The Price Is Determined by Income and Location

The Price Is Determined by Income and Location

Complex Formulas Are Not Necessary
Figuring out how much to pay for a property and how to estimate the profits does not require a complicated, lengthy set of financial calcu­lations! If it did, I can assure you there’s a whole bunch of millionaires out there who would never have made it.

After many years of doing this work, I’m convinced that simple formu­las are the best. But, before I tell you how and why this is true, I must warn you to be very skeptical of “high-tech” computer programs that tend to bowl you over with tons of elaborate financial computations. Hyped-up input data that shows rent increases year after year can make any proper­ty look like a gold mine. However, any experienced landlord or landlady will tell you that rents don’t always go up—and neither do values!

Too many people get all obsessive about complicated strategies. They seem to have the same mindset as body builders who insist, “No pain, no gain.” If you want pain, I suggest you buy a $100,000 house with a $850 mortgage payment and rent it out for $600 a month. If that doesn’t hurt enough, keep doing it. If you need higher levels of pain, buy a motel or small business opportunity. That should be enough.
Another trap that nails inexperienced buyers is relying too much on financial information supplied by selling agents. I have found the income data they provide is nearly always overly generous, while the expenses are usually understated. Before you put too much faith in the income and expense data printed in the multiple-listing book, let me remind you of the words you’ll find printed somewhere on each of the pages—“This information deemed reliable but not guaranteed.” You can get more assurance than that for a kidney transplant! Take my advice: pay very lit­tle attention to any financial numbers that can’t be verified. If they can’t be proven, they just aren’t so.

What Are Gross Rent Multipliers and Why Are They Important?

It’s vital that you understand gross rent multipliers (GRM), as mentioned in Chapter 3, because they will help you to determine the value of a prop-erty—both before you make your purchase and after you’ve fixed the place up. A GRM expresses the relationship or ratio between the sale price or value of a property and its gross rental income. GRM numbers reflect the quality, condition, and location of a property and the average rental income that can be expected for each unit. They directly impact your cash flow and profits.

GRM numbers are not the same for every location. For example, in Redding, California, the numbers vary from four on the low end to 10 for premium-grade buildings; the average is seven. Just 250 miles away, in the San Francisco Bay area, average apartments sell for 12 times their gross income. If a building is managed poorly, the GRM will be lower. Remember: the GRM numbers are set by buyers. When there are many buyers wanting to purchase a very limited number of available properties, the GRM goes up because of the competition. Conversely, during a buyer’s market, when there’s a glut of available buildings, the GRM goes down.

GRMs are not precision measurements; they would not work for brain surgery or splitting neutrons, but they work well enough for making money with fix-up real estate. You must, however, know how to use them properly. It goes without saying that any investment must ultimate­ly be valued on the net income it produces—not the gross. However, as you will see, there’s a direct correlation between the gross income and what’s left over.
In order to establish values and estimate future profits, the first thing I must do is determine the range of multiplier numbers for my particu­lar buying area. This is the essence of knowing how much I can pay, as well as estimating how much profit I can eventually earn. The following chart shows you the range of GRMs in my town. But remember that all locations are different. You must develop your own chart based upon where you invest!

GRM Description of Property Rent
10 Premium-grade. Long-term tenants. Excellent owner management. Shows pride of ownership every day. $525
9 Good property, tenants drive nice cars. Manage­ment very good. Quality maintenance. $500
8 Solid rentals. Most tenants have jobs. Management satisfactory. Little deferred maintenance. $475
7 Decent condition. Blue—collar tenants. Manage­ment OK. Average deferred maintenance. $450
6 Generally older buildings—trashy, rundown. Marginal tenants. Poor management. Needs work. $425
5 Older properties—ugly, junky. Deadbeat tenants. Lousy management. Heavy fix-up. $400
4 Older, “falling down” construction—”pigsty,” Hell’s Angels tenants. No management. Complete rebuild necessary. $375

