Long-term cash flow rental property is my favorite type of real estate investment.
It doesn’t require guessing about future prices. It’s less work and stress than flipping houses or running a hotel by renting houses on AirBnB. And it provides income every year, which can’t be said for raw land or an investment that only makes money by paying down the mortgage balance each month.
This is Part 2 of the PathwayToFI rental property series. As I said in Part 1, How to Know if a Rental Property Is a Winner, the best home does not make the best rental.
I didn’t understand this when I made my first rental property investment, and I bought a house that was too big and expensive to maintain. I barely broke even when I sold the house 7 years later. If I only knew one thing—the type of property that would create better cash flow—I would have never considered that house in the first place.
So what type of real estate makes the best cash flow rental property?
1 Great cash flow rental property doesn’t get an A
One way investors describe real estate is by class. There are four classes of real estate: A, B, C, and D. I’ll walk through each one and point out the two that you should stick with to maximize your cash flow. But you can also read this article by BiggerPockets, which goes into even more detail on the four classes.
1.1 Class A
Class A properties were built recently, have luxury materials, and are in the best locations. They command top prices in their area. Rents are the highest there, too. But rents aren’t high enough to reward investors for the higher costs that they pay in purchase price, maintenance, taxes, insurance, and Homeowner’s Association fees.
Most investors in Class A property are looking to profit with a higher sale price. It’s nearly impossible to get positive cash flow unless you buy the property with cash to begin with.
1.2 Class B
Class B properties are a little older. The materials used to finish the home are more middle-class. The same goes for the neighborhood. Rents are lower than Class A, but are often attractive for investors. There are two main reasons that Class B makes a great cash flow rental property:
- Occupancy rates are high for rentals. There is always a high demand for this type of rental home because the area is desirable, affordable for many renters, and the homes can be a stepping stone up or down. Wealthy people who are having bad luck in their business or career will move down to Class B. Poor people whose income has increased will move up to Class B.
- It’s possible to find renters who will stay in your house for life. I have two Class B properties. I have owned one since 2012 that has had only 2 renters. My current tenant is great! She’s a single mother and teacher, has lived there since 2016, and has told me she never wants to move again! This is the best possible situation for a landlord, and it’s my job to treat her well and build a lifelong relationship with her so that she’ll keep renting from me forever.
1.3 Class C
Class C properties are in lower-income neighborhoods, and are built with lower grade materials than Class B. They aren’t necessarily older than Class B, but that is sometimes why a neighborhood moves down from Class C to Class B over the years. Crime is generally higher in Class C neighborhoods, the schools might have lower ratings, and the stores nearby typically cater to lower income people.
The location and appearance of Class C homes give them lower rents. They are less expensive to buy, but you can expect them to require more renovation and maintenance. Don’t get scared off by a neighborhood you might not live in yourself, though. If you negotiate well based on its age and maintenance needs, a Class C home can be a very high cash flow rental property.
I have one townhouse in a Class C neighborhood. It’s on the same street where I lived for 3 semesters as a college student. I met some great people there. But the downside of my experience was having a couple of unpleasant roommates and having my car stolen—by my neighbor!
It wasn’t my favorite place I’ve ever lived. But it is my most profitable rental!
I bought the townhouse for the price of a new car at the bottom of the Great Recession. It needed a ton of work, all new appliances, new floors, and a new air conditioning unit. No one wanted it after getting the inspection report. And a bank wouldn’t finance it.
But my wife and I were young, ambitious, and ready to put in the work. So we got a private loan, fixed it up ourselves, and got it rented within a couple of months. In 11 years, it’s already paid for itself ten times over! In fact, at today’s rents, it will earn enough every 3 years to pay for itself again!
1.4 Class D
Class D real estate is bad news for cash flow rental property investors. These are properties that are in high crime, poverty-stricken neighborhoods. They’ve been neglected for many years, and may even be considered ‘unlivable’ without a major renovation.
The numbers for Class D properties may look good on paper at first. But it can be very difficult to find good tenants with stable jobs. And there is a good chance that you’ll find new problems every time you fix or replace something.
Plumbing and wiring not to code. Mold. Asbestos. Rot. Infestation.
It’s best to stay away from these properties unless you’re betting on gentrification—where many investors and residents work together to turn the neighborhood into Class C, B, or even A—and are willing to take a bigger risk with the chance of a higher reward.
Even if you see progress and newer, nicer homes and amenities are popping up, it can take many years for those investments to pay off. So you need to be in it for the long haul and willing to put money and time into that vision.
Class D is not the place to find consistent and immediate cash flow.
2 Great cash flow rental property has the right number of beds and toilets
2.1 Why bedrooms matter
The number of bedrooms in a rental property defines the number of people who can live there.
A studio apartment has no separate bedroom, and is built mostly for a single person. You wouldn’t expect a family of 3 or 4 to rent a studio.
A four bedroom house will be rented by a family with at least two children, but more likely 3 or 4. On the high side, there could be 8 or 9 people living in your house! This is something you can attempt to control when you screen tenants and take applications. But renters have been known to squeeze in extra people without the landlord’s consent in order to save money.
What’s the problem with a bunch of people living in your rental? Wear and tear.
