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Why don’t the wealthy invest more in the best ZIP codes?

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The three most important things in real estate are location, location, location. We have heard that claim all our lives.

So why do fewer than 10% of the apartment transactions happen in the glamourous ZIP codes? Are rich people dumb about investing, or is there more to the story?

Another old adage we often hear is “You get what you pay for.” The implication for real estate being a higher priced area will mean easier management, fewer evictions, and better income.

Many novice investors assume that purchasing units in the most expensive ZIP code will be a better investment than an asset in an ordinary ZIP code. Very few proven investors really purchase rental housing in the upscale ZIP codes. What do the proven investors understand that the rookies don’t yet know?

This article considers math in more detail than most in this series. These ideas may seem counter intuitive. If the words don’t make sense, contact me to receive a spread sheet which should clarify the numbers.

How does the loan to value affect the investor’s return?

First, recognize that most apartment properties are bought with a loan; few are all cash purchases. The property must generate enough cash after expenses to cover the debt and have a small cushion. Prudent lenders want $120 of cash flow for every $100 of mortgage payment.

Compare some ordinary areas like El Cajon or Escondido, to units in the beach ZIP codes.

Ordinary Locations (El Cajon, Escondido) Beach Locations (PB, Pt. Loma, Encinitas)
Current Price


$3,000,000

20 units


$1,800,000

6 units
Loan


$2,100,000

70%


$900,000

50%
Down Payment Required


$ 900,000

30%


$900,000

50%
So, for the same down payment, you buy more than three times the number of units in an ordinary location as you do in the beach neighborhoods.

Is beach cash flow higher than inland?

Well, no. Most of the costs like insurance, maintenance, utilities, and management are surprisingly similar, regardless of neighborhood. Property taxes are the biggest expense, just over 1% of the purchase price. A higher price per unit means higher taxes per unit, plus the beach needs bigger down payment per unit. The higher property taxes per unit offset the higher rents that are possible at the beach. Surprisingly, cash return on the down payment is nearly the same.

In a decade will the beach equity grow to a bigger amount?

Not necessarily. Let’s assume the ordinary location increases about 3% annually, or by a third from $3,000,000 to $4,000,000. That adds $1,000,000 equity in the common ZIP codes. What does it take for beach equity to match that million dollar increase at a beach asset? Beach value would need to climb 55% from $1,800,000 to $2,800,000.

For the sake of discussion, let’s look at values after 10 years assuming the ordinary location increases by 33%, and the beach locations actually do increase by 55%.

Ordinary location (ie El Cajon, Escondido, Oceanside) Beach Locations (PB, Pt. Loma, Encinitas)
Price after 10 years


$4,000,000

20 units


$2,800,000

6 units
Loan


$2,800,000

70%


$1,120,000

40%
Down Payment Required


$1,200,000

30%


$1,680,000

60%
Taxes per unit will be just over $4600 per unit vs just over $2000 per apartment in ordinary cities. Down payment per unit will be nearly five times as high in beach communities ($280k per unit) than inland ($60k per unit.) Higher taxes and higher down payment always work against the expensive ZIP codes, and the cash flow will probably be lower.

Few seasoned investors believe that fancy areas will grow substantially faster than the rest of the county forever. The beach is certainly more desirable, but that doesn’t mean expensive ZIP codes will outperform more modest neighborhoods.

Conclusion:

Location, location, location matters … for your primary residence; where your kids go to school, or where you retire. It can be wise to pay a premium.

Owning rentals in plush areas may not be the best investment. More than 90% of experienced apartment investors purchase in ordinary ZIP codes.

Investors can obtain safety or peace of mind with beach assets. Investors wanting superior returns will do better in most other area. Investigate, before you invest. Investigate not just the investment, but also your assumptions. Work with a proven coach, a guide who understands how things work, and will honestly challenge those assumptions and provide alternatives.

~~

Terry Moore, CCIM gleefully serves investors in all ZIP codes. He has represented sellers of ocean front property, in fancier areas like Rancho Santa Fe, as well as all those cash flow neighborhoods. Terry is principal at Apartment Consultants Inc. Reach him at: SanDiegoApartmentBroker.com, or 619-889-1031 or tmoore1031@gmail.com

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