Why Most Real Estate Investors Use the Wrong Buying Criteria

Question

Okay, let me start with a real live example of what I’m talking about. Then I’ll give you my take.

The year was 1976. The parents of a good friend of mine were doing pretty well financially, and decided to buy a much larger, more expensive home. They lived all their lives in the Detroit area, had an established business there, and decided to move to Bloomfield Hills, one of the two wealthiest suburbs of Detroit. They ended up purchasing a 7500 square foot home, for which they paid about $400,000. Their next store neighbor was John DeLorean.
At approximately the same time, a casual acquaintance wanted to purchase a cooperative apartment in New York. He asked me to take a look at it and to tell him what I thought. The home was about 1350 square feet, two bedroom, two and one half bath, with windows facing Central Park. I priced out other units for sale, and told him he was overpaying by $10,000, and paying extra for facing CP would never pay for itself. He was going to by the unit for $50,000.

In 2010 my friends parents in Bloomfield Hills needed to move to assisted living. Their home was not in great condition. However, after having owned the home 34 years, they sold it for $485,000. So they’re investment increased 20% - in 34 years.

I met up accidentally with the person who I suggested not to purchase the coop on CPW 45 years ago. He did purchase it, at the inflated price of $50,000, because he “loved the view”. Well, he’s owned it all these years. And can sell it now for about $2.75 million.

Here’s my take, and what my 40 plus years in real estate leads me to believe. Investors who plan to hold for the intermediate to long term miss the boat by concentrating on buying a property “below market” to the exclusion of all other criteria. Most real estate wealth is created through price appreciation, note amortization and reinvestment of cash flow. Purchasing below market is way over rated, especially when it results in purchasing property that doesn’t appreciate at the rate of other property that could be purchased. Better to concentrate on property that provides a safe steady cash flow, where mortgage payments can be reliably made from rents, and appreciation potential can provide “windfall” profits. Buying a property below market value is good for the psyche, but buying a property that appreciates significantly and throws off steadily increasing cash flow is better for the wallet.

Let me know your experiences and if you agree or not.

Bob Willis · Answer

A few months ago I heard David Greene on the BP podcast start discussing this very point. I have listened to many many BP podcasts, but this was the first time I remember someone specifically taking potential appreciation into account when making real estate investing decisions. I happen to own properties in areas that have both great potential appreciation and have very little potential for appreciation. The funny thing is, the properties with little potential for appreciation cash-flow very well.I guess the point I am trying to make defining what your investment goals are? Is it long-term appreciation vs short-term cash flow? I guess in the example given in the original post it would have been a more accurate comparison if you discussed the income that would have been thrown off over 40 years vs appreciation over 40 years... That's a more interesting analysis/conversation in my opinion.

Greg R. · Answer

The most wealthy RE investor I know thinks the same way. I think the property in Detroit was a fluke. Not sure what happened there, but a vast majority of other 400k properties purchased in in 1976 would have sold for a lot more than 485k 34 years later. Obviously, areas like NYC with central park views or beach front properties (for example), have gone up exponentially. While I agree with your point, the people that I've seen who are able to implement this strategy and make a boat load of money are people who have a lot of money already and don't need their properties to cash flow. If I am to buy now, above market and with a high rate I'm likely not going to cash flow or cash flow with a very poor COC. Now, if I were a millionaire and wanted to park my money somewhere and come back in 30 years to check on it, yeah this would be a great strategy. One other thing I'll mention about this investor, he told me that through all the years and buying investments since the 80s, that he's made more money in the stock market than real estate. And he's not doing anything wild, just buying the dow, or the S&P and holding. And that's saying a lot, because he's made an incredible amount of money in RE.

Paul Moore · Answer

Hi @Don Konipol! Lots of great discussion above. I am glad you raised this issue. I am in my 3rd decade as a real estate investor and I can tell you that in a bull market so to speak, there is always a big run up in desire for appreciation. It's the same in the stock market. They are highly focused on growth stocks. But after a downturn or crash, the market regains it's common sense and looks for high cashflow properties or stocks. We've been in a long run where both cashflow and appreciation has allowed investors in stocks and real estate to prosper. It looks like there is a shift in the making and it's likely that cashflow will be pre-imminent once again. Which means a lot of amateurs who touted appreciation and took huge risks will be flushed out of the market once again. Like Warren Buffett said, "the rising tide has lifted all boats but eventually the tide will go out and then we will see who is skinny dipping." It's always the same. Happy investing.

Doug Pretorius · Answer

@Don Konipol This is a horrible example to try to sell your point. If the auto industry hadn't tanked in Detroit that 7500 sq.ft. house would be worth a hell of a lot more than $485k, probably more than the NYC coop. Also neither buyer paid below market nor was all that concerned about the market price. And neither buyer was buying as a investment, but rather their personal residence.If anything your story illustrates that you can't know what the future market will bring. So you're better off focusing on finding profitable deals today and not resting your hopes for profit on unsure appreciation.

Thomas Higgins · Answer

I respectfully disagree. First rule of real estate investing is cash flow. Lower basis than market can often help achieve high enough yields for debt to accretive in todays market. Off market, and under market can help if your underwriting is sound.

JD Martin · Answer

I take your point to mean that initial purchase price is one of the lesser important variables in real estate investing, and to that I agree if a long horizon is an integral part of your strategy. Holding most properties for 20 or 30 years washes away a lot of "sins" when it comes to buying real estate. If your strategy involves a short horizon - I'd say less than 10 years - then initial purchase price is a lot more important.

Dan H. · Answer

You act like buying below market and buying a good investment are mutually exclusive when they are really unrelated. If the NY purchaser had purchased $10k ($30k) below value instead of $10k over value ($50k), he could have come close to purchasing two such properties and double the fern you reference for making your case. I do agree that if you have to choose only one of the two options (which is not the case), I would choose the better investment over the initial discount. However, why settle for one of the two when you can have both?

Matt Devincenzo · Answer

I definitely agree with your perspective, and I think it goes much further than just the discount discussion. 10 years ago I was buying SFRs in Central FL where I grew up and have family. These were rentals and cash flowed well when I refi'd out my initial cash investments. I was looking to possibly buy a home here in Socal (San Diego) and looked at duplexes in my area. I could not for the life of me get the numbers to work considering they were just barely past 'break even'. For context I was buying SFR for $20-50K cash in FL and these duplexes would be running ~$300-350K each... I did end up buying a duplex here in 2016 for $550K and it is now worth easily $1M. So had I bought just two other duplexes between 2012 and 2016 I'd have another $2M in additional asset value and likely $1M in net worth, also rents during that time easily doubled, so the break even nature of the purchase would have very quickly resolved itself. That is to say the 'cash flow' perspective can also become such a fixation that you exclude other criteria. Had I had more experience to understand the local market I'd have made a better long term decision. Instead I looked at it as appreciation 'hype' as if market statistics didn't support the purchases, and the fact that the cash-flow would follow.

Jared Hottle · Answer

I like this take. We do not see appreciation like many markets but recently, especially this summer have seen more than anticipated. For me if it cash flows you are going to be in good shape. Buying under value to fix up is also important as it builds the snowball so I try to buy value add which may be perceived as under value. Unsure. Where I really agree with you is the buy under value limiting belief that 80% of new investors have. It is crippling and had they just bought something their values would be going up, debt going down, and inflation would not be eating up their cash positions. My two cents.

Carlos Ptriawan · Answer

I guess because people don't understand the fundamentals of what makes economy (and appreciation) great again: it's the job market. The steady cash flow market is there because solely there's no market economic expansion aka less demand for the housing aka stagnant job market.