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downtown1Each week an investor says something like; “I want to make the most money possible so I want to invest in the best areas. The residents in those areas earn more, they can pay higher rents, and the vacancy will be less.”
After some discussion and some education almost none of my clients buy in the nicest zip codes. Why is that?
The short version is that the premium areas already have a premium price. In order for some to maximize their equity the best areas need to go up in value even more than ordinary ones. The attached chart provides details. This article aims to explain some powerful ideas about building wealth. Be aware it has more numbers than most of my articles. Gentle Reader, it is worth the few minutes to understand this information. We invest in real estate to make money work for us. This article tells you how to make the money work hard and smart.
Let’s assume that an average rental neighborhood might be North Park or the Highway 78 Corridor. Let’s call Pacific Beach, North County Coastal and Hillcrest the premium locations. Premium spots cost more, a lot more than average. There are two major reasons that the average areas can deliver a better return, leverage and relative prices. There is only one way that premium areas can out perform average, if the expensive area has even faster rental increases or earn a higher relative premium.
Importance of Leverage
Let’s think through this analysis together. In an average neighborhood you can borrow about 75% of the purchase price. If you pay $60,000 per unit then you can borrow about $45,000 per unit. In a classy section you may pay $100,000 per unit. The lender may loan $60,000 per unit, which is 25% more per unit. However that loan is only 60% of the value of the apartment. The lender considers how much cash the property generates to make the mortgage. You’ll read more on this in the second portion of the article.
Let’s consider the relative increases in wealth first. Later we will review the cash flow.
Make me Richer, FAST!!
Let’s assume that our great economy and the steadily increasing demand for rental housing push rental units up ten percent in value. We have seen this kind of increase for at least two years. This year may be the third year of substantial increases.
The $100,000 apartment would then be worth $110,000. Recognize that in the first few years there is relatively little mortgage reduction. For simplicity let’s assume that the loan were still $60,000 per unit. That means the apartments have $50,000 in equity each. You put in $40,000 and now they are worth $50,000 that is a 25% increase. That is fabulous!
Alternately consider the average units. They are now worth $66,000. The loan is still $45,000, which means $21,000 per unit in equity. That $6,000 increase in value is a 40% return on your equity. Gosh, that is even better than fabulous!
If this concept registers with you, you could stop reading now. Putting leverage to work for you is profoundly important. This relative leverage advantage overwhelms almost everything else.
What about Cash Flow?
This arithmetic alone is enough to justify buying in ordinary areas. Most of us also care about the cash flow. What are the impacts of plain versus fancy in terms of cash flow?
Higher units have higher costs. The two biggest single cash costs are the mortgage payment and the taxes. A $45,000 mortgage will have payments today in the range of $3600 per year. The $60,000 mortgage has payments of $4800. Taxes are directly related to the valuation. A $60,000 apartment will have taxes just over $600 annually. The $100,000 version will pay just over $1000 per year. Insurance is also related to value. The attached table shows that standard areas can have value related costs that are 72% of the same costs in better areas.
We know that more affluent zip codes earn more rent. In ordinary area the average unit might rent for $675 per month or $8100 annually. In superior locations the numbers could be $850 per month or $10,200 annually. In other words the regular area might pay 79% as much as the premium location.
In apartment investing the most common measure of value for most readers is the Gross Rent Multiple. How many times the annual rent does the market pay? As this is written you can buy on ordinary locations for 7.4 times the annual potential rents. In the best zip codes the values are closer to ten times the annual potential income. The average area has a GRM of 76% of the premium spots.
Can we cut to the chase? After one deducts the higher costs from the higher rents the cash flow per unit is amazingly close. In fact the difference there is less than ten percent difference between the high and medium locations. There are a host of other costs: management, maintenance, repair and utilities. Those expenses are relatively small. As a group they do not have as much variation as those related to the value of the apartment. Besides $400 per unit is less than half of one percent of the more expensive units. It is one percent of the $40,000 per unit in equity in the premium location. So even if the cash flow were slightly higher in the superior locations it would not offset the immense difference due to power of leverage.
In other words even if the cash flow was one percent higher per year it would not make up for the 15% advantage that average units have because of leverage.
Do Average Units Always Create More Wealth?
No. There are times when superior locations can outperform average areas. If the rents go up faster or if the premium associated with superior locations goes up more, those forces could overcome the advantage of relative leverage.
Earlier we made the simple assumption that values increased in both spots at ten percent. In reality the increases are not uniform and simultaneous. If the average area goes up ten percent and the premium location climbs 16%, they would both have a 40% increase in equity.
The question becomes, “Do you believe that the better area will increase another 16% in value before the average area goes up another 10%?”
The investors who buy in the high price zip codes usually do NOT expect that result.
Instead, they really want ease of management, or pride of ownership. Those are valid reasons for selecting investments.
We need to think clearly and then act accordingly. Most of us do better when we review what we need and why we need it. Many of us confuse our needs with our wants.
Author: Terry Moore, CCIM