Selecting the Right Location

As we’ve discussed, location can influence the GRM and the overall value of a property, so be sure to ask yourself these five basic questions before making a selection. If you answer “Yes” to all five, it’s OK to proceed.
1. Would I personally feel comfortable (safe) working in this part of town?
Do I think this particular location is safe at night, relative to other sections or areas of town?
Does this area look like it’s reasonably stable, i.e., not going down­hill, in terms of renter desirability?
Are city or private services—like buses, police protection, schools, fire department, hospitals, and decent shopping—available within a reasonable distance from the property?
Does this location look like a normal rental area, where I can easily attract the kind of tenants I’m looking for—for example, low-income families, HUD-assisted, working class or rich tycoons with Cadillac Sevilles and speedboats?

Cheap Deals in Bad Areas Are Not Worth the Hassle

Don’t buy property near the Beirut Airport or in locations where you’ll need a Bradley armored vehicle to drive through the neighborhood just because it’s cheap. It’s not that you can’t make money in a combat zone, because you can! But you’ll find that houses like the ones I’m recom­mending are not scarce in decent areas once you develop your “star search” network. Bad areas are simply not worth all the hassle or anxiety. Save your energy for painting!

In determining whether the location is suitable for purchase, many inexperienced investors develop tunnel vision. They zero in only on what they perceive to be a cheap price. Remember: if the price is cheap, com­pared with other properties the surrounding area, there’s always a reason. The secret here is to not get sucked in by a cheap price. Make sure the answers to the five basic location questions above are “Yes” before you jump in!
Here’s an illustration of what I’m telling you. Say you negotiate to purchase a duplex in a particular area for $70,000. We’ll say that compa­rable duplexes in the area are selling for somewhere between $85,000 and $90,000. On the surface, without knowing anything else about the deal, it would seem as though you’ve found a property 20% below the average market. That part sounds great! 20% is an excellent discount, under nor­mal circumstances. However, remember that everything that glitters isn’t necessarily gold. Fool’s gold glitters, too!

Will Your Location Attract the Kind of Tenants You Want?

If you answered “No” to any one of the five location questions, you could be buying a problem, regardless of the 20% discount. For instance, a 20% discount is not nearly enough, in my opinion, if you don’t feel comfort­able working on your own property. If you as the owner are not comfort­able being there, I assure you no one else will be either. Worst of all, nei­ther will any potential renters. If the property is in a rough area, only rough tenants will live there.

In the case of a “No” answer on Question 5, you should ask yourself, “How could I ever make money with the property if I’m not able to attract the kind of tenants I want to live there?” Generally speaking, working-class tenants desire to live around other working folks. That’s mainly what they have in common! Conversely, they would not likely be happy for very long living next to nonworking renters who stay up listening to screaming music until 3:00 in the morning. In case you are planning to rent duplexes to the BMW crowd, you better figure on garage doors that open without anybody touching them.

You Can’t Get There (Wealthy) Starting From Here

In my town, basic three-bedroom starter houses cost $105,000. Rented,
½ they’ll bring in $750 per month, tops. With a 30-year, 8 % fixed FHA
mortgage, the payments are $692.03 per month for principal and inter­est. That’s after paying $15,000 cash down, plus an additional $5,000 for all the other costs. When you add in the taxes and fire insurance policy, we’re talking $820 per month without a single nickel for repairs and management. It’s easy to see that total monthly expenses could average somewhere around $900 if I bought this house!
I don’t know about your financial means, but to me this kind of deal doesn’t make much sense! Worse yet, it may not make any profits for years to come. The only thing I can see happening here is continually pay­ing out hard cash every month, waiting for the value to go up or hoping to increase the rent enough to cover monthly operating expenses.

