By Simon J. Lau, CFA
Updated June 2024
What Makes a Good Investment Property?
First and foremost, it’s a good tenant. A stable, long-term tenant can make the difference between a good-to-great (or on the opposite end, terrible) investment. However, attracting, identifying, and retaining a good tenant is not only difficult but also mostly outside of one’s control. Putting the topic of tenants aside for now, we should first discuss and describe the two primary philosophies related to real estate investing before diving into the specific attributes that make for a good real estate investment.
The returns from real estate investing can generally be described across two dimensions: (1) cash flow and (2) capital gains. Investors that invest for cash flow generally purchase units that would appeal less to owner-occupied buyers. These include older and/or lower-quality units, in less desirable locations, and with a more diverse tenant mix. For commercial properties, these units would be referred to as Class C buildings. From a financial perspective, these properties can be purchased relatively cheaply (e.g., lower price per square foot) and are expected to generate higher initial cash flow margins.
Investors that invest for capital appreciation, on the other hand, generally purchase highly prized assets. These include newer and/or high-quality units, in desirable locations, and with a high-quality tenant mix. For commercial properties, these units would be referred to as Class A buildings. From a financial perspective, these properties are more expensive (e.g., higher price per square foot) but have greater potential for long-term capital appreciation.
When comparing commercial residential properties (e.g., 5 units or more) to residential properties (e.g., 4 units or less, including single owner-occupied units), there is an additional layer of complication. As mentioned above, investment properties can be valued based on financial returns. One can assemble financial statements, estimate risk, and calculate the inherent value of a property based on hard metrics. Owner-occupied units, on the other hand, are sometimes more difficult to value due to important non-financial attributes. For example, owner-occupied buyers intend to live in these units, raise families in these units, and their willingness to pay has much less to do with financial returns than quality of life metrics.
In large coastal cities such as San Francisco, Los Angeles, and New York, almost all residential properties are now priced at speculative levels. In these areas, both owner-occupied buyers and investors continue to bid up prices to the point where, as an investment, these homes can at best provide meaningful returns only after taking capital appreciation into consideration. Therein lies the opportunity for small-scale investors. One needs to identify and acquire properties where prices have not yet reached speculative levels and that a hedged investment—one where the cash flow at least covers the mortgage and costs—can be had.
Case Examples
To that end, I want to introduce several case examples that I’d consider great investment opportunities that typically fall below the radar.
I came across 2750 Market St. #201, located near the popular Castro District, in the winter of 2016. At the time, this unit was priced more than 20% below market value. I was fairly skeptical that this unit would sell for anything near the listed price. However, my wife and I were desperately searching for a home in an overheating seller’s market, so anything within our budget was a stop on our Sunday open house schedule. Of all the units I’ve seen in San Francisco, this one had the greatest investment potential for the following reasons:
- The previous owner had no immediate family and had passed away inside the unit. For those unfamiliar, a significant portion of homebuyers in San Francisco are Chinese, both from China and Chinese-American. As a Chinese-American myself, I know that the Chinese community is very superstitious, and the circumstances of the previous owner’s death, especially having occurred inside the unit, would leave a largely negative mark on the property. Few, if any, Chinese buyers would consider this unit as a potential owner-occupied home.
- Proceeds were bequeathed to the University of San Francisco (USF): The owner, in his will, had bequeathed the proceeds of the property to USF. Organizations like USF aren’t in the business of managing properties and, unlike individuals, are motivated to liquidate assets rather than drag out the sales process for a slightly higher bid. I knew immediately that this unit would sell soon.
- The unit was 1,500+ sq. ft. and only a 2/2: This unit was among the largest 2/2 units I had seen, and after a walk-through, I could easily see an opportunity to cost-effectively convert it into a 3/2.
After some lightweight analysis, I discovered that the cash outflow would be approximately $5.5K after the mortgage interest deduction at the asking price (before negotiations) and that it could easily be rented as a 3/2 for $6.5K+. Furthermore, in California, sellers are only required to disclose a death in the home within three years. After three years, the owner could presumably place the unit back on the market without needing to disclose this. This unit sold one month after the first open house at 5% below the listed price, or more than 25% below the market rate equivalent.
Several years ago, my wife and I booked an Airbnb in Bend, OR. The unit was affiliated with the Mill Inn Bed & Breakfast, a charming establishment not far from the Airbnb, and we were welcomed to their complimentary breakfast each morning. As an aside, the breakfast at the Mill Inn was one of the best I’ve ever had (and this is not a sponsored post)!
This Airbnb, called the Tudor Inn, was originally a 3-bedroom, 2-bathroom single-family home with a backyard cottage located in Downtown Bend. The rooms were cute, and for tourists, the complex was conveniently located. However, it was clear that as an owner-occupied unit, this would be an undesirable home for a family. It was adjacent to several parking lots, including one right next door. Furthermore, it was located in a commercial district and lacked the privacy and neighborhood feel that might be valuable to an owner-occupied buyer in the suburbs.
After some research, I discovered that the home was last purchased for $322K in 2014, presumably by the owners of the Mill Inn Bed & Breakfast. The new owners may have made significant upgrades to make it more attractive as an Airbnb, but compared to the rental rates (~$90/night for the smallest room up to ~$130/night for the backyard cottage), these units would only need to be booked about one week per month to cover the mortgage and expenses of the initial purchase. As I described in Should I Invest in an Airbnb or Long-Term Rental?, this is an example of a potentially lucrative investment opportunity if properly managed.
Summary
The reason I used these two examples is to demonstrate how an investor can exploit real estate opportunities where a unit may appear undesirable to the most common buyer (thereby reducing competition and price). These perceived weaknesses could either be overlooked (as a rental, for example, for 2750 Market St. #201) or considered an asset (as an Airbnb, for instance, for the Tudor Inn). By thinking creatively about how to segment and target customers—whether targeting a buyer, a renter, or a guest/tourist—an investor can discover many new ways to monetize properties in ways that generate tremendous value for both customers and owners.
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