Defying Gravity and Investing in Real Estate in the Land of Oz… [Why it Doesn’t Work!]

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Let’s begin with the assumption that actual investment principles are just that: principles.

For example, in physics, the principle of gravity is what we call a fundamental truth. Some might wanna convince us we’ll fall sideways when we jump off a 10 story building. Gravity and thousands of years of human experience tell us we’ll fall down. Airplanes don’t prove there’s no gravity, they use other principles of physics to ‘overcome’ gravity for a relatively short while. Pun intended, but no amount of rhetorical proof is gonna alter the results gravity will produce.

Gravity isn’t a theory. Gravity simply is.

What are Some of the Principles of Real Estate Investing?

In the Land of Oz any principle can be violated, even redefined. Let’s take just a few examples — location, age, and a perennial party favorite of mine, functional obsolescence. Is location quality a principle of real estate investment? Age? Functionality? If we’re honest, they really aren’t — until they are. Most of the time a truly well-located property will fare better, over the long haul, than say a property in a genuinely poor location. But we all know of stories where an investor did well with a C+ location. Same with younger vs older, and various subsets of functionality. And there’s the rub.

Many sincerely believe that these factors are often substantively overrated as it relates to both the current value and future performance of a given investment. They execute their long term real estate investment strategies with this belief firmly ensconced in the very foundation of their overall Plan. I’ve seen this thinking put into practice in my local market since Ford was in office.

And ya wanna know somethin’?

That approach worked, sometimes for decades.

Yep, it worked ’til the day it didn’t. 

Defy location quality long enough and it will own you. Same with the other two.

That’s not a statement I make willy nilly. I’ve seen it come back to haunt long term investors first hand, ad nauseum. Here’s how it begins.

1. The investor is focused from Day 1 on cash flow, even though it will be 2-3 decades or more before it becomes crucial.

2. They acquire older properties in areas selling for much lower prices than younger and better designed properties in superior locations.

3. They defeat ‘gravity’ for years, sometimes many, many years. The cash flow endorses their fundamental belief that the aforementioned factors are much overrated.

4. They ‘double down’ on this. Over the years they either buy more, trade for more, or both. Their portfolio grows impressively, as does their cash flow. Meanwhile, their portfolio continues to age, and not gracefully. They come across a new phrase — functional obsolescence.

5. As retirement nears, their ‘impressive’ portfolio is beginning to show its age. The cash flow has begun to flag a bit, even if it’s only to remain the same, though in a rising market. However, it goes for the most part either unnoticed or ignored. After all, these properties have always produced, right?

It’s time to ‘jump’ into retirement. Hint: This is when they leave Oz, and realize gravity can’t be defied forever.

To avoid my local buddies bushwhackin’ me for naming specific areas, I’ll just say the investment portfolio of our intrepid investor is located in neighborhoods in which you’d not even consider puttin’ Grandma to live alone.

Their cash flow at retirement is, relatively speaking, stunning. It’s just over six figures a year. So what’s the problem? Let us look closely.

1. They now belatedly realize the tenant quality has deteriorated to the point of discomfort. They’re goin’ to court more often. Folks aren’t stayin’ nearly as long as they used to.

2. They realize the younger, better designed competition in more universally preferred locations are doing far better.

3. The cost to remedy the functional obsolescence is prohibitive, and will virtually gut their cash flow.

4. Part of a property being 50-100 years old is the guarantee of at least two distasteful realities:

A. You’ll enjoy a much smaller slice of the tenant pie. When given the option, renters prefer newer, and absolutely abhor living with functional obsolescence. The part of the pie taken from you will be the higher quality tenants.

 B. Operating expenses as a percentage of GSI (Gross Scheduled Income) will increase, usually significantly. Studies show that when the NOI (Net Operating Income) decreases, cash flow decreases. (Sarcasm alert.)

The Dilemma

Since they’ve reached retirement age, and the income is pretty dang important, they find themselves in what we like to call a dilemma. They can sell or exchange and buy younger, better designed and located property. But the predictable problem at that point is that their adjusted cost basis is a tad more than a few HappyMeals. They simply can’t afford to sell due to the capital gains taxes they’d incur. If they executed a tax deferred exchange (Sec. 1031 of the IRC), they’d almost ensure themselves of significantly lower cash flow at the time they most need it.

It’s at that point the realization hits ‘em — ignoring location quality, age, and functional obsolescence only works long term in the Land of Oz.

Problem is, there is no Land of Oz, and none of us can defy gravity. Those are not epiphanies anyone wants to face in retirement.

Location quality matters. Age matters. Functional obsolescence is the deadly enemy of cash flow.

Those who realize the value and importance of those factors will not be surprised when their real estate investment portfolio performs like a champ in retirement. Those who don’t will learn that gravity never disappoints, and that the Land of Oz never existed.

 

 

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About Author

Licensed since 1969, broker/owner since 1977. Extensively trained and experienced in tax deferred exchanges, and long term retirement planning.

11 Comments

  1. Adam Arrigoni on

    Good article, I’ve been going over this for the last few months. I learned initially the hard way about taking cash flow over area and age. I’ve done a 180, and I’m trying to buy homes that people will want 20-30 years from now. Homes in my own neighborhood (large lots, good area, bigger homes, but just above the avg home price).

