Numbers are really pretty, aren’t they? I mean, we are all in real estate investing, and it’s likely that everyone here is out for the numbers. So shouldn’t we always go for the highest ones available?
Not always. Maybe. But not always.
I recently saw a forum post where someone asked if she should buy in a C-class neighborhood that offered a 20 percent return on investment (ROI) or an A/B-class neighborhood that offered a 10 percent ROI. For anyone not familiar with neighborhood classifications: As are the nicest, Ds are about the worst. Bs and Cs are in the middle. So in this case, a C neighborhood isn’t the absolute worst neighborhood out there, but it’s on the lower end. An A/B isn’t be the absolute nicest, but it’s extremely nice and on the higher-end of all neighborhoods.
So what’s the answer to her question? Do you go for the lower-quality neighborhood (or property) and get the higher returns? Or do you go for the nicer neighborhood (or property) and settle for lower returns—or half the returns in this case.
If you’re wondering more specifically about what return or cap rate you should aim for with a rental property, check out this blog post.
What I’m going to do to help you sort through this question is to convey the exact thought process that I’d go through if someone were to directly ask me this same question. Initially, when I read this question, I had some questions go through my own mind. After that, I had specific thoughts based on my experience in this area.
First, the questions that ran through my head:
- Specifically, what ROI is she talking about? Does she mean overall ROI? And if so, what exactly is she putting into that calculation? Does she mean cash-on-cash return? Or cap rate?
- Where did she get these ROI numbers? Did an agent tell them to her? How accurate are they?
- Exactly what kind of A/B and C neighborhoods are we talking about here? How bad is the C neighborhood in this case?
- Is she sure about the property’s cash flow in the A/B neighborhood? Typically, properties that nice don’t cash flow. Bs definitely can, but As often don’t. Is it closer to an A or a B?
- Do either of these property options require rehabs? Are they rent-ready properties that don’t need any work?
- Are we comparing apples to apples here or apples to oranges? If they both need fairly equal levels of rehabbing and are comparable on that front, then the comparison is more direct. If they need different levels of work, that’s a different comparison.
- What macro-market (i.e. big city) are these neighborhoods near (or in)?
I could spend some time telling you why I asked each of those questions, or why each of them matter. But I don’t really need to. Because the bigger question here is actually: Is it worth going after higher returns on lower-end properties (or in lower-end neighborhoods)? Or is it safer to go after lower returns on nicer properties — in nicer areas?
I’ll get to that.
But first, let’s dissect my questions, which should be asked of all potential rental properties:
- Exactly what is included in the projected ROI of this property? No one is required to ever use a standard formula for ROI. People use it to refer to different numbers. It’s imperative you know exactly what ROI is being referred to if someone uses it. There’s a big difference between an ROI that includes estimates for appreciation over 30 years versus an ROI that strictly refers to just the cash flow of a property. Twenty percent cash flow ROI is fantastic, whereas 20 percent assumed ROI over 30 years is a bunk estimate because it’s purely speculation.
- How accurate and/or realistic are the numbers that are being relayed? Are these actual returns? Are they numbers that the property is currently generating? Or are these estimates? Or someone’s best guess? If they are estimates or guesses, what are they based on? A rabbit can pull any number it wants out of a hat and pitch it as reality when it isn’t. I need to have an extreme amount of confidence in projected numbers. That confidence will be based on the source of each of the numbers. Numbers like expenses, rental income, rehab costs, etc. There’s no reason not to have actual numbers for some of these and incredibly intelligent estimates for the rest. An agent or a wholesaler pulling numbers from that rabbit’s hat doesn’t suffice for me (and shouldn’t for you).
- Exactly what is the quality of neighborhood that this property is located in? Again, with a lack of standardization, a B neighborhood or property in one person’s eye may be a D in another person’s. What can be a B neighborhood or property in one macro-market may be a D in another market. Generally, we can make some basic assumptions about quality if someone tells us A, B, C, or D. But we need to know more before we seriously pursue a property. At that point, letter categories no longer matter, and the actual quality of the neighborhood or property is what matters. So go find out if you don’t already know.
- How much work will I need to put into this property? There is a tremendous difference in weighing the returns for a property you have to put work into versus one you don’t. If a property I need to rehab gets me a 20 percent return, and a rent-ready property offers me a 20 percent return, which one am I going to go for? The rent-ready one, duh. Because why put work into something if I’m not going to get paid more? So when it comes to looking at returns, you have to consider how much time and work you will be putting into a property, if any, in order to better gauge whether the return is worth it. My general expectation is that the return on a property I put work into needs to be significantly higher than one I don’t need to put work into in order to compensate me for my efforts. I have no way of knowing if 20 percent or 10 percent are good returns if I don’t know how much I have to put into it in the first place.
- Are we comparing apples to apples here? Or apples to oranges? If one property needs work and the other doesn’t, it’s impossible to compare 20 percent and 10 percent. That would be comparing apples to oranges. But if both need the same amount of work, for example, then we are comparing more comparable things, and that’s OK.
