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Why real estate investors should not gamble on property quality

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Quality as a relative term

Having spent the lion’s share of my real estate brokerage career in San Diego, I learned that location quality was a relative term. If you didn’t need to shoot your way in ‘n out of a neighborhood, it probably wasn’t a bad place to invest. Now? My food dish has been moved, overturned, and smashed. The thing is, from about 1976 ’til the latest bubble burst, a San Diego real estate investor could’ve, and often did, buy income property in average to half a tick below average areas and come out 3-5 years later doin’ his best Trump impression at a neighborhood BBQ.

When in 2003 I made the decision to abandon my home market due to stoopid price/rent ratios (P/R ratio), it became quickly obvious I wasn’t in Kansas any more. Turns out when you’re not doin’ business in FantasyLand, location quality matters. Who knew?

In my defense (as weak as it is), when you experience over a quarter century of virtually guaranteed capital gains, regardless of location quality, it pretty much becomes your reality. When I left, it was akin to learning your whole career up to that point had been spent in a parallel universe where normal ‘economic physics’ were often suspended. To give perspective, I was 25 years old my first year on the investment side of the business. I was 52 when I left San Diego’s market in ’03. In those years, you almost literally had to be dumb as wood not to make money investing in San Diego real estate.

Quality and long term investments

I’m here to tell ya — quality is still the foundation of long term investment in real estate.

Everywhere we look we’re being told about the historically stellar P/R ratios. That’s of course part of the winning equation, but it comes below location quality on the ‘must have’ checklist. I’ll go even further than that. I’m willing to pay a premium for a blue ribbon location even if another property down the road has a better P/R, but an empirically inferior location. You won’t be able to find the difference in price 10-20 years from now. However, you’ll notice the discernible difference in tenant quality. You’ll have also learned, over time, that the so-called inferior P/R ratio at acquisition is now far better than the property you turned down so long ago.

One commandment about investing

Thou shalt not invest in less than blue ribbon locations… PERIOD.

For the first time in my 42 years in the biz, superbly built income property can now be bought without sacrificing equally superb location quality. When 30 year fixed rates of 5% — or less — are added to the mix, you can easily see why lowering your location standards is nothin’ less than stoopid. (And I say that with affection.) In fact, the lesson to learn and apply is that a location ’10’ just gets better, relatively speaking, over time. So grumbling about the alleged price premium you paid, begins sounding more like braggin’ a decade later.

This is what I have come to call ‘location inertia’

Speakin’ from personal experience over much time and in several states, there’s a common denominator when it comes to the ongoing desirability of a given neighborhood. There are exceptions of course, but rare enough so as to ‘prove the rule’. An average to poor quality location tends to remain so or decline.  A high quality location tends to remain so over the long run.  For example, in San Diego, all the killer good neighborhoods in which I grew up, or were close by, are still highly sought after destinations for homebuyers. Not a one has gone bad.

However, some of the marginally acceptable neighborhoods of the 1960’s and 1970’s are now considered a couple levels downgraded by the buying public. A perception with which I heartily agree. This becomes a real mood killer when, as retirement nears, you notice the properties on which you compromised location quality for P/R ratio are now eating up your bottom line in everything from repair and maintenance to management migraines.

That’s not what you signed up for, right? Right.

When you hear/read that we’re in the new normal, what I’ve been talkin’ about here is on the A-List. The markets that lulled us the last 40+ years into thinkin’ we were investment gods aren’t granting cartoonish appreciation rates any time in the near future. It successfully covered up all those times we brazenly broke the commandment to worship blue chip location quality. We were undeservedly lucky, at least those of us in the funny money appreciation markets like San Diego.

Don’t violate that commandment now or in the foreseeable future. It’ll come back to bite ya right in your retirement.

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33 Comments

33 Comments

  1. Cgabhart

    December 20, 2011 at 9:13 am

    Jeff,

    Well written as usual and overall good advice depending on someone's goals. Not everyone can buy in la Jolla or pacific beach.

    As a real estate investment group we buy in any area of san Diego and other parts of southern California. Some of the locations include logan & city heights, mission beach & hills, just bought an sold a high end san clemente property and finishing up a low end deal near burbank (area is similar to city heights). We have the highest demand for the entry level locations whether it is as a rental or a sale.

    What drives our decision making is looking into the sub-market we are considering buying and making sure there is a need for our product at a price that will allow us to make a profit.

    As rentals we do rent surveys and talk to building owners for our redevelopments (flips) we survey the market to see the volume of transactions, our competition, talk to agents etc.

    Based on the information we learn we make a decision on a price that fits OUR criteria and risk tolerances. I don't recommend a novice or someone who wants to be totally passive to invest in rougher areas but if someone understands what is involved there is just as much money in the hood to be made as as in bel air IMO.

    I would also rather own close to me in a crappy location then far away in a better location where I lose more control over costs and management.

    Thanks again for your insight, overall I agree in a perfect world we all would rather own in a great area than a crappy one.

