Recently I had the opportunity to attend a real estate education seminar as an invited guest to represent Memphis and Little Rock as a Turnkey Property Provider. During a Q&A panel discussion, one of the questions presented I found particularly interesting because it is something I see frequently through my turnkey business. The question was, “What are some of the things investors do that shoot themselves in the foot?” As soon as I heard the question, I knew what I was going to say. Jeremy Veldman, the Business Development and Marketing of Memphis Turnkey, was to my left and fielded the question first. Considering the core philosophy of Memphis Turnkey Properties of investing in better areas, it was no surprise that Jeremy took the words right out of my mouth before I could answer.
In summary, Jeremy’s answer was, “Investors paying too much attention to the Pro Formas of properties and not enough attention to the area.” Bham! Nailed It! It was just last week I took a call from a property investor interested in Memphis; his first question was, “What is your best returning property? I am only interested in properties with 18% ROI and higher.” This tells me that this individual is too focused on only the numbers and not on the property and , consequently, that his expectation of the performance of his property is unrealistic. Investing with the goal of obtaining the highest possible ROI on paper is the # 1 way to lose all your money. Are there properties that will return an 18% Pro Forma in Memphis, TN? Yes. Will that property ever return that 18%? Maybe, but highly unlikely. These properties show high Pro Formas because they are cheap, and since the properties are not worth much, the taxes are low (which should be a red flag). Also, since the properties are bought for so cheap, the cash value insurance policy is also really cheap. These properties are well known for tenant drama, tenant turn over, vandalism while vacant and higher maintenance…..all cash flow killers.
We have a core philosophy to invest where people want to live, not where they have to live. Obviously none of us can tell the future of what an area is going to do, but if you invest in an area that has economic indicators showing that the area is not in distress, then you stand a good chance of your property remaining stable. And you also stand a chance of rents and demand in that area staying stable or increasing with time. Most of our investors wisely leverage their cash with 15 or 30 year conventional loans, meaning there is a long term commitment to the property (and ultimately the area). Knowing that, if an area is already a lower tier property, what do you think the areas is going to be like in 10, 20, or 30 years? More often than not, lower tier properties do not become B or A class properties; they either stay the same or deteriorate over time.
One of the areas we invest is Bartlett, TN. It has routinely been recognized as one of the top places to live in the US (#97 by Money Magazine in 2007 and recently # 8 small city to live in by Movoto.com). The school system there is getting stronger and is just one of many economic indicators that the area will remain strong. While the returns on these properties do not look as sexy as a property that is bought for $75,000 and rents for $895; in the long run, we feel a property in a better area that rents for $1,200 that sells for $125,000 will actually have a higher return through less vacancy, less maintenance and increased property appreciation.
When I invest in property for my own portfolio, my goal is to invest in areas and homes that I believe will give me the least amount of vacancy. Obviously this is hard to predict as “life happens” (even to the best of tenants) and could potentially create a vacancy even in the best of areas. But if the house is nice, the area is strong, and the schools are strong; then your chances for long-term success are greater!
One of the concepts discussed during the weekend conference regarding evaluating properties was RV ratios (Rent to Value). Meaning, if you bought a property for $100,000 and it rented for $1,000, the RV ratio would be 1.0 ($1,000/$100,000). The thought from a few other Turnkey Providers was this is a quick way to evaluate a property as a good investment. Anything above a 1.0 would mean that the numbers worked and the property was worth considering for purchase. Once again, that would be an example of an investor looking at just the numbers in their decision to purchase. While I do think this is a good tool to use as a starting point to evaluate a deal, it is dangerous if that is an analysis that you consider heavily in your decision. Personally, one of my best properties in my own portfolio I own does not meet the 1% rule. Tune into future blogs, as I plan to write more about RV ratios and higher end properties.
If you needed to sell your investment property, a good rule of thumb is, the higher the RV ratio, the less likely you will be able to sell it on the retail market, thus leaving you with only investors to sell to. Unless you have an investor network to sell your property to, it could be hard to unload your property. But if your property is located in a solid area with plenty of retail sales that leaves the opportunity open to sell to an owner occupant. Even if your plan is to keep these properties for 30 years, and selling them on the open market as an exit strategy does not seem important, I still think it says something about the strength of the investment as a whole if your only way out is to sell to another investor. Actually what that tells me is, “I own a property that nobody with good credit is willing to move into the area.”
Am I saying you can’t be successful investing in mid to low tier areas? Absolutely not. Jeremy and I own a few in these areas, but we are realistic about the expectation of performance (and we bought in 2006 – 2008 during the $0 down days). What I am saying is the numbers rarely work out to the Pro Forma on low tier properties, especially in the long run because of higher vacancy and maintenance and further decline of the area. With that being the case, you should not only look at the numbers, but also heavily consider the area for the long term success of your property, especially if you are obtaining the property through conventional financing. You most certainly want to heavily consider the area if you want less turnover and hassles from your property and desire a more passive investment. Really, the area may be more important than the house (sounds like a good follow up blog). Maximize your investment by investing in the house AND the area. Consider the Pro Forma ROI, but don’t pick one property over another just because of ROI without considering the area and why that ROI is higher. On paper the higher ROI may look like a better deal, but is it?
Remember, Better renovated properties, in Better Areas will be Better Investments in the long run (and less headaches)!
President- Memphis Turnkey