“Location, location, location!”
You understand the importance. It’s the number one rule in Real Estate.
Yet when it comes time to choose between a high cash flow property in a less desirable neighborhood versus one with a lower cash return but in a great location, you naturally start questioning the age old adage.
Why does location matter? To understand, you have to look beyond the initial numbers.
The Inherent Value of Location
While real estate values don’t fluctuate to the degree stocks do, its value still rises and drops in cycles. In up cycles, well located properties appreciate sooner, at a higher velocity, and maintain the momentum over a longer period of time. In down cycles, these same properties are also the last to take the hit. Because of their location, they tend to sustain their values. Alternatively, a property in a poor location will experience just the opposite. But what does this really mean to you, the investor?
Most investors buy and hold for the long term — the hope is that the property will appreciate to a point that reaches their target goal. Because real estate is illiquid in nature, when such a large sum of money is committed, you obviously want assurance that the investment will maintain its value over time. The desire is to cash in the chips and recoup your initial investment and profit some too.
Properties in poor locations experience the biggest swings in value over a longer period of time, and these investments typically become a race against time to recover fully before the next down cycle arrives. Properties in better locations, however, will have had a head start during the up-cycle in the race for appreciation.
While many investors intend to buy and hold for extended periods, oftentimes they are forced to prematurely sell their property. If you have a property in a desirable location, you reduce the risk of selling the property at a loss.
Cash Flow and Property Location
Investment property value is tied to its rental income. If rents increase, then appreciation occurs. As you guessed, rents are directly correlated to property value.
Let’s take the statement described in the previous section but replace “value” with “rents”:
In up cycles, well located properties have rents that rise sooner, at a higher velocity, and are maintained over a longer period of time.
Well located properties are typically located nearby employment centers: a particular area with a concentration of jobs. People first seek out locations that are close to employment centers; these areas are first to experience growth in rents. Properties in areas further away don’t experience the same rise in rents until renters are priced out and forced to look farther. If rents begin to decline, properties closest to the employment center have a better chance of sustaining their rent values. Following that logic, if your property is in a poorly located area when the economy sours, then not only have you lost substantial equity due to loss in value, but you’ll also experience less cash in your pocket each month. Your cash flow will continue to stay low until demand again spills over to your area.
Connecting the Dots
High cash flow properties are tempting because of their initial high return. However, keep in mind that if you’re holding for the long term, then know that a property’s value and cash flow will rise and fall. If the property cannot consistently sustain its high cash flow, its value will plunge too. In the end, your overall rate of return may end up being much lower than anticipated.
It’s easy to dismiss the location factor when staring at a property with a high cash return in a less than desirable area. However, numbers itself cannot explain the entire investment picture. While none of us can predict the future, what we can predict with certainty is that a good location will likely stay desirable for many years. While there are many unknown risks when evaluating potential of investment properties, choosing a favorable location will reduce their impact.