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Long Term Real Estate Investing is like Pitching: Timing and Location Quality Rule

by Jeff Brown on December 27, 2013 · 12 comments

  
Long Term Real Estate Investing is like Pitching

The list of all that’s crucial to arriving at retirement with more than enough income is far longer than I knew, back when I was much younger and knew… pretty much everything. :)

So many factors must be infused into the ‘recipe’ that timing almost always becomes one of the most pivotal factors of all. Strategies executed late, or before their time, which is sometimes more injurious, can render the investor’s retirement results relatively disappointing. I’ve heard far too many times how ‘our retirement is not anywhere near what we thought it should be, and we have no idea where we went into the ditch’. When it comes to timing, the strategy most often mistimed is cash flow, when capital growth would be the preferred approach.

The debate over location quality not only pits those coveting higher cash flow against tenant quality, etc., but experienced against inexperienced investors. Not to say there aren’t those who’ve done exceptionally well in grossly subpar locations, cuz I know a few of ‘em. But it’s solid use of British understatement to say they’re a tiny minority of investors. Those who’ve tried that approach over the long haul have generally arrived at retirement wondering where they went wrong. Their cash on cash numbers were always higher than their buddies, yet when it counted most — in retirement — their buddies’ strategy of insisting on blue chip locations resulted in larger, far superior incomes when the retirement party’s last toast was uttered.

Remember: We can only spend after tax income. And even the pre-tax income is less, due to higher operating costs for poorly located, older property. Yeah, I know, Captain Obvious. Yet not so for far too many.

At the beginning of the year a caller asked me about their current portfolio. It consisted of four homes bought in a solid market. They were located, however, in what she termed a ‘blue collar’ neighborhood. They averaged 20-30 years old, with one being older. Now, I was raised in blue collar areas most of my childhood, and they were fine. However, when compared to areas with superior median household incomes, demonstrably better schools, and higher tenant/owner occupant demand, the long term results are virtually always much, much worse. But you’re interested in bottom line retirement income, right? You bet you are.

She’s now 43 years old, expecting to retire at 67 or so. That’s 24 years for those rentals to become pretty dang old. Over 40 at the youngest and over half a century at the oldest. Gee, wonder if that has any affect on the cost of management, repairs, maintenance, or, gulp, the quality of tenant it might attract by then? And what about functional obsolescence?

Floor plans from a couple generations ago are literally laughed at by tenants these days. In my local market, San Diego, a 1-4 unit property worth buying for a rental (what a joke that thought is) that’s under 30 years old is considered nice and broken in. :) If they’re 2-4 units, the youngest ones were built in the 1980s for Heaven’s sake, over 30 years old now. Kitchens with no dishwashers, wall heaters, and little or no off street parking, almost always with no garage, is simply not gonna cut it 2-3 decades from now, when she’s retired.

She’ll also be faced with much higher turnover and the costs that come with that. She’ll experience more evictions, an easy prediction to make. If she’d spent a bit more on the front end, which she could’ve easily afforded, her ultimate income woulda been roughly 30-35% higher at retirement. Not only that, but the age of her rentals woulda been 24 years old, as they were new at purchase.

Now, there’s nothin’ magical about new, don’t get me wrong. But new compared to 30 years old at purchase? She’s beggin’ for a lower NOI at retirement when the properties are debt free. Why would she opt for less than $24,000 a year when she just as easily coulda created just over $32,000? Oh, and to pile on, let’s be always reminded of the higher costs of owning rentals twice as old, with much functional obsolescence and in inferior neighborhoods. Yeah, that’s what she wants to put up with in her golden years. What many don’t realize is that their choice of management firms dwindles, and the price management charges rises as the location quality falls.

To revisit understatement, the above barely represents the tip of the iceberg when it comes to investment strategies and timing. Experienced investors know how and when to combine two or more strategies to enhance either ultimate retirement income or retiring sooner, rather than later, or both. They realize that the successful implementation of those combined approaches often crumble under the pressure of old and or poorly located investment properties.

The concepts of both ‘strategy’ and ‘synergy’ have been both overworked and very misused when it comes to investing in real estate and notes for retirement.

“My strategy is to buy and hold.” What the heck does that even mean? My mentors told me a gazillion times that buy and hold is good, given all the factors involved are appropriately executed. ‘Course, that implies the investors knows exactly what to buy and hold, right? Also, when to invest. Where — how — with what financing — and also in what ‘flavor’ of income property. Industrial? Office? Retail? Residential? Small? Large?  Is it buy ‘n hold ’til the end of days? :) Or, is it buy and hold ’til it’s better to stop holding? It all depends on with whom you’re talkin’.

