As a contractor who works exclusively with real estate investors, I often hear some “dangerous language” from my clients. I’m not talking about obscenities! I’m talking about investors who are so eager to spot the “next big thing” that they convince themselves that certain areas are about to take off in value when, in reality, those areas are still fairly risky places to invest. Although most real estate investors do have a certain degree of emotional detachment that other buyers may lack, they still can and do talk themselves into bad decisions because they do not want to miss out on a great opportunity in a hot market. Fortunately, there are some ways to spot a legitimate upward trend in real estate and identify areas that may be false alarms so that you don’t fall victim to local market hype.
How It Starts
Transition Alert: When I hear multiple investors say they are buying properties in an area for $30,000 over what I believe based on experience those properties are worth, I know it’s possible that neighborhood is heading for transition.
In Transition: When a neighborhood is experiencing appreciation and/or increased demand from local buyers.
When investors I work with start telling me they are paying what I consider too much for properties in an area, that’s the first sign for me, as a contractor, that a neighborhood could be in transition. For example, if I start to hear from clients that houses in neighborhoods I know full well have properties worth right around $140,000 are going for $175,000, that is an indicator the market is pushing upward. The question then becomes, “How far away is the ceiling on this upward momentum?”
I have to answer that question for two reasons. First, I don’t want one of my clients to make a bad investment if I can give them fair warning, and second, I don’t want to end up working on a job on which the client ultimately cannot compensate me because they miscalculated their returns when they evaluated the deal.
Signs of True Transition
Once you suspect that a neighborhood is transitioning, investors need to take a careful look around before buying. Otherwise, you could end up stuck with a beautifully-renovated property that utterly fails to fit the needs of local buyers. Here is a great example that shows how transition can be a little bit tricky to spot:
I was checking out a property in a neighborhood that is allegedly transitioning. My investor insisted the property was worth $250,000, but when I looked next door there were chickens running around in the front yard and a goat out back – and this is not a farming community!
The investor firmly believed young families would want to buy this house at a premium price despite the somewhat “unconventional” neighborhood. Why? Because, as he put it, “They will want the ZIP code. They know the neighborhood is going in the right direction.”
That sounds great, but is it true? Do these presently-unknown buyers really want that ZIP code badly enough to buy next door to chickens and goats? Do they actually “know the neighborhood is going in the right direction?”
Once I spotted the livestock, I had to look beyond the goats and chickens to see the facts of the matter. In this instance, the neighborhood in question is a hot market right now. It used to be a really nice, older part of town, then it experienced a downward phase. Now it is coming back, and the entire area is enjoying watching it happen. As a result, it is becoming a popular ZIP code again. The area is truly transitioning, and that investor is not just making hope where there is none, although he does need to be careful not to overpay for the property.
Comps are Everything
Definition: Comparable Sales (Comps): sales prices of similar homes that have sold in an area. Comps should not include pending sales or active listings, although you should evaluate those values separately.
At the end of the day, an investor who relies on existing comparable sales (comps) in an area to support the idea that the area is transitioning will probably be on stable footing. For example, if you have three houses that have been rehabbed with the recent color palates and design schemes and then sold for a comparable value to the home you wish to rehab, your odds are good the area will support the fourth rehab even if there are still chickens, goats, and older properties in evidence. All you need is one or two investors in an area to set a true trend. However, you do not want to be the first investor in the area unless you are very experienced in identifying and even setting transitional trends.
Be Willing to Be Wrong
At the end of the day, real estate investors who are willing to revise their opinions on an area, even if it means acknowledging they were mistaken, are the ones who will live to invest another day. While I have seen firsthand how exciting and rewarding it is to “call” a transitioning neighborhood correctly, I have more often seen how painful it is to miscalculate the returns on a deal because an investor got carried away with the idea that they had spotted the beginnings of the next local market boom. Look carefully, act cautiously, and be willing to let go of your dream deal if the signs of transition are not really there.
The Latest and Greatest
In most cases, transitioning relies heavily on an area rising in retail value, not in value just to other investors, as would be the case in a neighborhood full of rentals. That is why the details of someone else’s rehab can provide you signs you are spotting a transition trend rather than just reacting to heated investor interest in an area. Ask yourself: Does the rehab cater to owner-occupant buyers rather than renters or other investors?
Color palette, appliance choices, and physical layout in a property are all indicators of what an owner hopes to accomplish with a rehab. For example, the current favorite color palette for buyers revolves around cool gray schemes, compared to a year or two ago when more designers were working in shades of brown. If a rehab is done in a brown color palette, which is also often less expensive than the cooler colors, the owner may be thinking the property will appeal to a landlord rather than an owner or the rehab may not be as recent as you think.
Both options, rehab-for-rental and slightly-dated rehab, may indicate your transitioning neighborhood may not be as hot as you thought. Similarly, outdated appliances in a recently-rehabbed home or a boxy, constricted layout instead of today’s popular open layout can indicate a rehab is too dated or not designed to attract a retail buyer ready to pay top dollar.
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