Last week I discussed the common investment problem of overemphasizing the Pro Formas over the strengths of the areas where the investment properties are located (a situation that causes a lot of investors to shoot themselves in the foot). The gist of this discussion was to raise the question- “What is more important, the house or the area?” Most investors are taught to be area “agnostic” and focus exclusively on numbers. “Fall in love with the numbers, not the house”, we are taught. However, the fallacy in this line of reasoning lies in the fact that most of our investor-clients will be financing their properties on 15 or 30 year mortgages (taking advantage of leverage- a benefit unique to real estate investing) and hence, essentially be married to the area for a very long time! Taking this into consideration, the importance of area suddenly is on the table.
The house is an asset that produces income through rents and takes away this income through maintenance and vacancy. For the most part, area itself does not impact the routine maintenance of the house (I will actually argue this later, but for now, let’s keep it simple). If you buy a poorly renovated property, maintenance is going to happen regardless of where the house sits. Items such as carpet in the main living areas, vinyl flooring in the kitchen, old faucets, fuse boxes, etc. result in the maintenance cost being much higher than what is reflected on the Pro Forma you received from your seller when you purchased the property. Further, if the HVAC is old and the roof is near the end of its useful life, you will face large capital expenses early in the life of the investment. That being said, the house itself would seem to be the decisive factor from the standpoint of income as the property produces the income and its condition determines the maintenance cost you incur. Now let’s consider the impact of location on an investment property.
The area determines the rental amount and the type of tenant you will get in your property. For now, we will assume that location does affect maintenance cost. When buying an investment property, most investors assume (at the very least) that the market rent would stay the same and hope for periodic rent increases to keep up with inflation. However, if the area where the property is located at the time of purchase is not stable, has peaked in value, has peaked in rental income, is subject to an economic downturn or increase in crime, then it is possible that the income on the property will decline regardless of what kind of maintenance costs the property incurs. A downturn in the area could also lead to longer periods of vacancy, higher tenant turnover and theft and vandalism of the property while it sits vacant.
On a side note, if you own a property in a declining area and you are fortunate enough to have a paying tenant, then I’d suggest never raising the rent. Treat your tenants like gold and hopefully they will stay forever. Taking these factors into consideration- declining neighborhood, increase in crime, higher vacancy rates, the threat of vandalism and theft- a valid argument can be made that property location is critical for the long term sustainability of the property. Maintenance problems can be fixed, but location and downturn in an area cannot.
Looking at both sides of this issue, the house and its condition is most important for the immediate success of your property in terms of cash flow. This is especially true if you buy from a Turnkey Provider who has sold you a renovated property with a tenant in place. In fact, a lot of Turnkey Providers offer guarantees on rents and maintenance for a period of time to hook you and sell you. But what happens when those guarantees run out and the property goes vacant for the first time? At that point, the location (along with the competence of the Property Manager) becomes critical in maintaining the same level of cash flow on the property. Area sets the rent and there is no doubt that the long term success of your property is based heavily on where it is located. If this were not the case, we would all buy cheap properties in Detroit from a Turnkey Provider that offers the best short term guarantees. The reason you don’t do this is because low-income Detroit neighborhoods do not offer long term (one can argue it can’t offer short term either, but I am trying to make a point) success (Just to clarify, I personally have nothing against Detroit, I have actually only been to the airport in Detroit while connecting flights; I am simply going off what I have read about Detroit and the current economic state of the city).
So what should you do for long term success and rent stability of your income property? Simple, buy a well-renovated house in an area where schools are good, home retail sales are still present, there are lots of amenities in close proximity, and there are economic indicators that show that the area is still going to be desirable in 10, 20 or 30 years. None of us has a crystal ball and can foresee what is going to happen within a specific area, but we can mitigate away a lot of potential risk by doing proper due diligence now on the neighborhoods and focus on buying in better areas.
Now let’s go a step further. Remember earlier when I said maintenance “for the most part” is not related to area? Well, it absolutely is! The data from our in-house property management company- CB Properties shows that, largely, properties with higher rents located in better areas tend to have fewer monthly maintenance issues. Also, the turnover costs (commonly known as “Get Ready”) to make the property rent ready for the next tenant are cheaper. Why? It’s hard to say, but probably due to one of multiple reasons. For the sake of argument, I will share what I have personally seen and heard directly from tenants:
- Tenant improvements to the property
- Pride of homeownership leading to better care of the property during tenancy.
- Motivation to earn goodwill with the landlord in order to transition from a tenant to a homeowner down the road.
- HOA rules
- Other owner-occupants involvement in the preservation of the area (i.e. tattling on tenants to their Property Manager if the tenant does not care for the lawn or exterior and the property becomes a blight to the neighborhood).
- Higher education level of tenants, which translates into an understanding that this property is an investment for someone and not taking care of the property is not an option
- They were homeowners in the past themselves
- Value of their own time- meaning, tenants are more autonomous in taking care of minor maintenance issues themselves (a run to HD or Lowe’s) instead of waiting 24 to 48 hours for the Property Manager to fix the problem or take off work to meet the maintenance individual at the house
Does a better area always mean less maintenance? Of course not! Does owning a low tier property mean your tenant will not take care of the house, resulting in higher maintenance costs? Of course not! I own lower tier properties myself and have great tenants as well as problem tenants in some of the higher-tier (A and B class) properties. But I can tell you that there are considerably fewer problems with the higher-end as opposed to the lower-end properties. We manage a lot of properties and our core beliefs that constitute our Real Estate Investment Worldview have been forged from the daily activities in our Property Management Company.
Finally, let’s talk about the impact of vacancy. Vacancy is the # 1 cash flow killer in real estate! Area impacts vacancy. As important as the condition of the house is to performance, if it’s located in a bad area it will be a challenge to keep it rented. It’s hard to put good people into bad houses. And if the area is in decline, your vacancy will go up and will lead to a better chance of a tenant moving out before the lease is completed. Most tenants do not want to live in an area just because “that is all they can afford.” Everyone wants to live in an area they feels safe and are proud to call that area home. The data from our property management company shows that the vacancy rates for C class properties under management is much higher than the A and B properties. Also, it is worth mentioning that tenants living in better areas (A class) typically don’t mind signing long term leases. C class tenants will do this too, but it’s more common for them to break the lease than it is with A and B class tenants.
So back to our discussion- House or Area? Given that area impacts rents, area impacts vacancy rate, area impacts maintenance costs, area impacts tenant longevity, and area cannot be changed… The Winner by TKO is “Area!” If I had to offer my best advice, from years of management experience, I’d suggest that you buy a well-renovated property in a sustainable area that will attract a better quality tenant who is proud to live there and give you the best chance of winning in the game of real estate investing.