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