I started investing in real estate nearly 60 years ago, and along the way I compiled a list of real estate investment principles every investor should know. One of the most important rules that many new investors today overlook is one that anyone who has been in the business for more than about 10 years will tell you is among the best to follow:
Buy the worst building in the best neighborhood.
Any experienced real estate operator will tell you this practice is vital, especially in commercial real estate investments. The reasons are two-fold.
- You do not want a class A building in a class D or class C neighborhood. If you have this type of property, then when anything goes wrong in the local economy, your tenants will not be able to pay your rents. During a recession, you will see rents suffer more in class A neighborhoods than they do in class C neighborhoods. In fact, rents may fall 30 or 40% in a class A neighborhood during a recession, while in most cases a class C neighborhood’s rates will fall about 20%. If you own a class A building in a neighborhood that does not have other comparable buildings in it, then you are likely to suffer even sooner and even more substantially when economic pressures rise on your tenants.
- Buying the best building in the neighborhood can limit your potential returns. If you buy a prime piece of property in most good neighborhoods, then you might be able to get as much as a 5% return on your original investment by making improvements. However, find a building into which you can invest some time, thought, and money to improve operations, rental rates, and amenities, and you might make four times as much. In my company, we buy the “worst buildings” because they offer the best returns: about 20% on the improvements when we’re done with them. This also relates to the first part of this rule because if you buy a property that is already too expensive for its location, people certainly won’t pay your rents once you make those improvements and raise them!
In my experience, the best kind of deal you can buy is a building you can improve in a higher-income neighborhood. This allows you room to make changes and still charge attractive rents after making capital improvements.
Samuel K. Freshman is the founder & CEO of Standard Management Company and the author of Principles of Real Estate Syndication, the industry “bible” on the topic. He may be reached at firstname.lastname@example.org or learn more at standardmanagement.com.