- What major market or city is this property near or closest to? To know at all whether any particular return is good or not, I need to know what major market or city this property is in or around. For instance, if I found a 10 percent return near Los Angeles, I would be ecstatic. I’d be all over it. If I found a 10 percent return in Detroit, I wouldn’t touch it with a 10-foot pole. Markets run at extremely different rates of returns and return options, so without knowing what major city I’m looking near, I can’t know if 20 percent or 10 percent are good returns at all — much less in comparison with each other.
Now, back to the original question — for real this time!
Now that those initial questions are out, I can move on to whether I would chase higher returns with lower quality or stick to lower return with higher quality.
I’m going to start my answer to this question by telling you the question that I think matters most when it comes to projected returns on an investment property (of any kind):
How sustainable are the projected cash flow and returns?
Notice I didn’t ask what the cash flow or returns are. I asked, how sustainable are they?
Back to this rabbit in a hat idea — anyone can tell you any numbers they want on a property. I could tell you I have a rental property to sell you and it comes with a 50 percent ROI. Call it freedom of speech or whatever you want — there’s nothing illegal about completely BS-ing and trying to convince you that you can get a 50 percent ROI on my property. You, as the investor, need to be able to call my BS.
But I’ve already talked about confirming the feasibility of the projected returns that you are given. Don’t rely on estimates. Get actuals. Confirm your sources, etc. Now what I’m talking about is slightly different. Instead of feasibility, I’m talking about sustainability. And this is where the quality of the neighborhood and property really matter.
Even if you have the most realistic and accurate projected returns or cash flow possible, if you get one gnarly tenant in your property, or if the market you buy in collapses, you can kiss those accurate projected returns goodbye. Evictions, vacancies, damages, court costs, and rental decreases will have you crying in a corner cuddling with your checkbook that you can no longer write checks from because you’re out of money. So much for that 20 percent or 10 percent return!
What two things are most likely to cause any of those things to happen?
- Low-quality tenants
- Low-quality or declining neighborhoods
Notice I use the word quality in relation to low. Low quality. Technically, you could have a low-quality tenant who makes six figures a year and pays $3,000/month in rent in a really nice neighborhood and in a great property. It’s not always just low-income that constitutes low-quality. Trust me, I’ve met some low-quality high earners in my time! And just the same, you could get the nicest, most trustworthy tenant who consistently pays on time each month for years on end, but pays very little in rent and makes very little money.
What has to be considered though is this: How likely are you to land low-quality tenants at the higher-end and lower-end sides of the spectrum? The reality is, for good or for bad, you are more likely to land low-quality tenants the lower in quality you go in a property or neighborhood. Therefore, the poorer the tenants will be. Your chances are lessened significantly when you go with higher-end properties and neighborhoods. Again, no guarantees one way or another, but we have to look at this realistically.
If you end up with a low-quality tenant, you risk expensive damages to your property, evictions, and the subsequent costs. Plus, more vacancies means a blow to your cash flow, possible lawsuits, and a heck of a lot of headaches. With low-quality properties, you are more likely to have to repair things more often, usually to the tune of a lot of money. You are also more likely to attract lower-quality tenants. Your property may lose value with time rather than appreciate; rehabs can be more expensive than expected; and your resale options down the road may be significantly hindered.
Do you see how all of those things could completely demolish that initially projected cash flow?
You have to look at it like a risk spectrum. The lower you go in quality with a property or neighborhood, the higher your chances are of running into the aforementioned issues that can be very costly. The higher you go in quality with property or neighborhood, the less the chances become.
So what is more worth it to you? Take on the added risk and try for the higher projected returns? Or stay a little safer and in doing so, settle for the lower projected return?
The answer is completely up to you.
Some things you need to consider when answering this for yourself are:
- What is your current skill level? Do you know how to manage lower-quality properties and neighborhoods? (Hint: there are specific methods to properly managing these types of situations that successful investors have used. Do you know what they are?)
- How risk-adverse are you? (Be honest.)
- Is the difference in projected return enough to justify the risk you are taking on? (It better be!)
- What is your exit strategy or escape plan should things get hairy? (Please have one.)
- Do you like challenges like this? Or do you prefer things to just be easy and with fewer headaches? (I love challenges but not that kind.)
- Are you brand-new to investing? (If so, I highly encourage you to not go flying into the deep-end.)
And again, you could end up with terror tenants and ultimate destruction with high-end stuff too. There’s no guarantee that that will never happen. But it’s about risk mitigation and the spectrum of risk we talked about.
My best advice is this. No matter what route or strategy you decide to go with in real estate investing, know exactly what you are getting into and exactly what the risks are. I will never judge someone for going after an insanely risky property if they are at least able to explain exactly what the risks are. The problem comes when people go flying into an insanely risky deal and can’t identify or speak to exactly what they are getting into. At that point, I begin to judge. Be educated. Know exactly what you are getting into and why. If you can do this, you will do well in this industry. Bumbling around with little knowledge will only get you in trouble.
Current investors—what’s your sweet spot between lower- and higher-quality returns and lower returns for higher quality?