High Value home worth risk for appreciation?

Question

Hi All -

I'm a relatively new investor who is seeking to grow a appreciating portfolio first, followed by cash flowing properties.  I have enough assets that I'm not in need of cash flow at this moment, and I'd like to focus on assets that will build me more wealth long term. (that said - since I rely heavily on dividends for income, I don't want to completely negate cash flow either. Nor do I particularly want to lose money).

I have a property I think I can get under contract in a prime Los Angeles location. It was listed @ 1.6, but I think it will sell closer to 1.8.  It is in an AA+ neighborhood that is hard to replace, and it's really beautiful. It is a turn key property - so not something I can build equity into.

The rent will just break even with my P+I+taxes and insurance (9,500k monthly) and maybe even fall short. It will not cash flow, unless i turn it into an Airbnb and then maybe... though Ive never owned an airbbnb and that would be a learning curve.  It has 2 bedrooms, a pool and a guest house, so  maybe not ideal for airbnb (i'm told airbnb thrives with 4 bedrooms) but still an excellent property.

My question is it worth buying and holding even if it doesn't cash flow, and may in fact cost me money? I know many believe we're at the top of  the market, and that there may be a correction in the future. However, this is the type of property (in the right area) that could very well appreciate almost a million dollars in the next seven - ten years.

I've heard others say that with inflation, they're banking on appreciation and buying high desirable properties to profit from it. That is in essence what I would be doing with this property - buying a high value assets that may cost me money in the short term, but in the long term will grow in value. That's real estate investing 101, but I guess I'm wondering if that's worth doing in such choppy economic times?

I wouldn't be considering this investment strategy if i didn't believe the property was valuable. Otherwise, I would much prefer a BRRR strategy or cash flow or something that I have a cleaner exit on. However, I thought I'd ask you more experienced investors if you have any thoughts about this. Any and all are appreciated.

Thank you!

Jon Schwartz · Answer

David,

LA realtor and investor here.

Couple thoughts:

In expensive markets like LA, it's not necessarily a bad plan to invest for appreciation. A lot of wealth has been made this way.

That's said, be sure to factor in all the costs of owning the property, not just the PITI. You'll want to account for ongoing maintenance and capital expenditure (that's a fancy term for replacing stuff when it breaks, including items like the roof, flooring, etc), as well as vacancy. I'd consider 15% of rent as expense -- 10% for cap ex and 5% for vacancy. If rent is $9500/month (to equal PITI), you're looking at $1425/month in expense that will eventually come due.

Also, even though investing for appreciation can work out, it's better to find situations where you can force appreciation. In LA, the best option for this right now is ADU conversion. If you have the means to invest in a $1.8M house in an A++ neighborhood, I'd highly recommend you consider buying a house in an A- neighborhood that has a garage to convert to an ADU. When both are rented, you'll be able to cashflow, albeit modestly, while the appreciation gains compound.

And speaking of appreciation, to maximize it in LA specifically, you want to buy in the B neighborhood that's next door to the A- neighborhood. A++ neighborhoods are always great areas to invest, but to capture the most upside, you want to buy where the transition upward is happening fastest. Those are the neighborhoods to which I pay the most attention.

Best!

Jon

Evan Polaski · Answer

@David B., for one, you are not breaking even.  You are already losing money.  If rents are $10,000 per month by way of example, and your PITI is 9,500, you may cash flow $500 this month and next.  But when the water heater breaks, or fridge dies, or earthquake comes and you have a $10,000 deductible, you are going to be underwater.  Then a tenant moves out, or worse, you are stuck with a tenant who stops paying but you can't evict them.  Your mortgage is still due.  Point being you are going to lose money from a cash flow perspective.

But ultimately, if you know those risks, while not ideal, the cold hard facts is almost everyone in real estate only makes money in appreciation.  Often times, cash flow is just deferred maintenance that will come back to bite the owner on resale.

There are other factors that scare me about LA: are evictions allowed yet?  Will wildfires be coming near you?  But I personally, if I could convince my wife, would be an LA investor.  I don't think it is going anywhere, and for all the talk about everyone moving out of LA, somehow every house sells, immediately, for more than ask.  So clearly people still want to be there.

Andrew Garcia · Answer

Hi @David B., it really all depends on how long you are going to hold it. Let's say it costs you $1,000 a month. Being conservative, let's say that the property appreciates $1,000,000 over 10 years.

That means you lose $120,000. However, you make $1,000,000 (plus the principal that you paid down)

Principal more than nets out the $120,000 but let's just say you made $1m flat as profit. Assuming 25% down initially, that is over a 12% IRR, which is really good.

With the choppy economic conditions, the biggest thing to be concerned about is inflation on a macroeconomic scale. However, with inflation, home prices also rise so that is not too much of a concern. Cash would be more of a concern.

The housing market could see a correction but with the area, you are unlikely to see the same amount of decline in prices.

This strategy is often employed on the commercial side of things. They buy an A+ property at a 2% cap rate and make a killing when they sell or refinance. They just take the losses until then.

Hope this helps! Let me know if I can be of any assistance.

Ali Boone · Answer

I did something similar in LA... got a duplex in Venice that's in a great neighborhood, closer to the top of the market than not, negative cash flow for a while. The only difference is my plan is to live in it myself later on, so it's a mega long-term investment. Since we got it, we did a money-in refinance so lowered the mortgage payment, so now we're in the positive. If one were to run cash flow returns, they're low, but a lot like what you said-- AA+ neighborhood, long-term hold, and LA is unlikely to not appreciate, especially Venice since it's squished between SM and MDR which have already been developed, so Venice won't last much longer before the developers come in too (ugh, I live in Venice and I don't want it to gentrify but it's already started).

So if you can afford the negative cash flow for awhile or whatever expenses, rents will eventually catch up, you're likely going to see appreciation (probably more than I will since mine is a duplex and they don't appreciate as much as a SFR), and you ultimately have a plan for how you plan to profit on it... it could be a good move! Just speculative. But if it's a long-term hold, I can't imagine it wouldn't work out well.

David B. · Answer

Jon -

Thanks so much for the detailed response. It's nice to hear that I'm no so far off the mark.

This was actually a property with a garage that I was going to convert into an ADU, which already had a studio built on top of it. So in essence, after the conversion the property would have been two free standing units on the property. I estimate the cashflow would have been 1,000 + a month.

Unfortunately... I DIDN'T GET IT! lol

I ended raising my bid all the way to 2million and I still didn't it under contract. WOW. Crazy market man.

So back on the search! I'm curious - what are the other neighborhoods A-/ B class neighborhood you keep your eyes on? I've been looking into silver lake, echo park, woodland hills, and even places in the flats (Noho, Lake Balboa) that I could possible BRRRR. This property happened to be in Studio City Hills, so I made an exception as I really value that area.

Thanks everyone for their thoughtful responses! Trying to learn more every day.

D

High Value home worth risk for appreciation?

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