Choosing the Right Neighborhood | PREI 007
Classifying a neighborhood by “type”, or what many investors refer to as a “grade”, is typically nothing more than a subjective description. Although most people will have a general idea of what is being referred to, in my experience it is usually nothing more than a qualitative rather than quantitative description.
Because of that ambiguity, we’ve developed a proprietary, simple grading system that we use with all our investment-grade properties. In this episode we help you to better understand neighborhood types.
We also take a look at another turnkey investment property available in our Deal of the Day segment.
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Choosing the Right Neighborhood
Hello. Welcome back to another episode of Passive Real Estate Investing. I’m your host, Marco Santarelli. This is the show where busy people like you learn how to build substantial passive income and create wealth for the long term. Thanks for joining us again. Today’s show is very important. It’s about choosing the right neighborhood and how do you go about doing that. This is an important topic.
A lot of people talk about neighborhoods and how they qualify them or grade them, but classifying a neighborhood by type varies from investor to investor. In fact, what many investors refer to as a grade is typically nothing more than a subjective description. Although most people will have a pretty general idea of what is being referred to, in my experience, it is usually nothing more than a qualitative rather than a quantitative description. The fact is, is there’s no formal definition out there of what a neighborhood type or neighborhood grade is.
In fact, if you go back to episode number four where I talk about turnkey real estate investing and turnkey real estate investments, even there I have talked about there not being a formal definition of what turnkey real estate and real estate investments are. Everybody has a different idea or definition of what that might be. In an effort to level the playing field and define what that is, I’ve gone into some detail about that in episode four. If you haven’t listened to that, be sure to take a listen.
With this ambiguity, we’ve, over the years, developed a somewhat proprietary but simple grading system that we use to grade all of our investment grade properties. To help you better understand this, I’m going to go over a basic overview and describe each of the neighborhood types and the grading system and what it means so you have an idea of what it should mean in case you don’t know. If you have your own idea, I’m sure this is going to be fairly similar to your existing model or paradigm of neighborhood grading.
Hopefully, this will help you to better understand how to look at a neighborhood and grade it or put it into some sort of spectrum in order to compare one neighborhood from another and what may be a good choice versus what may be a bad choice. Ultimately, this comes down to what is your investment criteria. If you know what your goals are, you have a strategy, you’ve defined what your criteria is, finding the properties that fit that criteria to meet your goals becomes infinitely easier.
Let’s begin by describing the low income neighborhoods. These are typically what we call C and D grade neighborhoods. These low income neighborhoods generally have a large portion of their residence on government assistance. For example, the section eight housing program. The ratio of renters to owner occupied homes in these areas are often greater than 50% and more often they’re as high as 80%. A C grade neighborhood would probably be 50 to 60, 70% tenant occupied. A D grade neighborhood would be as high as 80% or more. These are general metrics but it gives you pretty good idea. I do find that there is a pretty strong correlation in most neighborhoods using this particular scale.
There’s more to it than this. Again, I am giving you an overview. I’m trying to just educate you about one type of neighborhood versus another. These C and D grade neighborhoods or low income neighborhoods are almost always the most affordable, meaning the lowest priced areas within a metropolitan area or market. Usually have some of the highest rent to value ratios. Often, we’ll see these RV ratios as high as 1.3, 1.4, 1.5% or even higher. This provides some of the highest cap rates and the highest cash on cash returns compared to other neighborhood types. Understand that when you’re investing in a C type neighborhood or a D grade neighborhood, you’re going to have lower property prices and you’re going to have high cap rates, high cash on cash returns.
You will find substantial area anchors within these neighborhoods such as schools, churches, shopping in the form of strip malls. These anchors or amenities are there to meet the needs of the people that live there. I emphasize the word needs. These low income neighborhood are best suited for the wholesale flip strategy.
Now, let’s compare that to a moderate income type neighborhood. These are what we generally grade as B type neighborhood. Moderate income neighborhoods are similar to low income neighborhoods with one critical difference. They have higher home ownership. While low income areas have a large portion of their residence on government assistance, moderate income areas have a large portion of their residence working in the blue collar sectors. These are what I sometimes refer to as bread and butter housing areas.
This stabilizes the neighborhood and it makes it a more attractive investment area. The ratio of renters to owner occupied homes in these areas is much more balanced and it’s closer to 50%. You have 50% owner occupied, 50% renter occupied. Area anchors in moderate income areas are very similar to low income areas or low income neighborhoods but there’s one key difference. Obviously, it’s what we just mentioned, that home owners being a larger percentage of the population of the demographic there, they become anchors as well. I do find that home ownership is an anchor because these types of occupants have pride of ownership and they take care of their properties. They are more rooted in those neighborhoods than tenants are in lower income areas like C or D grade type neighborhood.