In baseball pitching is the foundation for virtually all championship teams. We all love the pitcher who can throw balls through brick walls at 98-100 mph. Yet, Sandy Koufax, one of the best pitchers ever to toe a major league rubber, had to shave a few miles an hour off his fastball before he even began to succeed. Why? Cuz there is no correlation between high velocity pitchers and success. None whatsoever, period.

There is, however, a tremendous link between those who throw 98+ mph for strikes, and winning big. Turns out 100 mph outa the strike zone is just as worthless as 87 mph outa the strike zone. Pitching is all about location and timing. The more successful a pitcher is in messin’ up hitters’ timing, the more games they’ll win. If the hitter expects Koufax’s legendary fastball, but instead gets his impossibly cartoonish 12 to 6 curveball, he’s doomed.

Again, timing and location turns out to be crucial.

Who knew? There are pitchers who can’t break glass with their fastball, yet win more games than fireballers. In the long run, history, and to be honest, wisdom shows us that much like baseball, gettin’ timing and location right is over half the battle. Screw up the timing of your strategies and location in either pitching or real estate, and I promise you won’t hafta worry too much about other things. You won’t get that far. :)

By the way, ya know what kinda hitters don’t last in the big leagues? The ones who never learn the strike zone, and swing at anything that looks good to ‘em. Pitchers love those guys to death. :)
Photo Credit: artolog

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{ 12 comments… read them below or add one }

Jorge Caicedo December 27, 2013 at 3:05 pm

Great article Jeff..Myself, although I’m just getting into the fix and flip world, I plan on getting a multi-unit commercial office space for cash flow w/in 2-3 years..I’ve read a lot of John Reed’s stuff and he says that holding a prop for 3-5 years max is a good yardstick and then instead of selling, do a 1031 Exchange…Certainly makes sense considering you could constantly get cash flow every 5 years or so by playing the timing and location cards right, so to speak.

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Jeff Brown December 27, 2013 at 6:06 pm

The only thing against which I’d caution you is to stay away from formulas, especially for holding times.

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Jorge Caicedo December 27, 2013 at 7:16 pm

I see, well I guessed I looked at it more as a period of time in which to gauge how the market will go and then go from there. Not a big fan of formulas either…

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Brad December 28, 2013 at 3:53 am

Great article Jack Morris :)

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Jeff Brown December 28, 2013 at 9:56 am

A guy who should be HOF.

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Ken Cardillo December 28, 2013 at 11:16 am

Interesting comparison. I also prefer a “buy and hold” strategy but often wonder when the right time is to sell. I don’t like the idea of timing the market and selling high because I question our ability to make that type of prediction. At the end of the day, I think the time to sell is a more personal question in which you need to consider what you will do with the money. Thoughts?

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Jeff Brown December 29, 2013 at 9:50 am

Your instincts are solid, Ken. Thing is, whether or not we sell at the top or not is, as you accurately point out, mostly luck. It’s about doin’ what makes sense for your specific circumstances and for your specific Plan. So often we learn that what made sense in our Plan five years ago, simply isn’t the best move now. Flexibility is the #1 factor in any sensible retirement Plan.

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Gerald Harris December 28, 2013 at 7:28 pm

I found out about location the hard way. I bought my second house in the high desert area of Southern California back in 1999. I bought in an are that was cheap cause I knew the area would rent easily and quickly. This particular area was heavy in section 8 rentals. The area was commonly called “Felony Flats”. Its was in the Apple Valley, California area. You don’t know what you don’t know. Where you purchase at you will attract typically that type of renter. At the time it would have been considered a D or and F type of area. There were many investors buying up units in that area because of the cheap prices. No rent control and no screening was going on in that location. Thus, drugs and crime were at an all time high! Lesson Learned. A buy and hold strategy was not the way to go in this area. There was some fixing and flipping going on in the area, but only on particular streets.

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Jeff Brown December 29, 2013 at 9:52 am

A very real example, Gerald. Bet you’ve helped many readers.

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Amit M. December 31, 2013 at 10:54 am

Appreciate your article on quality vs cash flow. I think it’s all relative as you seem “down” on your local market, San Diego, because it’s too expensive/hard to cash flow, and normally recommend out of state. So here’s a question for you: assume someone who already has $300k equity in property. They could put 30% down on a 2-4 units in SD, say a gentrifying neighborhood. Their cash flow will be less than out of state, but they could do really well on future appreciation, especially if they pick the right neighborhood. So many California investors have built a lot of equity over the last 20 years this way. Would you recommend that, or do you think out of state is generally better, even for those with existing equity. I ask because many successful CA investors that have equity are committed to continuing buying in their local markets like SD, LA, SF, etc. Thanks.

