by Jack Hilton II | Hilton Financial Corporation
The following are a few topics an investment guru will know forwards and backward. These are, incidentally, issues of primary importance in choosing a real estate investment. You may be familiar with several of them. The first rule of thumb in real estate investment is that old saw, “location, location, location.” Contrary to popular belief, this doesn’t mean that you should only invest in the best locations. More often, it means that your investment model needs to suit the location of the property and your personal risk tolerance.
It would be nice to operate solely within neighborhoods that have great demographics: high disposable income, low crime, excellent schools, etc. But the reality for most beginning investors is that Silicon Valley condos and Scottsdale mansions are out of reach. For the average investor, reality means starting with a modest fix and flip or rental. As we gain experience, we tend to gravitate to the products that suit our temperament naturally.
I’ve worked with many investors who never thought they would be building homes in South Phoenix or renovating historic properties off 3rd and Roosevelt. It just wasn’t in their game plan. But they fell into it because they took a gamble that paid, and then they figured out how to replicate that success. The locations in which they developed their niche weren’t traditionally considered “great areas.” But those investors became successful because they understood their location, understood their financial limits, and understood the real value of their products.
Location, finances, and value – not exactly groundbreaking focal points.
So why do so many first-time investors fail? Usually, it comes down to a miscalculation in one of these areas.
Let’s look at location. The primary method used to analyze property is to look at surrounding properties. Several demographic factors reveal the state of a sub-market. I’ve already mentioned several indicators of a good market: high disposable income, low crime, great schools. High disposable income markers tell you that the market can absorb growth. With disposable income, crimes of desperation tend to be less frequent. With less crime, the neighborhood becomes a more attractive place, generating more competition for available real estate, pushing prices up. As prices rise, property taxes trend upward, generating more revenue for schools. Better education leads to more disposable income, lower crime rates, more tax revenue, better ed. You see the cycle.
Many of these demographic data points are available through your Realtor’s MLS. Finding a Realtor who knows and understands this data is crucial to understanding the market and targeting a viable investment location. That kind of Realtor will be able to help you understand historic trends and adjust your investment strategy accordingly.
In areas with higher crime or worse schools, vacancy rates are going to be higher, the costs of holding property will be proportionately higher, insurance claims tend to be more frequent, and home prices lower. You’re going to need to understand how these markers influence your purchase price, renovation, or build costs, holding time, and sales price. Ultimately, there is a dollar figure associated with these riskier areas. But these areas also tend to have lower barriers to entry. The savvy investor will take these factors into account, only pulling the trigger on an investment when the entry price is low enough to make up for additional costs.
When I was new to the business, I learned this lesson about miscalculating additional costs. I had a borrower who specialized in renovating homes on the historic registry. Most of these homes were in downtown Phoenix along the Central Corridor. He knew the codes like the back of his hand. He had lots of friends in the local historical society. He knew his costs to renovate in and out. He knew his target market and what he could sell his products for. Then one day, he came to me excited about a new project several miles south of his usual haunts. It looked like a good deal on paper, so we funded it.
He sent his demo crews through the old house, completely gutting the structure. But every day, some tools would wander off. Or materials. The area had significantly higher vacancy and crime rates than he was used to seeing. In a short time, it became difficult to get his crews to show up to the job site. He had to evict vagrants regularly and deal with constant vandalism. Renovations slowed to a halt. He chewed through his contingency line and interest reserve until he couldn’t make payments anymore. Then the great recession hit. He signed a deed in lieu of foreclosure, losing thousands of dollars. What went wrong? He didn’t understand the location well enough to account for the additional costs of appropriate security measures. Neither did I. We made the mistake of assuming the area was like the other one where we had made a lot of money together. We didn’t look at the property demographics closely enough, and that lack of research bit us.
The project didn’t fail because the investment was inherently bad. It failed because we didn’t properly account for the challenges it faced. Our investment models didn’t suit the location of the property. If we had known then what we learned shortly thereafter, my borrower would have lowered his purchase offer, and I would have checked for a security line in the cost breakdown.
And what happened to the project? We owned it. We rode the market cycle until we found a partner who knew to put up a security fence. We split the lot, built out two houses where one used to be, and recovered the principal we would have otherwise lost if we had walked on a fire-sale.
Contact the Author
Jack Hilton II
Hilton Financial Corporation
11024 N. 28th Dr. #170
Phoenix, AZ 85029
NMLS 1471011/ AZ LO 0935845
NMLS 143636/ AZ BK 1001945