From a strategy perspective, moderate income neighborhoods are best suited for wholesale flips and buy and hold strategies. We have a lot of investor clients that focus on B grade neighborhoods because it’s a balanced type of area where you’ll get good quality tenants that are in the workforce, you have high relative rates of return and cap rates. It is a very attractive area to be.
Middle income or what we call A grade neighborhoods are completely different in almost every way to low income and moderate income neighborhoods. The biggest difference are home ownership and the types of employment. Most of the residents own their homes in these neighborhoods and are employed in high level blue collar jobs or in the white collar sector.
Middle income areas are excellent for long term holds because of the stable nature of the area and tenants. The ratio of renters to owner occupied homes is closer to 80% owner occupied and 20% renters. Middle income areas will have a greater number of anchors that meet the wants of the people that live there. Notice that when you have anchors that meet the needs of the people in the low and moderate income areas, the middle income areas have anchors that meet the wants of those people. These include the three Ms, malls, movies and meals.
I didn’t come up with this. Actually it was a mentor of mine many many years ago by the name of Todd that came up with this breakdown and classification for these neighborhoods. I’ve just taken it a little bit further. This middle income areas have larger malls, they have more disposable income type merchants, you’ll find movie theaters, you’ll find restaurants. That’s what is meant by malls, movies and meals. Middle income neighborhoods are best suited for the retail fix and flips if you’re a flipper. Of course, it’s also well suited for the buy and hold strategy if you’re into more premium type properties.
It’s important that we talk about home values here to put this into perspective because it provides a frame or some context when it comes to neighborhood grades versus property values within a particular market. This will differ from market to market because remember, all real estate is local. Home values vary from market to market and between neighborhoods within each of those markets. One should not choose a neighborhood based on the market values alone. It’s usually best to target neighborhoods where property values represent the affordable housing stock in the middle market.
We’ll talk about that here in a second. This is referred to as the median income within a metropolitan area or a market. These properties are often within desirable neighborhoods, making them easy to buy, easy to lease, easy to sell. If you go to one extreme or the other, what you might call the high end or the luxury market or you go into like a D type of neighborhood, you’re going to have a very hard time either buying these properties, selling these properties or keeping these properties leased if at all.
Properties in the upper end of a market’s price spectrum often don’t provide desirable rates of return. While the properties in the lower end of a market’s price spectrum often provides some of the highest expected returns. Notice I mentioned expected returns. They come along with the risk of attracting some of lowest quality tenants, which means you’re going to have headaches, more maintenance and repair, more wear and tear, more tenant turnover, more vacancy or late payments or missed payments. You really don’t want to on the far ends of the spectrum.
Looking at this within the framework of a market’s median home price, which is something I think is important to consider, is how you would grade these classifications relative to a market’s median home price or an MSA, metropolitan statistical area. If you take a market’s median home price and you compare the subject property you’re looking at, whether it’s your property or a property that you’re looking at, and compare. What you will find is that A grade neighborhoods typically will fall at or above the median home price of a market. That could be anywhere from 20 to 40% above the median home price. That is what we would call an A grade neighborhood.
When you look at properties that are priced at the median home price and maybe 20 to 25% below the median home price, you’re going to find those properties are typically B class or B grade neighborhoods. If you go below that, another 30%, you’re going to find those properties are often in C grade neighborhoods. Anything below that will be classified as a D grade neighborhood. Again, this is not hard and fast, black and white and cut and dry. This is a basic but functional scale and grading system that you can use to quickly and easily classify properties based on the amenities and the price relative to the median home price of that particular local market.
When it comes to comparing A, B and C grade neighborhoods, here’s what you’re typically going to find. A grade neighborhoods, which are a little bit more premium, higher priced properties relatively speaking to that market. You will find that these over time will provide the highest return on investment. That’s because these are neighborhoods that typically experience greater appreciation than the lower end neighborhoods within a market. Over time, over the long term, you will find better appreciation potential, therefore higher total return on investment.
Your tenants will typically stay longer, you often attract a higher quality type of tenant. Therefore, you have lower vacancy in these areas. These tenants often will take better pride in where they live and who they are and the possessions they own, the neighbors that they associate with or want to be around. At the end of the day, they often take better care of the property and lower maintenance costs on your part. That just means that there are fewer headaches. It’s just a better quality property and you’ll have a better quality tenant.
We normally recommend properties in A grade neighborhoods for new investors or investors that really just want a hassle free investment. That doesn’t mean you’re detached or uninvolved. There’s always going to be involvement between you and your property manager and there will be small issues that come up from time to time. These are solid areas.
Now, compare that to a B grade neighborhood. The B in B grade can refer to a balanced neighborhood. What you’ll find in B grade neighborhoods are properties that have a decent balance between appreciation or appreciation potential and cash flow. You do get good rates of return in terms of cap rates or cash on cash returns in B grade neighborhoods, but at the same time, you still have attractive appreciation potential. It should at least keep up with the rate of inflation.
