Do Lower-Grade Properties Really Cash Flow Better than Higher-Grade?
It is commonly believed that when looking at different investment properties, your Class A properties offer the best appreciation, Class B gives a combination of cash flow and appreciation, and Class C and lower are cash flow plays. But is this perception really true?
First, I want to point out that properties and areas are two different things. A Class A area has lots of in-demand amenities, low crime, and the best schools, but you can have a Class B and C property in that great area. Alternatively, a developer can build a great property with all the amenities tenants want and need, but in a very bad area.
Oftentimes, when I see the underwriting on assets ranging from single-family to large apartment complexes to retail strip centers, I see assumptions that do not seem to take into account the class of property or area. In residential real estate, whether it be a single-family rental or large apartment complex, the numbers projected do not consider real-world risks.
CapEx and Age
Let’s start with a single-family rental. I often see properties that were built in the 1960s and ’70s utilizing the same CapEx reserves as a property built in the 2010s. Age is one factor leading to a property’s class. Older properties, even if most items have been upgraded, are far more likely to have real issues that newer houses won’t. There are common items, like the roof, HVAC, and cosmetic upgrades. But less common items are water and sewer supply lines, underground drain lines for downspouts, and retaining walls failing.
I am a huge advocate of building a CapEx budget and reserving on a line-by-line basis for every item in a house: estimated cost divided by remaining useful life. I look at newer houses and older ones with the same process; however, new construction will have a longer useful life, since everything has full life left, which means the monthly reserves will be lower.
As a note, I combine my repairs and maintenance and CapEx budgets together, since the two often constitute very similar items. For tax purposes, repairs and maintenance and CapEx are not the same.
A more market-driven aspect of underwriting that is often overlooked is the tenant base, specifically the length of tenancy and turnover costs. In my experience, the lower the rent in a submarket, the harder the average tenant is on the unit and the more frequently they turn over. This churn comes at a very real cost, as wear and tear repairs come out of the landlord’s pocket. And while larger damages can be withheld from a security deposit, there is a level of damage that often occurs in excess of the deposit but is also not worth the legal expense of pursuing a claim against a tenant that does not have the financial means to pay.
This risk can be mitigated through thorough tenant screening and high standards for applicants, in regard to income, landlord referrals, evictions, and the like. But again, lower-rent areas typically have a higher set of less qualified tenants, potentially meaning more vacancy and screening costs.
Considering the Odds
At the end of the day, underwriting is all about playing the odds. The odds of having a tenant damage a property are higher in lower-rent areas vs higher-rent areas. The odds of having a tenant with an eviction are higher in lower-rent areas vs higher-rent areas. This does not guarantee that the landlord in lower-rent areas can’t find great tenants, but the odds are stacked against the lower-income landlord.
When fully assessing items like CapEx, vacancy, and tenant turnover costs, many times these lower-rent areas simply equate to the same cash flow as slightly nicer areas, but with more risk. That risk does create opportunities if all the assessed risks don’t actually come to fruition, but for many that are looking for stable, passive income out of their real estate investments, that stability comes from fully accounting for all risks.
About the author:
Evan is the Investor Relations Manager for Ashcroft Capital. As such, he spends his days working with investors to better understand their investment goals and background. With over 13 years in real estate, he has seen all sides of real estate from acquisitions to capital raising on the equity and debt side, to operations, and both actively and passively invests himself. Please feel free to connect with Evan here.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.