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Jeff Brown January 2, 2014 at 11:52 am

Hey Amit — I’ll be more specific about my thoughts on the San Diego market. For most, if they can afford a home here, and will be more or less permanent, buy one. Investment property? Stay the heck away, period, end of sentence, over ‘n out.

The days of suffering through little if any cash flow, or huge down payments to create it in SD, so that when the tsunami of appreciation comes, you’ll make out like a bandit, are over. But that’s just my opinion. If you add a $5 bill to that opinion you’ll get some coffee and a cookie at Starbucks. :) Here’s why I believe that.

Duplexes at the bubble’s peak were averaging around $580k in SD County. That represented a range of 18-22 times the annual GSI. I’d be more than surprised if we found ourselves back in that circumstance again any time soon. But let’s say we did. The reason prices here went up so much was that lenders gave loans to eighth grade teachers based upon their app which claimed they made $150k a year. That increased the pool of buyers almost endlessly, which skewed the supply/demand equation. That just ain’t gonna happen, again, in my opinion. But let’s say it does, as stranger things have happened. Wouldn’t the wiser investors see it this time and avoid markets like San Diego in advance?

Furthermore, due to the ability of wise investors all over the country to invest outside of their own local markets, the markets that make sense are where the investment capital is now flowing. I love Texas, but that’s not the only place around producing real numbers for serious investors. I live and work in La Mesa, a suburb of SD about 12 miles due east of the GasLamp. I wouldn’t sell my worst enemy a 2-4 unit property there, and La Mesa’s been a killer good place to invest since I opened up my firm in 1977. I wouldn’t put ‘em in a ‘gentrifying’ neighborhood either. Again, my opinion.

Think about it. If the investor buys a 2-4 unit property in SD, they’d hafta put 30% down just to avoid negative cash flow. In the few markets around the nation now attracting outa state investors, that much down payment would generate 5-12% cash on cash return, using normal spreadsheet practices. By the way, I used 40% operating expenses/vacancy, and 5.25% interest rate. I tell clients they should just divide the GSI by 2, and call it their NOI. :) In other words, I gave SD the benefit of the doubt by not applying the 50% rule. If I had, the SD investor woulda been forced to put MORE than 40% down — just to break even. And THAT’s for today’s prices, not when they go up in value.

On the other hand, with your $300k, you’d easily be able to acquire 4 brand new duplexes in blue chip locations for just 25% down, plus closing costs, yielding positive cash flow even with the 50% rule in effect. You’d own roughly $1-1.1 million in brand new, very well located income property. In San Diego? Using the 40% down figure, you’d be able to acquire less than $750k, once you factored in closing costs.

Now let’s focus on what you’d be owning. More likely than not, a 40-70 year old building(s), likely with some form of functional obsolescence. Let’s assume they do go up in value quite a bit. Assuming lenders don’t resume the silly underwriting that saddled them with zillions of foreclosed properties, and that real estate investors learned from their previous horrible, money losing experiences in SD, who’s gonna buy ‘em from ya, so you can make all that profit?

Who’s gonna pay you well over half a million for a half century old duplex with a laughable floor plan, and other built in laugh tracks? They’ll make the comparison I just laid out above, and wonder what they were thinkin’. Again, just my opinion.

How serious am I about these thoughts on the San Diego long term real estate investment market? I literally turned my life upside down for almost two years, when, over 10 years ago I abandoned San Diego’s market for good. I’ll list and sell/exchange local stuff for the purpose of movin’ ‘em outa state, but refuse to be a part of any investor buying local long term income property here. That’s how serious I am. Heck, I couldn’t go to a Happy Hour for well over a year when I left. :)

Again, all the above is merely one guy’s take. I hope this has helped you in some way.

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Dennis January 19, 2014 at 3:52 pm

Great article, if only humans were not so greedy, we might actually think ahead to retirement.
At least the above statement fits my situation. My rentals are all low income half are multiunit, when first purchased they were very promising, all bought no money down with 100% financing some 125%. All bought for 25-30 cents on the dollar, with infinite returns on investment.

But things do get old, not just the physical properties (don’t need to be too fancy) but dealing with the tenants gets old. The cash flow is still there, but looking back less cash flow in a better tenant area would be nice right about now.

The neighborhood is not bad and decent tenants can still be had, but the pool of buyers is thin. A few months back I decided to get a large part of my life back by hiring a professional manager, but I would rather have sold the lot in favor buying a few SFH.

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