    Buffet doesn’t buy sexy companies, he buys companies that produce a product that will be in demand in 50 years. I think he said, “people will be drinking coke, and eating snickers bars in 50 years, thats why I own it.”

  2. I have been purchasing properties in A/B location that were run down due to tenant quality. Once you move the ‘bad’ tenants out, rents go up, and profitability sky rockets.

    I have taken an apartment complex that the cops would go in without double or triple back up, and turned it around. The story is on my blog.

  3. Toni DeSalvo on

    Our strategy has been flips but the LA & OC market is too tight to venture in so we decided to change our strategy to apartments. So, please bear with my ignorance, I’m not exactly sure what your article is supporting or telling me, newer apartments? location I know is important! I am beginning to do an extensive research for the location we are interested in. We have a SFR for rental in indianapolis & have spent time there so together with our PM I hope he can guide us to the right location!!! I know nothing is a sure thing, but hopefully there’s some history I can look back at to make decisions.
    So, I’m asking the bottom line of your article, main points!!
    Thank you!!

    Toni DeSalvo

    • Jeff Brown

      Hey Tony — I was born and raised in the L.A. and OC areas. :) Investing in those areas won’t do you very well, relatively speaking. Even if your locations are high quality, that means the rent/price ratio is poor, to be kind. The older the property the higher the expenses, which leads to reduced net operating income. If you hold those properties ’til retirement that reality only worsens.

      I left CA over a decade ago cuz it’s one of the worst investment destinations in the country, at least in my view. CA hates business owners and investors, not to mention landlords. I’d look at states where investors and business owners are welcomed with open arms, not taxed and regulated into oblivion, and where landlords are respected in the court system. When the smoke clears it’s ALWAYS about jobs. Find out what state is producing jobs, to where businesses from other states are moving, and do serious research there.

  4. Jeff:

    Practical advice as usual.

    We continual to look at a mix: a couple of 20-something apartment buildings on one end and a few converted Second Empire and Victorian buildings on the other end. The older-buildings, once having undergone a modernization, are as, or nearly as, functional as our newer properties, but with a little more style.

    Unfortunately, newer does not always mean better functionality. We have also found that many of the newer {stick-built} buildings are closer to functional obsolescence at 30 than a rejuvenated Second Empire building at 140.

    • Jeff Brown

      Your point is spot on, Roy, and couldn’t agree with ya more. I’ve learned from experience that design and construction quality is not just important, but the difference between success and failure for any particular building. Here in San Diego we have have bunches of those ancient, but proudly and totally restored income properties. As you noted, they do perform better than many of their younger, cheaply built counterparts.

      However, two things to beware. First, a fully restored 80 year old property with gorgeous architecture is still anathema to tenants who insist on kitchens with a dishwasher. Or not having to walk through one bedroom to get to another. Or bedrooms so tiny that would cramp even a child’s style. :)

      Some of the lovingly restored homes and 2-4 units properties in San Diego located in the general Balboa Park area are, as you said, proud reminders of what used to be.

  5. Jeff,

    You have incredible insight & experience that we’re fortunate enough to be the recipient of here on BP. Although I’ve never invested in the hood (which BTW cash flow’s the most but to your point will incur a huge future cost) I could only really afford similar properties to what your article describes, and you are correct in saying that my maintenance costs have gone up while my deductions have started to dwindle. I have been fortunate enough to learn the lesson you described at an early age of 42, when I first retired due to an injury. I have since started other ventures and have been blessed to have taken some of my cash flow off the table and invested in some other cash flowing vehicles and asset classes, but my thinking has shifted to your way of thinking today, by moving into higher quality RE with lower levels of future maintenance and deferred obsolescence, via 1031 Exchange and otherwise. Thanks for the validation and inspiration to focus on making this happen with my own future retirement portfolio.

    Best,
    Dave Van Horn

  6. Jeff,
    I always enjoy your articles. Your long term view of investing is often in contrast to the way most of us look at it, and that’s a good thing. Thanks for sharing hour knowledge.

  7. Brant Richardson on

    I thought you were going to let us in on a great opportunity in Australia! Good article, the cash flow of those lower quality properties is so seductive its hard to resist. We need constant reminders not to go there.

  8. Loved it Jeff. Why are you looking over my shoulder because that’s exactly what I am doing “cash flow”. I really appreciate you pointing out the aging aspects of properties but I am planning to do it for a while until I have enough income in class B area because of my limited resources. It is blogs like yours that I am part of BP community. Thank you.

  9. Jeff,

    Awesome post, thank you! Agreed on all counts. If I were to summarize for myself – these are not the types of properties you want to hold forever.

    Curious about one point you mentioned briefly –

    If they executed a tax deferred exchange (Sec. 1031 of the IRC), they’d almost ensure themselves of significantly lower cash flow at the time they most need it.

    Could you maybe expand on this a little bit? Is there something inherent to the 1031 that causes cash flow to decrease when trading up? Or is it simply the fact that trading “up” either means buying a newer property with less NOI for the same capital / or taking out financing for a bigger property?

    Regards
    Dmitri

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