Q: Dear Spence and Marty: I’ve inherited a small nest egg and would like to get started in real estate. I would like to buy a 2 or 3-unit apartment building but I’m finding that I cannot really find the quality of building I would like and in the kind of neighborhood I’d feel comfortable owning in. I’m not sure what to do next. What should I do?
A: One thing we have found after a combined more than 50 years in real estate is that one common mistake many novice real estate investors make is thinking in terms of ‘pride of ownership’ rather than ‘profit of ownership.’ In all actuality just as many fortunes have been made by investing in lower income areas as in higher-end areas, and usually for a much less outlay of upfront money and trouble.
When talking to investors about the kind and location of property you would like to buy the answer we most often get is the “best property” in the “best location: with the “best tenants.” Boiled down, what they are saying is something like this:
- By best property, they mean a property they would be willing to live in or better.
- By best location, they mean something comparable to their own neighborhood, or better
- By best tenants, they mean someone like himself or herself, or better.
These goals are well and good, but expensive. It is probably unlikely that you could (or would want to) buy a three or four unit property in an expensive neighborhood of your choice; buying a small building in an upscale area is really out of reach for most beginning investors.
But don’t fret; you’ll be surprised to learn that the best property in the best locations only rarely makes the best real estate investment because high-end properties demand high-end prices and as such, the economics of operation are usually far less attractive.
The best part of buying the moderately priced investment property is that these middle-of-the-road-type buildings create positive cash flow.
On the other hand, lesser buildings located in your second or third choice for location often will have just the reverse effect.
- Prices are more favorable
- Terms will be negotiable
- Operating costs will be less
- A lower down payment is needed
- Sellers will frequently carry some of the financing at favorable terms.
- These usually areas that are least affected by recession.
Sure it’s true that tenants in richer areas are typically better off financially, but guess what? It is the tenant in lesser areas who really appreciate all the little things you might do to make their home a nicer place to live – painting the front stoop when needed, putting in new window coverings, planting some flowers outside). Conversely, the tenants in the best areas often always expect you to go the extra mile for them, and then some.
Furthermore, higher-end units will necessitate more expensive carpet, trendier window coverings, and top of the line appliance as well as that they often have multiple baths, decks or patios, extensive landscaping needs, and other extra luxuries that the moderately priced rentals won’t have.
And the upkeep on all these extras will always add up to a significantly higher ongoing expense for, which is something that will never make a smart investor happy.
Additionally, from a practical standpoint, managing tenants in these more middle-of-the-road units can easily be handled by a professional property management firm. Most investors have more than enough going on in their lives that they don’t need another part-time job like property management to worry about.
The best part of buying the moderately priced investment property is that most of these middle-of-the-road-type buildings will create enough cash flow to pay for professional management and still give the investor a nice cash-on-cash return on top of the other benefits of owning investment property.
Though we’re certainly not advocating that you buy in a gang-laced area, we are suggesting that you find an area that is somewhere in between the best and the worst. Successful billionaire real estate investors like Donald Sterling, Marvin Davis, and even Donald Trump would all agree that this is where the money is made.
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