600 a month
3BR - $2000 to $2500 a month
3BR House $3000 to $3500 a month
The average 3 bedroom 2 bathroom house goes for $700,000. The mortgage alone based on an interest rate of 6.25% and a 20% down payment is going to be over $3400 a month. If you rent this house out to a tenant, even if you can get $3500 a month you are still going to have a negative cashflow property.
On the surface, this doesn’t look good for you as the investor. If the homeowner can’t sell the home, you as the investor have to pay off the lien before purchasing the property. Depending on the terms of the deal, this may not be feasible.
However, before making a decision to walk away from the deal, there are certain things you need to know about judgment liens that could have a major impact on your decision.
If you encounter a property that has a judgment lien filed against it, your first step should be to find out how much all of the liens of the property amount to. Then consider the amount you are buying the property for as well as the full market value of the property. Depending on what the With the Real Estate arbritrage what you would instead do is rent out the bedrooms to three different tenants. Each tenant would have exclusive use of the bedroom and shared use of the rest of the house.
Suppose you charged $1300 a month to each tenant? Mutiply that times 3 tenants and the monthly income for this property now goes to $3900 a month. Whereas in the first scenario, this property would have produced a negative cashflow in the 2nd scenario this property produces a positive cashflow.
Is a house out of your budget? No problem! You can purchase an apartment and implement this same strategy. You can purchase a 3 bedroom condo for $500,000. With a down payment of 20% and an interest rate of 6.25% your mortgage comes out to a little over $2400 a month.
Like the house scenario trying to get a positive cashflow by renting out the entire apartment to one person is going to be difficult at best. Even if you charged $2500 a month, you will still experience negative cashflow when you factor in taxes and insurance.
Once again, the arbitrage strategy works in this scenario as well. Using the arbritrage strategy and renting the apartment out to 3 separate tenants, even if you only charged $1000 a month, you would still have positive cashflow from the unit overall.
There are some investors that take this strategy to the extreme. For instance, I have seen some investors put as many as 2 beds to each bedroom, plus 2 additional beds in the living room. The investor rents it out for $500 a month per bed to 8 different tenants. With the apartment scenario, even if your expenses was $3000 a month, under this scenario the investor would make $1000 a month positive cashflow.
I personally don’t recommend that strategy as it may be illegal in many areas of the country. You will need to check the laws in your area. In addition a strategy like that would only work if you target specific communities that don’t mind such shared living quarters. Two examples are college students and immigrants who have just moved to the country or are temporary in the country on a student or work visa.
In addition to the additional cashflow, another advantage of using the real estate arbritrage strategy is lower vancancy costs. If you rent an apartment out to one tenant and that tenant moves, that apartment produces no cash flow for the duration that the property is vacant.
With the arbritrage strategy if one of your tenants moves out, instead of having an empty apartment producing zero cashflow, you have an apartment that still has other tenanats paying rent. While you aren’t going to receive the full cash flow during this period, the good thing is that you will at least receive some cashflow as oppose to nothing at all.
There are some disadvantages to this strategy as well. For example, if there are damages to the property, there’s really no way of knowing who is responsible for the damages unless the damages are in one of the specific bedrooms. Trying to prove that in court or penalizing all of the tenants may prove difficult depending on what the laws and regulations are in the area that you ware looking to invest in.
Finally, you should note that the arbritrage strategy works in other ways as well. For instance if you have a commercial space, you can rent out part of the space to another company. I’ve seen some owners even set up a single desk and telephone line and rent the desk out to a business owner that wants to have an office but only really needs one desk. Be creative and you will find many ways you can use this strategy to profit from your real estate investments.
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