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Why real estate investors should not gamble on property quality

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.

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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.

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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.

Written By

Jeff Brown specializes in real estate investment for retirement, has practiced real estate for over 40 years and is a veteran of over 200 tax deferred exchanges, many multi-state. Brown is a second generation broker and works daily with the third generation. With CCIM training and decades of hands on experience, Brown's expertise is highly sought after, some of which he shares on his real estate investing blog.

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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