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This Is the Worst Type of Real Estate to Invest in

Any real estate that costs more money than it makes is the worst type. But how would you know what type that might be?

Key Points

It's difficult to accurately predict housing prices.
The trick to real estate investing is to pick a good location and know the market.
There's such a thing as being overleveraged.

Zillow Group (NASDAQ:Z) (NASDAQ:ZG), the online real estate marketplace, recently announced that it's shutting down its homebuying section, Zillow Offers. Why? Because having a business based solely on the assumption that houses will appreciate in the short term is a risky business, one that's proved to be a losing proposition. Not to mention that the costs of fixing up houses has risen amid inflation, supply chain problems, and a labor shortage.

It was difficult for Zillow, even with its fancy Zestimate algorithm, to accurately predict housing prices. And indeed, this mega-real estate tech player is going to take a bath on much of its inventory of 7,000 homes by selling them, not to the public as planned, but to institutional investors. On top of being a financial setback, it shows the enormous challenge of buying homes with the goal of flipping them.

Real estate bought for the appreciation

So where does that leave us mere mortals who are in the same fix-and-flip game as Zillow was during these unprecedented times of low supply and high prices? Some real estate investors are still making money flipping houses, but in the future, "investors may need to reframe how they look at these deals," Todd Teta, chief product and technology officer of real estate analytics firm ATTOM, told CNBC.

The trick to being successful flipping houses these days is to pick a good location. According to CNBC, the worst areas as of the second quarter of 2021 to flip houses are the following:

Gulfport, Mississippi: -8% profit
Corpus Christi, Texas: 0.7% profit
College Station, Texas: 1% profit
Longview, Texas: 7% profit
Daphne-Fairhope, Alabama: 8.5% profit

Compare those areas with the best flipping returns on investment, and you'll see how important it is to choose a good location:

Oklahoma City: 196% profit
Fargo, North Dakota: 185% profit
Pittsburgh: 154% profit
Omaha, Nebraska: 135% profit
Philadelphia: 100% profit

2 people tossing papers in the air

Image source: Getty Images.

Real estate with negative cash flow

Another common way to make money owning real estate is by holding the investment and renting it out. The land mine here would be not understanding the market. The wrong way to go about buying rental property is to buy as you would for your primary residence, namely choosing something you like. There's nothing wrong with liking your investment property, but that should just be icing on the cake. The right way to buy rental property is to study the market, determine what area rents are going for, and then buy accordingly.

In addition, during today's market, it's a good idea to buy rental property that's as move-in ready as possible, given the high cost of renovation materials and the shortage of labor.

A shorthand method to determine whether a property would be worth buying is if you can get 1% (or in these times, as close to 1% as possible) of the home's price in rent. If you buy a $500,000 property, for example, what are the chances you could get $5,000 a month in rent? That's out of reach for many renters.

Real estate you can't afford

Leveraging your money can be a great way to obtain real estate. For most people, it's the only way. But there's such a thing as being overleveraged. If you are, you could lose money. Just consider what happened with Airbnb investors before the pandemic: They were getting so much money for their short-term rentals, many investors were buying more of them and accumulating tens of thousands of dollars in monthly expenses.

Having high monthly expenses isn't a bad thing if your properties are rented and covering those expenses. But when COVID-19 hit, so did Airbnb cancellations, and many investors who were overleveraged and didn't have rent money coming in lost those properties.

Any investment could put an investor in a bad position if the property doesn't create the expected cash flow.

No sure things

People like to invest in real estate because they think it's a sure thing. But real estate, while it often appreciates and is desirable to renters, isn't always a moneymaker. Investors can minimize risk by studying the market and not taking on more investment than they can handle.

This article represents the opinion of the writer, who may disagree with the "official" recommendation position of a Motley Fool premium advisory service. We're motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.

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