How to find the “Sweet Spot”
In any given real estate market there as many bad deals as there are good. When shifting through this vast selection of potential opportunities it is important for an investor to be able to find what segment of this inventory will provide the best candidate for their portfolio. When analyzing a market there are 4 areas that are paramount in finding those good deals:
Cash Flow, Appreciation, Hassle and Liquidity
These investing "criteria" will ultimately determine the true performance of any investment property. Finding the best combination of these factors can lead an investor to a "Sweet Spot" in a given market where the potential for performance of the asset is at its highest.
Looked at further in depth, Cash Flow will always vary based on the price of a given property and the rent received. A common rule of thumb used is the "1% Rule", shown as a ratio of monthly rent to property value. Using this rule provides a quick guide to evaluate cash flow in a particular property. In evaluating a potential investment an investor will see that rents for a property increase at a disproportionate rate to home values, thus lower cash flows occur as home prices increase. A real world example is shown in California where given the height of the median priced home it is very difficult, if not next to impossible, to be in a positive cash flow position. In contrast, lower priced homes often appear to have the strongest cash flow potential. An investor will need to find a property that lays within the segment for the strongest cash flow potential remembering that cash flow is only one component of these investment criteria.
Appreciation, or equity build up, is another factor to be considered and there will be a similar relationship tied to appreciation and property values for the investor to consider. Again the goal here is for an investor to find the segment of the market where their potential to capitalize on this appreciation is at its highest. Looking at the ends of the spectrum, low priced homes do not have the necessary quality of property or location for solid appreciation. Conversely, high prices home have solid appreciation potential, but as discussed before have little to no cash flow.
The Hassle factor is one the more over looked components of this discussion. The time and work involved dealing with the typical tenant and quality of home given a certain price range will affect both the investors’ returns and their “peace of mind”. In low priced properties this hassle factor can be seen in many forms such as higher maintenance fees and repairs that come with older, lower quality homes. The average tenant in these homes also brings higher vacancy (both physical and economic), higher crime, property damage and management headaches. Important to note here is that those apparent great cash flows with low priced homes evaporate very quickly with these expenses. With high priced homes the opposite is true and an investor can find a more hassle-free investment. Remember again that these high priced investments struggle to cash flow.
Lastly there is the Liquidity of the investment opportunity to consider. In assessing a potential opportunity the investor must look at the full cycle of ownership thus measuring the exit strategy, or the ease and ability to sell the asset. It is true that for both high and low priced homes the sale is much more difficult due to the limited size of the qualified buyer pool. This difficulty of exiting can leave an investor with an asset that they must either continue to hold on to or sell at a deep discount, both of which dramatically affect the returns provided. We often like to joke that a cheap home is like the Hotel California; you can check in but, you can never check out.
For an investor, considering each of these four criteria is imperative to finding solid and true performing assets. To oversimplify these factors quickly show that a home can be either too expensive or too cheap to truly capitalize on returns. Many investors are unaware about the “too cheap” paradox often being hyper-focused on purchase price alone. So where is this "sweet spot" one might ask?
The true Sweet Spot in any market will be where the combination of these four factors overlay. We find this spot to be within 30% of the median priced home or, in other words, at the low end of the middle of any market. These solid cash flowing, strong appreciation, low hassle properties found in the Sweet Spot will give an investor the greatest odds for success.
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