Should You Buy Cheap Properties with High Returns or Nice Properties with Low Returns?

by | BiggerPockets.com

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?

Well…

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!

Related: Your Complete Guide to Analyzing a Property in Just 10 Minutes

What two things are most likely to cause any of those things to happen?

  1. Low-quality tenants
  2. 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.

Related: NEW “Annualized Total Return” Estimate on the BiggerPockets Rental Property Calculator

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?

Share below!

About Author

Ali Boone

Ali Boone(G+) left her corporate job as an Aeronautical Engineer to work full-time in Real Estate Investing. She began as an investor in 2011 and managed to buy 5 properties in her first 18 months using only creative financing methods. Her focus is on rental properties, specifically turnkey rental properties, and has also invested out of the country in Nicaragua.

5 Comments

  1. Cindy Larsen

    Ali,

    GREAT article. As usually you have thought it through very thoroughly, and explained the issues clearly.

    I think that the decision is also dependent on your long term goals for the property. If you are a buy and hold investor, like myself, you may spend more on upgrading/improving/remodeling because you plan to still own the property 20 or 30 years (or more) years from now. So I install more durable interior finishes, which also cost more for materials. Labor costs are about the same to install lower quality materias as to install higher quality ones. And labor costs keep going up. So I spend more on higher quality materials, and don’t have to pay the labor costs, and material costs over again in a few years. So, for example, I don’t buy the laminate-over-particle-board counter tops that look great the first year, and get trashed in just a few years.

    Long term, I want durable, nice looking, finish materials, so I can avoid spending money on upgrading the same things over and over again. The higher up front costs of making the units look nicer and last longer also attract higher quality tenants, who are willing to pay more rent for a nicer place, which helps,pay off the cost of the upgrades quicker.

    So, I look exclusively for properties in B or higher C neighborhoods that have lower than market rents, and are in need of upgrading. Unfortunately, I have found that at least half of existing tenants in those properties are low quality tenants, and another 20% or so are high quality tenants who can not afford market rents. So I experience high vacancy rates the first year of owning a property, as tenants leases expire, but I also get the opportunity to upgrade the units and attract great tenants at higher rents.
    I just did this with a unit last month, and went
    From Section8 tenant: $1000/month rent with tenant paying $75 for Water/Sewer/Trash,
    plus their own electric
    To recent college grads (with jobs) paying $1300/month with tenant paying $125 for Water/Sewer/Trash, plus their own electric

    And the new tenants are way less likely to trash the place, which the section 8 tenants had definitely done terrible things to. So, this year, I am likely to experience 8%-10% vacancy rates becuase of the time it will take to get the units cleaned and upgraded. I will also have signifcant upgrade costs, replacing damaged linoleum with tile, broken blinds with washable cotton curtains and new rods, damaged laminate countertops with tile, damaged carpets with tile, and, cleaning and painting everything else.

    But next year, and for years to come, I will have low vacancy, and lower maintenance costs, because of better tenants who are living more mindfully, in more durable units. Basically, I am just reiterating the old advice to buy the worst house in the best neighborhood you can afford, and fix it up.

    But for investor A who plans to sell within a few years, it might make more sense to spend less on your upgrades, put in vinyl plank floors and laminate countertops, get the rents up as high as possible, improving the cap rate, and then sell to investor B. I think investor B should look carefully at the numbers, including his maintenance/capex costs over time.

  2. Cody L.

    I’m all about the return. People say “well old/ugly places require more repairs and more capex, and more cost of management”. That’s 100% true. So factor for that. If you factor for that extra cost of repair, capex, and managment and they STILL make more money, THEN what’s the argument for the nice property?

    Nice properties are mostly for one thing: Ego. And that’s not to say ego is an invalid reason to buy. But make no mistake that some people buy properties with the idea that cash flow isn’t that important but having a nice property to show your friends is.

    I can see that happening with me. My first properties were all about cash flow. And I’ve built a nice collection of them. And now that I have plenty of cash flow I’ve started to buy “cooler” properties that don’t cash flow as much because it’s nice / fun / whatever to have a hip place downtown. Or some cool shopping complex in a trendy part of the city. Sure it might be a 5 CAP but whatever.

    I suggest people start with “medium” on the class scale because you don’t want D stuff when you’re first learning the ropes. Then when you get your baring, go get the D stuff and make a ton of cash. Then start moving to B stuff, then A. I call it “CDBA” (Okay, I don’t call it that as it doesn’t sound out to a word — but you get the idea)

  3. Brent Rogers

    My two cents. In my early investing days I focused soley on cash flow and thought of appreciation as gravy. However I have always stayed away from C class and below. I generally operate in the B areas with some that you might consider A-. I do put heavy emphasis on location as I believe the flight from the burbs to the city will continue for some time.

    All that is to say I have changed my strategy a bit. High cash flow properties in A/B areas are much harder to find as rents have not kept pace with home appreciation in the areas I invest. So I have shifted more towards a mix of cash flow / appreciation thinking when buying a property. To put this into numbers my early purchases were getting 15 – 20% cash flow. I am now settling for 10 – 12 but still focusing on buying below market value. While we may indeed see another crash at some point my models project getting 10 – 12 from each of cash flow and appreciation for a total of 25 – 30. If I were to sell a couple of them today I would easily get this. I do worry a little that appreciation rates can’t keep climbing at this rate. That is why I am big on location. I also believe location lessens the potential for a vacancy. I do not have a large volume like many on here nor have I been in this too long but I have yet to have a property empty since the day I put it into service.

    I have only been in this since 2014 so take that for what it’s worth. I wish I had started a couple years earlier as the prices were right for great returns from 2010 – 2015.

  4. John Barnette

    I have had a lot of luck with investing in working class very mixed C kind of SF Bay area towns (good zips in Richmond and San Pablo). Overall a very high A market for sure. Close to transit, schools, etc. Mix of Section 8 and regular. Large often multi generational families. Older. And not wanting an apartment. Have my pick of tenants. Getting 10% plus cash on cash from rents. And been getting 15-20% appreciation. Though would have to say these types of homes are tough to find.

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