Location Matters More Than You Realize
This is what happens when you buy in the wrong area
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You hear it all the time - Real estate is all about location, location, location!
Everybody says it, but very few truly understand why location is so critical when choosing which properties to pursue.
As someone who’s owned and sold buildings in every asset class from A to D, I can attest to the importance of market selection and the obstacles that come along with disregarding the golden rule.
To all of my fellow value-add investors out there, I’m not saying that you should never buy in sub-Class C markets, but I am saying that you should keep these 5 risk factors in mind when doing so.
(these are in no particular order, they’re all equally important)
#1. Insurance Risk
Let’s start with one of the least obvious - insurance risk.
If you’re financing the acquisition you’re going to need insurance.
A myriad of factors are taken into consideration when calculating your annual premium. But the greatest determining factor - aside from the property’s condition - is location.
It’s not just flood and fire zones that drive up your insurance cost. Being located in a high crime area will lead to steeper premiums as well.
#2. Construction & Rehab Risk
Compared to upper-middle class and higher-end neighborhoods, carrying out construction and renovations in Class C and D markets is 10X tougher.
Squatters will make themselves at home like they own the place. Vandals will break in and carry out senseless damage such as spray painting all over the walls or shattering windows. And thieves will steal anything they can scrap for a few bucks: copper, generators, appliances, you name it.
Heightened security is a must and this comes at a cost.
#3. Tenant Risk
It can be hard to find ‘good tenants’ that are willing to move into ‘bad neighborhoods’.
Regardless of how nicely you’ve renovated the units, or how many upgrades you’ve made throughout the interior and exterior, if the area is dicey you’ll always face an uphill battle when it comes to tenant sourcing.
You should expect for your lease-up to take a bit longer, and be prepared to withstand the additional carrying costs that come along with extended vacancy.
#4. Slower Growth & Appreciation
As a long-term buy-and-hold investor, I’ve never been one to fixate on appreciation.
I primarily invest for cash-flow and future rental income potential.
But for those whose business models are dependent upon a swift exit, I caution you to underwrite conservatively when projecting the future value of assets that are located in tertiary markets.
Unless you strike gentrification gold and outside capital begins flooding the area, properties located in Class C and D markets appreciate much slower than their Class A and B counterparts.
#5. Liquidity Risk
Lastly is liquidity risk.
Similar to insurance risk, this is another inconspicuous obstacle that early-stage investors often overlook.
Lenders like to have their funds backed by quality assets in great neighborhoods. If your building is in rough shape, or it’s situated in a less desirable area, this will give lenders pause. Ultimately, making it more difficult to refinance or sell to non-cash buyers down the line.
I’m not trying to scare you away from value-add opportunities.
Repositioning Class C assets into Class B work-force housing is an investment model that’s tried and true.
But you can’t let the spreadsheet fool you.
If you’re not careful, these deals that often look like a dream come true, can quickly turn into a living nightmare.
The potential for strong returns can be spoiled by theft, vacancy, insurance risks and financial hurdles that you never saw coming.
If you’re going to invest in transitioning neighborhoods and tertiary markets, do it with your eyes wide open.
Run your numbers twice, pad your reserves, and factor in the real-world challenges that don’t show up on an Excel pro forma.
If you take into consideration, not just the good, but the bad and the ugly as well, you’ll never be caught off guard by a surprise pot-hole or roadblock along your real estate journey.
You’ll have the foresight necessary to mitigate risk and successfully navigate these more nuanced investment opportunities.
What’s your take on today’s topic? Do you agree, disagree, or is there something I missed?
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