Posted over 7 years ago

Every Real Estate Investor's Dilemma

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Invest in one $200k property or two $100k properties?

What is the best way, as a real estate investor, to invest $200,000? Should you purchase one Class A property for $200,000 or two Class C properties for $100,000? Each class of property has its own set of benefits and challenges. Class A properties are more stable investments with lower returns, and Class C properties offer higher potential cash flow with higher risk. Let’s consider a scenario where we have $200,000 from a recent 1031 exchange that needs to be reinvested. How should we use it?

The Paper Yield of a Real Estate Investor

Class A Property

Let’s start with a typical Class A property in Dallas, TX. The median home price in DFW is $170,000. In the surrounding suburbs, it’s entirely possible to find an Class A home for $200,000. Here’s a breakdown of what a $200,000 property in Dallas would yield for a real estate investor:

Home Value: $200,000
Rent: $1,600-1,900
Annual Rental Revenue: $19,200-$22,800
Property Management: 8%
Annual Insurance: $1,000
Annual Taxes: $6,000
Estimated Yield: 5.3-7.0%

Class A properties are typically found in suburban neighborhoods with a high rate of owner occupancy. The newer, upgraded homes attract tenants with higher incomes and better possibility of renewing their lease. Because many tenants move to Class A neighborhoods for work or amenities such as the school system, they typically stay in the home longer.

Normal 1505407321 6803 Old Ox Dr Dallas Tx

Class C Property

Class C properties are located in many of the inner-city neighborhoods across America. These homes are usually older builds, requiring more maintenance and repairs fir real estate investors. They can be found in areas that have higher crime rates and less desirable school districts. Typical occupants of Class C properties are blue-collar professionals with minimal financial flexibility.

Home Value: $100,000
Rent: $900-1,200
Annual Rental Revenue: $10,800-$14,400
Property Management: 8%
Annual Insurance: $700
Annual Taxes: $1,400
Estimated Yield: 7.8-11.1%

Class C properties also have higher vacancy rates, plus non-payment and eviction rates. These negative situations are typically a result of tenants who utilize the Section 8 housing program. Section 8 tenants have little-or-no financial investment in the property. Thus, they are more likely to miss rent payments or vacate the property without notice – a result that can significantly lower the return for a real estate investor.

The X-Factor

Maintenance and Vacancies

The scenarios above don’t account for maintenance and vacancy costs. A conservative estimate for maintenance + vacancy rates is 8% for Class A properties and 25% for Class C properties. With these factors accounted for, the new yield for real estate investors tells a very different story:

Class A Property

8% maintenance and vacancy: $1,536-$1,824
Revised Yield: 4.5%-6%
Annual Cash Flow with x1 Class A Property: $9,128-$12,152

Class C Property

25% maintenance and vacancy: $2,700-$3,600
Revised Yield: 5.1%-7.5%
Annual Cash Flow with x2 Class C Properties: $10,272-15,096

Once the higher risk of vacancy and expenses are accounted, we see the yields for Class A and Class C properties decline, especially for the Class C properties. The Class C property still has a higher yield. However, the Class A property may be worth a slightly lower yield for an investor because it is a lower risk (and lower stress) investment. Financing a rental property can also positively affect the yield of a real estate investment, something I don’t discuss here.

Appreciation

Class A properties appreciate in value more than Class C properties because of their strong market location. Strong appreciation makes a property easier to sell. The property appeals to both real estate investors and potential homeowners who are willing to pay a higher price.

Class A or Class C? Which One is Best?

Both Class A and Class C properties offer advantages and risks to real estate investors. By determining your specific investment goals, and identifying your personal tolerance for risk, you will be able to learn which investment works best for you.