You’ve probably heard the age-old maxim, “Buy land, they’re not making any more of it” as a justification for investing in real estate. Of course, it’s a bit more complicated than that, with so many different kinds of real estate - residential, commercial, industrial, farmland, and now even virtual land - and so many different ways to invest. While every property is unique and needs to be evaluated individually, it is helpful to understand what to look for first when deciding to invest into real estate.
Operator
For any way of investing into a property you are not buying yourself, it is as important to research the people behind it as it is to research the property itself. Look into the track record of the platform, the sponsor (the person or company behind the project) or flipper, the property management team and anyone involved with the project. Look at their previous projects to see if they have achieved successful exits and have a history of meeting expectations. See how long they have been in business to see if they have survived a bear market. Anyone can give a projection of outsized returns but not everyone can back it up with a record of achieving them. Read the offering memorandums and look at the financial projections to try and figure out if what an offer is advertising is realistic. Look at the fees that the platform or sponsor is taking and understand what the incentive structure is like. It is always best if they have “skin in the game” and their incentives are aligned with the investors’.
Location
Another tried-and-true cliché when it comes to buying real estate is, of course, that the three most important factors are “location, location, location.” Not every real estate investment is a good one, and often the difference between the best ones and worst ones comes down to, well, their location.
In real estate investing across all types, properties and neighborhoods are generally rated on a letter grade scale - “A”, “B”, “C” or “D”. It is used as a shorthand to describe the type of neighborhood and the type of building in a given offering. It should give investors an idea of potential maintenance costs, the typical tenant base in an area, and generally the level of risk associated with an offering. For a neighborhood, the grade is determined by the types of properties in a neighborhood, the crime rate, and proximity to desirable commercial areas, parks and schools. For a property, the grade is determined by its age and condition, and the quality and type of amenities offered.
Class “A” - Class A neighborhoods are the wealthiest in a given area, generally with large single-family houses or luxury multi-family apartment buildings. Crime is virtually nonexistent, unemployment is low, and schools are highly rated. Upscale restaurants and shops are nearby and commute times are short. Class A properties are newly built or newly renovated, usually with high-end finishes, manicured landscaping and amenities like parking, swimming pools and gyms.
Class “B” - Class B neighborhoods are generally upper middle-class areas with above-average schools, a low crime rate and in close proximity to commercial areas. Class B properties are still in good condition but are usually built with average quality materials and finishes and feature fewer amenities.
Class “C” - Class C neighborhoods are more working class, with more modest single-family homes and apartment complexes with lower rents. Schools are generally average to below average and the crime rate is average. Class C properties tend to be older and unrenovated with no amenities.
Class “D” - Class D neighborhoods are rough - high crime rates, abandoned and dilapidated buildings, poorly rated schools and high unemployment rates. Class D properties are those that need full renovations.
The better the neighborhood, the higher and more stable the appreciation rates tend to be, but the tradeoff is lower potential cash flows - generally the price of properties are high relative to potential rents. However, the vacancy rates are lower and quality of tenants are higher in the better graded neighborhoods. Properties in poorly graded neighborhoods may look good on paper, because rents are higher compared to property values, but high vacancy rates and higher rates of nonpayment of rent often lead to poor outcomes. Overall, higher graded neighborhoods and properties are less risky but may have less upside.
It is important to remember that while generally the two grades are related - most properties in a Class A neighborhood will be Class A properties, that is not always the case. For example, there can be a Class C property in a Class A neighborhood or a Class B property in a Class D neighborhood. It is also extremely important to consider that the grade of a neighborhood is not set in stone - some of the best investments can be in a neighborhood that might be a Class C now, but could be a Class B or even Class A in the future. Another good strategy is to look for “the worst house on the best block” because a house or building can be renovated relatively quickly but it may take a lot longer for a neighborhood to change.
Conclusion
Understanding the different categories of neighborhoods and properties is a helpful tool to filter your property search and is also useful as a quick way to compare properties. If two properties seem similar, but one is in a Class A neighborhood and one is in a Class C neighborhood, that can go a long way in explaining any price difference. Ultimately, every property should be researched individually and this is vital information to get the process started.