  2. Jeff Brown

    December 20, 2011 at 2:45 pm

    I've learned never to argue with results. 🙂 Also, the principle about which we both agree is the level of expertise needed to 'go against the grain' so to speak. I've made much money in ESD, but wouldn't do it now, just no inclination.

    You guys obviously know exactly what you're doin'.

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Commercial Real Estate

When office hunting, don’t call a Realtor first

Often, a startup’s first step when hunting for offices is to call a Realtor, but that is not necessarily a good idea – do your homework first.

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do not call realtor

do not call realtor

Are you getting ahead of yourself?

So you want to buy a building for your startup business? Do you really want to do that? Should you really do that? I am sure you have pondered over these questions in your mind a million times by now if you are actually on the phone asking a REALTOR to show you some places in the location of your dreams! After all, the REALTOR is the first step right? Finding a great affordable location?

WRONG. Your REALTOR is actually the person that you should be talking to LAST. Now I know this seems counter-intuitive, but there are some pretty important steps that must be taken first before looking for a location. Any REALTOR out there that either sends you active listings or takes you out looking for space without the following steps being completed first is either just hunting for a paycheck, or isn’t worth their salt in the industry and is about to make some pretty big mistakes on your behalf.

Before you look for your space…

Here is a quick protocol someone should do before they even start to look for space:

  • A well-built business plan. This should be at least 5-10 pages long. You can actually get great examples and templates at SBA.gov or your local Small Business Administration where you live. Have that business plan ironed out. That is going to then provide you with a monthly rent or loan payment allowance and based upon the information in the business plan that figure may also be altered.
  • A personal financial sheet is going to be needed. This will tell the landlord or the lender, if you and your business will be bankable.
  • Money. Bottom line, it takes money to make money. It doesn’t have to be your money, but it does have to be accessible to you at all times. There will be things that your lender or landlord won’t cover and that will be on you. Consider this the term you probably by now have heard “skin in the game.” Oh yeah, and whatever figure you think you will need to have in your head, double it.

The takeaway

I have had the painful privilege of dealing with hundreds of small business startup’s in my day, and I have also witnessed REALTORS unknowingly destroy a business success before the doors even open. Most of which could have been avoided if the startup would have had these three things figured out before they called the REALTOR.

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Housing News

Housing’s silver lining: turning REOs into rentals

While housing sputters along near the bottom, most entities are cynical of the market, while one company is expanding rapidly and seeing success in turning REOs into rentals while revitalizing communities and getting involved in the up-and-coming real estate hot spots.

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REO-to-rental market

With a continually struggling housing market, the prognosis for the sector is still poor, but there are areas of the nation and types of investments that are improving greatly, pointing to signs of life in real estate. One company embodies the signs of health, a family-owned company in Memphis that focuses on the REO-to-rental market.

Memphis Invest converts distressed REO properties to rentals, and they place a tenant, so it is a performing asset for private investors. The company recently released their first quarter activity report, showing a 67 percent year-over-year increase in the number of its homes sold to investors. Of those, 82 percent were REO, thus providing the nation a great example of how the REO to rental strategy can help revitalize communities one home at a time.

Chris Clothier, Partner at Memphis Invest is one of the nation’s leading experts in single-family rental real estate services and attributes the company’s growth to lower prices and lower interest rates, as he notes they have “removed many barriers for both novice and experienced investors, and these individuals are now getting heavily involved in the single-family rental housing industry.”

Clothier added that many investors have no interest in being a landlord, so they work with companies like theirs to allow remote involvement. “That ease of entry and passive involvement also lead investors to move beyond two or three properties and into portfolios of seven to ten,” said Clothier.

Cities primed for growth

The REO conversion market is heating up, and Clothier points to Memphis, Dallas, and Atlanta as hot spots. “We obviously like Memphis and Dallas,” said Clothier, “and feel that they will continue to be strong markets for single-family rental investments, and we continue to look toward expansion into Atlanta and possibly Nashville. These southern cities are some of the fastest growing areas in the country and have solid, fundamental economies in place. Large employers, solid infrastructure and solid future demand for their core industries mean consistent demand for good housing in these markets. In light of the shift from home ownership to renting, much of that housing demand will be for high quality rental housing.”

Making an important distinction, Clothier adds, “So MSAs with growing economies, solid fundamental industries and growing populations are prime areas – not simply cities with high concentrations of foreclosures.”

What government programs should be expanded or contracted?

In an election year, there is much focus and introspection as a nation as to what our government is doing to help or hurt the economy, and Clothier takes an optimistic look at which programs are beneficial.

“A federal government program that I would like to see expanded is the Federal National Mortgage Association’s (FNMA) role in providing funding to SFH investors,” said Clothier. “This is a group that can and will adhere to stricter guidelines designed to offer protection to FNMA’s portfolio. I would love to see FNMA expand their financing options for investors beyond 10 properties and couple that expansion with tighter lending requirements such as higher down-payments. If investors were asked to put 35 percent to 45 percent down on investment properties in order to obtain mortgages number 11-20, I feel this would draw many investors who are sitting on the sidelines holding 10 mortgages back into the market. These are typically investors who would like to be participating but would prefer to stretch their capital further by using financing.”

