Apartment Investing: Location, Location, Location (Or Not)
In residential real estate, the three most important things are? What about the three most important things in apartment investing?
If you said location, location, location unfortunately you’re wrong, wrong, wrong. This truth is a shock to most new rental owners. But if you understand why, you can make more profitable apartment investments.
When you search for a house to purchase, or an apartment to rent, you want the best possible location. You’re looking for a neighborhood or zip code where people take care of their property and are good neighbors. If you have school age children, a great location is one where your children can attend superb schools. However, when you search for apartment investments, you consider different factors.
You want as much profit as possible for every dollar you invest. In most markets, the best location to live is not the best location to invest. Often, working class rentals can be bought for half price on a dollar per unit basis or near a third less on a price per rent dollar basis compared with more upscale properties.
Here’s a simple example. Suppose there are 100 ZIP Codes in a major metropolitan area. Further, let’s assume that in the 20 most expensive ZIP Codes that apartments are less than 20% of the housing units. And at the other end of the scale, let’s assume that in the 20 least expensive ZIP Codes apartments are more than 60% of the housing units.
Consider the 20th ZIP Code from the top. A two-bedroom apartment rents for $1,500 a month or $18,000 annually and it sells for 15 times the annual gross rent. This property would sell for $270,000 per apartment
Next, consider the 75th ZIP Code from the top. Here a two bedroom rents for $1,000 a month or $12,000 annually and it sells for 12 ½ times the annual gross rents or $150,000 per apartment. Tenants will pay more to be in a more desirable area than in the less desirable area. Not surprisingly, owners will pay more to collect rent from higher educated and higher income tenants.
The biggest check a landlord writes each month is for the mortgage. More expensive apartments have bigger loans and thus bigger mortgage payments. In California and in many other places the next biggest cost is property taxes. More expensive properties have higher property taxes. So the owner’s two biggest costs are both related to the value of the asset.
The next idea astounded me when I first discovered it. In San Diego County, most ZIP Codes go up about the same rate over a decade. In the last generation, I have done the analysis several times. If the fancy ZIP Code doubles in a decade, the least expensive ZIP Codes also roughly doubles. In decades when the fancy ZIP Code goes up about 50%, the humblest ZIP Code goes up about 50%, too. You may think that’s crazy but that is history’s lesson.
Often in life the ultimate question is: “So what?” Here’s the answer.
Because of the banking laws, lenders demand higher down payments for fancier ZIP Codes. In effect, government regulators want there to be $120 of cash flow every $100 of mortgage payment. So that could mean that in the 20th ZIP Code an investor might have to put 50% down, a $135,000, to obtain a $135,000 loan. In the 75th ZIP Code the investor might only put down a third, $50,000 and borrow$100,000.
What if prices double? The property in the fancy neighborhood goes from $270,000 per apartment to $540,000 per apartment. Wahoo! Take away the $135,000 loan and that means equity of $305,000! That’s incredible! That equity is 2.25 times what you began with, more than double your equity! What could be better than that?
Let’s look at the 75th ZIP Code which went from $150,000 per unit to $300,000 per unit. Take away the $100,000 loan and that leaves $200,000 equity. $200,000 is four times the $50,000 starting equity. Equity growth to 4.00 is better than 2.25.
Thus for investment real estate, leverage, leverage, leverage can be better than location, location, location. What are your thoughts?
Article by Terry Moore, CCIM – from Apartment Owners Association of California, Inc. Magazine, August 2019