More people in the house means the carpet wears down faster, the dishwasher gets used more often, and something is more likely to get broken. The house will generally be in worse shape when your renters move out. Right when you need to get it back in shape for a new renter. This can be expensive.
2.2 Why bathrooms matter
After bedrooms, the number of bathrooms is the most important thing to get right. Every bathroom you have means one more toilet that can be clogged, one more sink that can leak, and one more possibility for water damage. Plumbing is one of the most expensive and commonly used trades, so one extra bathroom can add up to quite a bit more maintenance cost over the years.
Sure, renters might pay a little more for an extra bathroom. But a home with too many bathrooms typically increases your expenses without enough of a rent increase to make up for the lost cash flow.
2.3 Optimal bed/bath numbers for cash flow
So what’s the best bed/bath combination for cash flow rental property?
There isn’t necessarily a single best answer here, but the consensus among investors I’ve heard from seems to be 2 bedrooms and 1 bathroom.
2 bed / 1 bath units are the most common, versatile, and affordable rentals out there. They have a relatively low purchase price, and are often in condo or townhouse complexes. They’re attractive for a single person or couple who wants a guest room or an office, two roommates splitting the bills, or a small family with 1 or 2 children. This keeps demand high, while the single bathroom keeps maintenance low.
Don’t believe me? Run the numbers on a few properties yourself to see what you come up with.
Enter your email below to get the simple rental property cash flow and ROI (Return on Investment) calculator that I use:
I have a 2 bed / 1 bath Class B townhouse and a 3 bed / 1 bath Class C townhouse. Three bedrooms with just one bathroom is rare, but I could argue that it works even better for cash flow rental property than a 2 bed / 1 bath.
And I think I will!
My best performing property is the 3 bed / 1 bath. It seems to be in a sweet spot for the local rental market. The 3rd bedroom increases the rent that people are willing to pay, and the single bathroom makes it the most affordable 3 bedroom home that they can find and that I can buy. So there is always high demand.
But the property class also factors in to the number of beds/baths that a cash flow investor should target.
As you go up from Class C to Class B, a 3 bed / 1 bath might be harder to rent. When people are paying for a nicer neighborhood and a more luxurious space, they will also look for the extra convenience of a half or full bathroom for guests and children. So keep that in mind before taking the 3 bed / 1 bath concept globally.
Look for 2 bed / 1 bath rentals in Class B neighborhoods and, if you can find them, 3 bed / 1 bath rentals in Class C neighborhoods.
I also have a 3 bed / 2 bath Class B rental that works fine. The cash flow is a little lower, but it’s the one that attracted the ‘forever’ tenant.
My experience with more bedrooms and bathrooms than that, though, is enough that I’ll never go that way again!
2.4 Why I’ll never go higher than 3 bed / 2 bath
My first rental had 4 bedrooms and 2.5 bathrooms. We had interest from renters who were living with 3 generations: grandparents, parents, and children. And we had a family of 8 rent the house!
It was really expensive every time someone moved out and we had to replace or shampoo carpets, fix dents in the walls, and repaint the interior of the house. And one of those times we found a water stain where an upstairs bath tub had overflowed. We had to fix the drywall upstairs and downstairs and make sure everything was dry and mold-free.
The water issue could have happened in any size home, but the larger family size only increased the chance of that happening. I barely broke even in cash flow on the big house. Though I bought it for 50% more than a smaller home, it only rented for 20% more! This is the fundamental reason that a big house doesn’t work as a cash flow rental property. And it goes right to the first test a rental property investor should use: The 1% Rule
3 Summary
The type of real estate that makes the best cash flow rental property can be defined by one letter and two numbers:
- Property class – A, B, C, or D
- Number of bedrooms
- Number of bathrooms
Based on the experience of myself and other successful rental property investors, I’ve made the following conclusions:
- The best cash flow rental property is either Class B or Class C
- Class A rent is not high enough to offset the purchase price
- Class D rent is not high enough to offset the location, tenant stability, and maintenance of the building
- Class B properties have the best cash flow when they have 2 bedrooms and 1 bathroom
- This is the most common type of rental
- Class C properties have the best cash flow when they have 3 bedrooms and 1 bathroom
- This is a harder property type to find, but that gives the investor an advantage in the rental market
- A 2 bed / 1 bath rental also works well in Class C
- Stick with 3 bedrooms and 2 bathrooms or less per rental unit to maximize cash flow
These conclusions are the narrowest ‘rules’ that I have found to be true. You might find exceptions with the specific location and listings where you invest, but I would expect those to be rare.
Have you narrowed your locations and properties of interest to fit within these rules?
If not, you may be setting yourself up to learn some of the same things I did. The hard way.
If you haven’t read the other articles in the Pathway to FI rental property series yet, here they are:
- Part 1 How to Know if a Rental Property Is a Winner
- Part 2 What Makes the Best Cash Flow Rental Property
- Part 3 How to Know if You Should Invest in Rental Property
- Part 4 How to Find Good Rental Properties to Buy
- Part 5 8 Ways to Make Extra Money on Your Home and Land
And don’t forget to sign up for FREE at the bottom of the page to get much more value from PathwayToFI.
Join me on the Pathway to FI!