Clothier noted, “In addition, I would love to see the federal government work with local governments to turn over foreclosed properties in extremely blighted areas for the local government to remove dwellings and take the properties back to unimproved land. This would greatly reduce crime in these areas, discourage vandalism and blight and when the time is right, allow a community to re-invest and rebuild areas.”

Company growth plans

Where does Memphis Invest see their company headed? “Our growth demands are predicated by the appetite of our clients,” said Clothier. “We are constantly being asked for more options to diversify portfolios and are answering that demand by entering Dallas and Atlanta.”

The company says they will be managing over 2,000 properties in Memphis, Dallas, and Atlanta by the end of 2013, representing $200 million in real estate value. “Future plans involve identifying additional markets that include Nashville, among others, and continuing to meet the demand of the new investor,” noted Clothier.

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Investments

Millennials learning from their Boomer-parents’ mistakes

As Boomers lost their pants with IRAs and 401Ks, Millennials are increasingly seeking out real estate investments and planning out their retirement, taking into account the losses of the previous generation.

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A sizable Millennial clientele

Though the percentage of my clientele who’re 35 years old or younger is less than half, it is significantly sizable, and happily so. Roughly 20%. In any given year, I now have more clients in that age group than in any 10 year period between the time I opened my real estate investment firm, January of 1977, and 2006. This is an excellent trend, if six years can be counted as a trend — and for just one firm.

I bring this up in order to sound the alarm to the children of Boomers. As a Boomer, I view this development as possible evidence of Millennials and their big brothers ‘n sisters eschewing the advice of their elders. This is a good thing.

Millennials learning from others’ mistakes

I view that as a silly question. Boomers as a generation, are retiring ugly, or at best, boring, generally speaking. Millennials and their older sibs are simply using their heads, nothin’ more and nothin’ less. Would you take shooting lessons from a guy with three missing toes? Nor would I — and I wouldn’t take retirement advice from a 69 year old barely makin’ it, whether it was a parent or not.

Based upon first hand experience, I’ve come to admire Millennials. So many of ’em seem to be from Missouri — in other words, ‘show me’. They don’t necessarily buy the story sold them about 401Ks and IRAs being the likeliest road to a solid retirement. After all, it worked so well for their parents — NOT.

I applaud them. The fact so many of ’em are landing on real estate as a vehicle to retirement, shows freshly gained wisdom — and a lotta reading. History shows us that in good times and bad, in recession and in boom times, even, maybe especially in times of economic inflation, real estate not only holds its own, it triumphs. And no, citing your Uncle Fred’s disastrous experience with real estate doesn’t change any of it. People have lost fortunes investing in gold, yet it remains on the ‘A’ list of wise, long term investors.

Staying away from 401Ks and IRAs

So, in case I’m not being clear, the point is to STAY AWAY FROM 401Ks AND IRAS.

They will suck you dry for no readily apparent reason. Sometime around your 45th to 50th birthday it will hit you like a red hot anvil, falling from the sky. ‘Holy crap, I’ve screwed the pooch’. This nasty little thought bubble happens when a 40 to 50-something realizes they have $132,000 in their so-called ‘retirement plan’ at work. This is followed by the horrifying epiphany that there’s no way in hell they’re gonna build that paltry figure into even a laughably viable figure, allowing them to retire to a life of bitter resentment, and endless ‘StayCations’.

Here’s my advice: Get out of your 401K/IRA — period, end of sentence, no exceptions. 

If ya can’t get out, at least stop throwin’ good money after bad, and stop contributing. And no, your next objection about forgoing the ‘hugely beneficial’ employer match, is better left unsaid, to avoid embarrassment. Remember, the vast majority of your parents had employer matches too. Let’s review, OK? How’s that been workin’ out for THEM lately?

Invest in real estate.

Get outa your 401k/IRA if allowed. Pay the taxes and penalty. You’ll be lucky to end up with 50-60% of the original balance. That’s the bad news. The good news? If a solid real estate investment program, beginning with half your current capital balance can’t slaughter the ultimate long term results of your crummy employer retirement plan, then somebody’s not payin’ attention.

Let’s conclude with some real numbers, shall we?

If your parents had invested when they were your age, say back in 1975, they’d of enjoyed two impressive upturns, and one historically colossal upturn in real estate values. Same with rents. If their luck was less than cool, and they retired a couple days before the aforementioned historical bubble burst, where would they have been then, and where would they be now?

So happy you asked, as I lived through those times and know how the final chapter works out. They lost big time — give or take about a third of the value of their real estate investment portfolio, almost faster than they could watch it happen. Yet, having spent just over 30 years investing and/or exchanging when times were good, and waiting when times were bad, they easily built that portfolio into $2.5-3 Million. They paid off their home too. They’re debt free. Imagine that. They never bought into the myth of the employer match or any other such Barnum and Bailey hokum.

From the day they retired their monthly income has never fallen below five figures monthly. Most likely $12-15,000. Know what you’ll never hear them paid to say?

Hi — Welcome to WalMart! I rest my case.

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