The most underrated asset class

[Zachary McDonough]

Hey, guys! I am an agent-investor who often gets asked about the types of properties people should consider buying. Usually, I break down what a buy box is. In case you're not familiar, a buy box refers to your specific criteria (the more specific, the better typically) for buying, including the number of beds/baths, size, home features, area, neighborhood, zip code, price point, and more.

One implied element of a buy box is the asset class. Asset class is entirely subjective but is given grades such as A, B, C, and D. Now, these grades are usually specific to certain areas, but in general, A represents luxury, while D refers to neighborhoods with high crime rates and/or areas with a larger population of poorly maintained houses. The four grades provide a basis for investors to categorize neighborhoods and communities.

I have read many forum posts and watched videos where investors only seek out A and B class properties. However, I believe it's a financial mistake. While A/B class properties may attract higher quality tenants, the major opportunity in today's market lies in C-class properties nationwide due to increased rental demand, greater supply, and disproportional rent-to-price ratios.

In my agent business, I love helping my investors find tenants for two reasons: providing a white glove experience and capitalizing on the current rental demand. I am seeing looming fears in the market, resulting in a tremendous increase in rental demand. Sellers are off-loading properties and choosing to rent instead of buying. Just last week, during a recent rental open house, a prospective tenant explained to me that she had just sold her house for a large profit but wanted to hold off on buying until the market bottomed out. First-time home buyers accounted for 30% of purchases in 2022. So what does that say about the other 70%? They are step-up buyers, relocators, downsizers, and so on—essentially, people who already own homes and would also be potential buyers. However, in 2023, they are renting. In the southern Maryland market, transaction volume is down 37% according to June 2023 market reports. As a result, those sellers are entering the rental market with great liquidity and strong financial positions, making the rental market more competitive. Consequently, average earners are being pushed to areas where prices and rental terms are more acceptable. Demand outweighs supply. While average earners could buy, they are also waiting for the market to change or "cool" and are fearful of high rates. Saving for their down payment and closing costs has become difficult, especially with outrageous inflation. The increased demand is related to renting and other post-buying expertise for C-class properties, but what about actually buying C-class properties?

Two factors that go hand-in-hand in a buyer's market are higher DOM (days on market) and more inventory. Nationally, we are not currently in a buyer's market, yet high DOM and increased supply are measures that favor buyers. In my market, C-class markets have both. We find older homes and older neighborhoods hosting ill-maintained homeowners that yield more "fixer-uppers." Consequently, even fully finished homes are limited in value due to nearby poorly maintained properties, resulting in greater buying opportunities for savvy investors.

Lastly, the most important arbitrage opportunity I've found is the disproportional rent-to-price ratios. Generally, the DC, MD, and VA markets are considered "cyclical" markets, where property appreciation outweighs cash flow. "Cashflow" markets are typically found in the Midwest (e.g., Indiana), where you can buy a $75k home that rents for $1,500 per month. In the D(M)V area, investors often struggle to find properties with positive cash flow. However, when it comes to C-class properties, as discussed earlier, they can be bought at market discounts. Market trends indicate that rent prices in those communities do not have proportional (or sometimes any) discounts at all. Therefore, the greatest arbitrage opportunity for an investor in a cyclical market would be high cash flow with tremendous upside potential for appreciation if the neighborhood undergoes redevelopment over time.

I am personally putting my money into C-class assets. With enough time, C-class neighborhoods can turn into B-class neighborhoods.

[Jay Hinrichs]

Quote from @Nathan Gesner:

Quote from @Zachary McDonough:

Good analysis, but it's not a guarantee. The door swings both ways. Some C-class properties started out as A-class. 

Buying C-class properties (or even D-class) in up-and-coming neighborhoods is an excellent strategy, but it requires a strong understanding of where the market is, where it is headed, then buying in the path of progress, and riding out the storms until the progress arrives.

as it relates to SFR props its quite rare that C or D class ever get better.. It of course happens in commercial redevelopment.. I would say once areas start to get saturated with tenants they are on a down hill trajectory and will just erode from there.  Unless there is a Tear down rebuild element happening.. but you start taking what was an Owner occ neighborhood fill it with tenants and your pretty well done on values going any higher than what an investor will pay for a given cash flow RISK / REWARD.