Why Real Estate Investors Pay More for Investments with Lower Returns

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Real estate investors often chase the highest initial returns possible in an investment property, only looking at the financial statements for their underwriting and financial projections. These investors often fail to account for the many additional factors that should be considered when purchasing an investment property. Failing to consider these critical aspects will affect the expected returns over the life of the investment both in the short and long term, and will leave the investor dazed and confused when looking at that real estate investment’s performance.

Why are sophisticated real estate investors willing to pay more for certain properties and accept lower initial returns, while most inexperienced real estate investors are only concerned with buying cheaper investment properties with a higher initial return?

Below are five reasons experienced real estate investors choose to buy investment real estate with a smaller initial return, and why you should consider them for your portfolio.

5 Reasons Why Buying Cheaper Real Estate Investments Isn’t Always Better

  1. Stable and more consistent returns. Experienced investors are willing to pay more for properties demonstrating consistent financial performance over many years, which are in solid locations where the tenant base won’t deteriorate. They understand that while past performance doesn’t guarantee future results, it IS a good indication of how the property will perform. Many investors would rather have smaller, consistent returns than higher up and down returns, and they’re willing to pay for investment real estate that provide them.
  2. Less risky and fewer unknowns. If the property is newer, well maintained with little to no deferred maintenance, and well managed, you can be more confident that you won’t get hit with unexpected major expenses when you operate the property. Buying better maintained real estate allows you to put your money directly into the property instead of having to bring large amounts of additional capital to the investment after purchasing to fix deferred maintenance items from the previous owner. When you buy a higher initial return investment real estate that has not been property maintained, you have to spend additional capital fixing deferred maintenance or taking care of unexpected maintenance items that raise the operating costs and lower expected returns.
  3. Better quality tenant with more disposable income. Investment properties that have been well maintained and well managed attract a higher tenant profile. These tenants normally have a higher and more consistent income plus more disposable income. This means that they can normally pay their bills on time and it’s easier for them to absorb rent increases. Many investors are willing to pay more for these properties because they know that the tenants can afford to live there, which leads to higher collections and the ability to maximize rents and force appreciation of the property.
  4. Ease of management. Investment properties that have been well maintained and managed are usually easier to manage. Well maintained and managed properties attract tenants who will take care of your property. Typically, when your tenants put down a bigger deposit and pay more for rent, they take better care of the property. This leads to smaller turn costs as tenants move out, and new tenants who will live at your property longer. In contrast, properties that have been poorly managed and taken care of attract less stable tenants. These tenants often create issues such as crime, inconsistent paying of rent, or trashing of units when they move out.
  5. Sell for a premium. Experienced real estate investors know that well maintained and managed properties will attract more potential buyers who are willing to pay top dollar. The more potential buyers for your property, the higher it will sell for, bringing the owner maximum return on investment. In more desirable properties, every dollar that you increase the Net Operating Income during the life of your investment is worth more than with a higher initial return investment. Well maintained, well managed, and well located properties usually have more appreciation potential for these reasons.

When considering an investment property it is important to consider more than the initial cash returns that the property produces. What type of owner do you want to be? Are you comfortable with property that produces a higher return but has challenges described above, or would you prefer a property with less challenges, but a smaller initial return and more appreciation potential? While an initial higher return property might be attractive, it can also leave you wondering “what happened to the anticipated returns?” if the property breaks down or the area changes in demographics. Higher priced investments properties may look like a lower return initially, but the returns can add up to a lot more over the life of your investment when investors are banging down your door to pay you top dollar when you go to sell.

Photo: Infrogmation of New Orleans

About Author

Spencer Cullor

Spencer Cullor has spent the last 10 years as a real estate investor and currently owns single family, multifamily apartments, and commercial properties with his investment partners. Currently he is the Director of Acquisitions and Principal of ApartmentVestors, a multifamily real estate investment company.

10 Comments

  1. Investments with lower returns are also great for keeping thing going. Also, there are way less variables involved. For people who are just starting out, it’s definitely the best choice to consider to avoid any unnecessary damage. Thanks for the insights Spencer.

    M Stephanie

  2. This article is spot on !! I constantly have investors who try to hit home runs with every property they acquire. I also have several investors who have taken the cheaper homes and have had huge issues down the road when rehabbing before renting. Both of these groups usually do not fair well with their ROI. Consistent return with minimal expenses is a plan that will never fail. More investors would prosper by reading this article and taking into consideration these tips. Great article Spencer !!!

  3. Thank you for your comments. It was one of the hardest things for me to learn as a new investor, that initial returns didn’t tell the whole picture. Focusing on quality in the right markets almost always returns a higher percentage over time. Plus, they tend to be much easier to manage.

  4. Samantha Smyth on

    I totally agree with what Stephanie said, it’s like buying a used car over a new one. You might think you’re getting a great deal with a used car for the cheap price. But little do you know that there are potential expenses that are likely to cost you more than buying a new one. Thank you for sharing this Spencer.

  5. Ultimately it’s about knowing what you want to achieve as an investor, and whether the investment you are considering can do that for you. From there, diversification across the portfolio will help with lowering overall risk exposure.

  6. Speaking of rents, Can anyone tell me how much I should raise my tenants rent each year ?
    I have both a townhouse and a condo with tenants in both. No rent control in either.
    thanks

  7. Lynn, a good way to determine how much you can raise your rents is by doing a market survey for your area. Find out what others in your area are charging for similar units and then you can determine if you are getting more than your competition or less. We usually compare the real rates by square foot and also by unit type (1 bed, 2 bed/2 bath). Once you know what others are charging, it will give you a good idea as to what you can charge. We normally try to get at least a $10 bump in rents every year no matter what, but depending on the area they could be anywhere from zero increases to 4%+. It really depends on your area and how desirable your property is vs the competition. A lot of landlords look at 2-3% as a benchmark and then adjust for the area and market. If you’d like to discuss further, please contact me and I would be happy to help.

  8. Thanks for your advise :}
    You mention 2%-3% as a bench mark, is that monthly or yearly ?
    |Both units are 2 bed room and 2 baths.
    I will raise at least $10- $25 a month just to keep up with the increases .
    Lynn

  9. Either monthly or annually and you should come out the same. If your tenants are on a yearly lease, it would be an increase in their monthly rate. But, that will stay the same through the year until they are up for renewal again. Just know that every market is different. An appropriate rental increase in NY is probably going to be different than an appropriate rental increase in Oklahoma. It’s all going to depend on your local market.

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