Tenants in these B grade neighborhoods are what you may call every day average working Joes. They’re middle to lower middle income tenants. They’re also what I referred to before as bread and butter housing. They’re typically going to be low maintenance, minimal hassle and just decent all around tenants. Your investments in a B class neighborhood would be what I would call middle of the road and well balanced.
The focus on C class neighborhoods is all about cash flow. Investors will invest in C class neighborhoods because of cash flow. They’re not concerned about appreciation or appreciation potential because they’re simply not going to get as much of it as you would if you were in B or especially A grade neighborhoods. The main focus is all about income or cash flow.
Also, it’s important to understand that tenants on average in C grade neighborhoods are going to be higher maintenance. They’re going to be a little bit more difficult to deal with. If you’re not managing your property, you have a property manager in place, they’re the ones who’re going to be dealing with it. Although indirectly you may be dealing with it, they’re going to be higher maintenance for you or your property manager.
These are cash flow properties that are often cash cows. They don’t have large expected appreciation returns over the long term so your overall rate of return is going to be lower, but you can get into high cash flow, high leverage, high rates of return with these types of properties in C grade neighborhoods.
Our focus with Norada Real Estate is primarily in B grade neighborhoods followed by A grade neighborhoods and followed by a small percentage of C grade neighborhoods. Now, when it comes to residential real estate investing, it is not important to have a top rated school system but it is important to have multiple schools located in the area. This is an area that is a little bit subjective because some investors think that they should only invest in areas that have great school systems or you need to be in some of the best school districts. Too many investors put more weight and emphasis on the school’s rating than any other factor, which can be a mistake and it can cost you in lost opportunities.
While many of our investors choose properties and neighborhoods with some of the best school districts, when it comes to investment properties, oftentimes these properties come at a premium price relative to the income that it generates. That means that they have lower rent to value ratios because these are typically in more premium type areas like the A grade neighborhoods and your rent to value ratios will be lower. Many renters are just not willing to pay premium rents for premium schools. A lot of them will settle for good schools in good neighborhoods or great neighborhoods or maybe decent schools in average neighborhoods.
When it comes to crime, generally speaking, better neighborhoods, in other words the A and B grade neighborhoods will have below average crime rates, both violent and property crimes. Although lower relative crime are certainly a desirable characteristic to have, it is not the most important factor in your neighborhood selection criteria.
I’m looking into getting a few guests on the show that have put together an analysis tool that looks at neighborhoods around the country and looks at the neighborhood rental rates, rent ranges, schools, crime rates and just does a simplified neighborhood analysis to compare one potential neighborhood versus another potential neighborhood if you’re in the market looking for investment properties. I will hopefully have them on the show here soon.
A comment about working with a real estate agent or another turnkey provider, if you’re working with a reputable company, such as a real estate brokerage, a turnkey provider or some team members you have in any particular market, be sure that they’re able to provide you with neighborhood characteristics and demographics on any neighborhood that you’re looking to purchase investment property in.
This information is widely available on the internet. It’s scattered, a little fragmented. They should be able to provide you information so you can do your due diligence on the investment opportunities available to you.
While we’re talking about neighborhood grades, let’s take a look at a property that we have in our network in an A grade neighborhood. For today’s deal of the day, let’s take a look at a property we have in the Dallas metro area of Duncanville. This is an A grade neighborhood. This is a beautiful four bedroom, two and a half bath home built in 1998. It’s over 2000 square feet with a two car attached garage. The purchase price is $168,000. Its gross rental income is $1550. After all expenses, the cash flow on this property in terms of the net operating income is a little over $11,000 a year. That gives you a total return on investment of 37.6%. Fantastic property, great area, good school district, good appreciation potential. This is what we would classify as an A grade neighborhood.
If you’re interested in this type of property or anything else that we have on our website, just give one of our investment counselors a call and we can send you more information about the property and the neighborhood. That’s the best way to analyze and create a shortlist for yourself if you’re in the market for an investment property to build your portfolio. We’ll take a look at neighborhoods in more detail as the weeks and months go by in future episodes. We’ll have guests on to describe how they analyze neighborhoods and how they choose properties.
For now, we’re going to wrap it up. Be sure to download our free report, The Ultimate Guide to Passive Real Estate Investing. While you’re on our website, you can submit a question or topic suggestion. Please remember to subscribe and leave a rating or review on iTunes. It would really help us out. We still are giving out a $100 Amazon gift card every week to someone who puts a review on iTunes for us. We really appreciate the feedback, it’s been excellent. I really thank you for that. Again, thanks for listening. We love having you on the show. Spread the word. Remember to subscribe. We will see you again on the next episode of Passive Real Estate Investing.
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