Why Real Estate Investors Pay More for Investments with Lower Returns
Published on: Friday, December 18th, 2015
5 reasons why buying cheaper real estate investments isn’t always better.
Real estate Investors often chase the highest initial returns possible in an investment property, only looking at the financial statements for their underwriting and financial projections. These investors often fail to account for the many additional factors that should be considered when purchasing an investment property. Failing to consider these critical aspects will affect the expected returns over the life of the investment both in the short and long term, and will leave the investor dazed and confused when looking at that real estate investment’s performance.
Why are sophisticated real estate investors willing to pay more for certain properties and accept lower initial returns, while most inexperienced real estate investors are only concerned with buying cheaper investment properties with a higher initial return?
Below are five reasons experienced real estate investors choose to buy investment real estate with a smaller initial return, and why you should consider them for your portfolio.
- Stable and more consistent returns. Experienced investors are willing to pay more for properties demonstrating consistent financial performance over many years, which are in solid locations where the tenant base won’t deteriorate. They understand that while past performance doesn’t guarantee future results, it IS a good indication of how the property will perform. Many investors would rather have smaller, consistent returns than higher up and down returns, and they’re willing to pay for properties that provide them.
- Less risky and fewer unknowns. If the property is newer, well maintained with little to no deferred maintenance, and well managed, you can be more confident that you won’t get hit with unexpected major expenses when you operate the property. Buying a better maintained property allows you to put your money directly into the property instead of having to bring large amounts of additional capital to the investment after purchases to fix deferred maintenance items from the previous owner. When you buy a higher initial return property that has not been properly maintained, you have to spend additional capital fixing deferred maintenance or taking care of unexpected maintenance items that raise the operating costs and lower the expected returns.
- Better quality tenant with more disposable income. Properties that have been well maintained and well managed attract a higher tenant profile. These tenants normally have a higher and more consistent income plus more disposable income. This means that they can normally pay their bills on time and it’s easier for them to absorb rent increases. Many investors are willing to pay more for these properties because they know that the tenants can afford to live there, which leads to higher collections and the ability to maximize rents and force appreciation of the property.
- Ease of management. Investment properties that have been well maintained and managed are usually easier to manage. Well maintained and managed properties attract tenants who will take care of your property. Typically, when your tenants put down a bigger deposit and pay more for rent, they take better care of the property. This leads to lower turn costs as tenants move out, and new tenants who will live at your property longer. In contrast, properties that have been poorly managed and taken care of attract less stable tenants. These tenants often create issues such as crime, inconsistent paying of rent, or trashing of units when they move out.
- Sell for a premium. Experienced investors know that well maintained and managed properties will attract more potential buyers who are willing to pay top dollar. The more potential buyers for your property, the higher it will sell for, bringing the owner maximum return on investment. In more desirable properties, every dollar that you increase the Net Operating Income during the life of your investment is worth more than with a higher initial return investment. Well maintained, well managed, and well located properties usually have more appreciation potential for these reasons.
When considering an investment property it is important to consider more than the initial cash returns that the property produces. What type of owner do you want to be? Are you comfortable with property that produces a higher return but has challenges described above, or would you prefer a property with less challenges, but a lower initial return and more appreciation potential? While an initial higher return property might be attractive, it can also leave you wondering “what happened to the anticipated returns?” if the property breaks down or the area changes in demographics.