When discussing real estate investments, we often hear people say the three most important words in real estate are location, location, location. And while “3L” properties may be some of the finest looking and most prestigious properties to own, the reality is that they are generally very poor investment choices. The reason is that the investment returns on these location properties are typically very low; and one should strive for better investment returns to compensate for the risk. The primary reason for those low returns is that A+ location properties are usually bid up to prices that are very high for the rental income and cash flows they can generate.
So where are the better cash flow properties that investors should pursue? It’s really the moderately priced, non-descript, boring location properties – whether apartments, single units, or commercial properties – that typically generate the higher cash flows and investment returns. And, higher returns, for similar risk, should be an investor’s primary goal. This is because cash flow pays the bills and excess cash flow accumulates in one’s bank account.
Let’s just think through a few numbers herein.
Moderately Priced Property – If I find an average non-descript apartment property in Southern California that sells at a realistic 6% capitalization rate (Cap Rate); that means on a $1,000,000 investment I would earn $60,000 per year (if no mortgage) and a return of 6.0% on my investment. That’s a really fair deal, and with that money I can pay the bills, put some money in reserves, and diversify the extra cash into other investments.
Fancy 3L Property – A prize property, so beach area properties, fancy areas of town, the 3L properties, are going to have very low real Cap Rates. Maybe 2.5% to 3.0%. That means on my same $1,000,000 investment, I only get $25,000 to $30,000 per year in cash flow – just half the cash flow of a moderately priced property! That may be enough to pay the bills and put away some reserves, but it’s significantly less than I’d have from a non-prize property.
Now you may think that prize properties appreciate more in value over time, but there just isn’t any long term proof that it is true. And even if it is true, that doesn’t mean it will be the same way into the future. However, the cash flows are clearly different and over long periods of time the investor collecting all that extra cash flow is virtually guaranteed to earn much more wealth on their real estate investment(s).
If you agree with the above information – and please review property listings and do some research for yourself – you might wonder why an individual would buy a very poor cash flow investment property?
There are many reasons: the buyer might not even know how bad a deal it is because they are simply buying the property in hopes that it will go up in value; without evening considering the cash flows. Also, most real estate investors have no idea how cash flows can differ based on a property’s location so it doesn’t even enter one’s mind to consider this issue. And, they may just be buying a property so they can brag about owning a prize, the “I own the nicest property in the land” and the fancy car, big house, etc. Finally, sometimes people are investing other people’s money and earning a fee on that investment; so they’re more concerned about placing investment dollars than making a smart investment.
There really are many reasons why an investor would make less than optimal decisions when purchasing property. And that is to their own financial detriment, or possibly to their investor’s detriment. But you can do better!
My guess is that if you understand the above and do your research, you’ll conclude to similar findings that those prize properties are just not the best of investments.
So to increase your affluence, find the cash flow properties that pay you more cash flow! They’re usually in the boring location, location, locations and they’ll probably provide the most long term wealth building into your future.
Leonard Baron is America’s Real Estate Professor – his unbiased, neutral and inexpensive “Real Estate Ownership, Investment and Due Diligence 101” textbook teaches real estate buyers how to make smart and safe purchase decisions. He is a San Diego State University Lecturer, blogs at Zillow.com, and loves kicking the tires of a good piece of dirt! More at ProfessorBaron.com.