Five Common Locations and Their Investment Potential

Often seminar students quiz me about where to purchase ugly, rundown houses for cheap prices, when I tell them that undesirable areas are off limits and that the newer, tract houses are most likely too expensive to ever produce cash flow! “Where on earth is there left for us to go?” they ask. Here’s the answer, so pay close attention.
Most towns and cities, both large and small, have five separate, but distinguishable, sections where residential properties exist. There are obviously overlapping and combination locations; but, for the most part, the sections are quite separated and, if you think about it, you’ll know exactly where I’m talking about in your town. Here are the five locations. You’ll recognize them, I’m sure.
Snob Hill—where the wealthiest folks in town reside.
Downtown commercial—mostly businesses with acres of concrete and blacktop.
Older residential—surrounding downtown area, generally 50 years and older.
Dense slums—downtown or pocket areas, often older, plus newer projects, most notably HUD projects.
Suburbia—sprawling subdivisions, tract houses, mostly owner-occupied.
Let’s take these five locations, one at a time, and discuss what’s right and wrong with each in terms of investing:
Snob Hill

This is the place to live once you make it! It’s not the kind of real estate to make money with. It’s most certainly prime residential property and will undoubtedly increase in value over time. If inflation breaks loose, obviously, this type of real estate will soar in value, which is exactly what happened years ago in Southern California. Many who bought homes to live in and raise their families watched the values increase 20 times or more during the life of their mortgage.

Still, when all is said and done, modestly priced rental houses did about the same thing with respect to jumping values; but, of course, as their values shot up, they earned their owners steadily increasing rents. Naturally, the big difference between owning a home and owning rental houses is that tenants pay all the bills for the rentals. A home is an excel­lent investment for a family, but the houses you see on Snob Hill will sel­dom achieve cash flow, so long as there’s a mortgage to pay. Even with­out one, the investment returns are not satisfactory for most investors.

Downtown Commercial

Cagey sellers will often attempt to market houses in the downtown areas using the proposition that zoning is commercial; therefore, the property is much more valuable because it has unlimited future potential. Do not fall for this! There’s no such thing as unlimited potential and, although an older house in the downtown area may be an excellent rental proper­ty, it’s still a fish in the wrong pond. Only speculators should buy for the future. Investors should always buy properties and pay for them on the basis of their earning capacity right now. I’m always happy to buy prop­erties with commercial zoning, but I’ll buy them only for the same price that I’d pay without the zoning.

Older Residential

This is the best location to buy for cash flow, the older residential sections surrounding the downtown area. Many of these older properties are func­tionally obsolete, with three bedrooms and one bath or single-car garages. Today’s homeowners are shopping for two bathrooms and dou­ble garages, so investors won’t find as much competition for these prop­erties. Less competition means lower prices, since the owners have fewer selling opportunities. Many long-term owners are in the retirement age group, with mortgage-free properties. There are great possibilities for seller financing—a real plus!
Many of these older properties consist of several (multiple) units on one lot. Often there’s a duplex in the back or a “granny” apartment above the garage. Renters are willing to pay top prices, because they’re close to shopping, yet still able to enjoy the privacy of residential neighborhoods. There’s also a bustling first-time homeowner market when these older properties are cleaned up, rejuvenated, and sold to young couples or fam­ilies. This is the area where rundown properties can be fine-tuned and rented for cash flow or sold on easy terms to a first-time buyer.

Dense Slums

I do not recommend investing in slum areas, even if the property is dirt-cheap or half the regular price. They violate some or all of the five basic location questions listed earlier. The bottom line: when there are doubts about personal safety and marketing opportunities are very restricted, you’re simply taking on too much risk, in my opinion. There are always exceptions, of course, but not very many.

Suburbia

This is the location most investors choose when they decide to acquire residential properties—the giant subdivisions and sprawling tracts of houses, most generally located a few miles from the city core, tied togeth­er by express lanes and freeways. Most subdivisions are occupied by mid­dle-class America.
Buying middle-class houses in these locations makes perfect sense, but very little cash flow. The only opportunity to make any serious money is during inflationary periods or after holding the property 20 years or more until the mortgage is paid off. Few investors I know are able to quit their day jobs anytime soon when they invest in subdivision houses. To me, building a dependable cash flow income is first priority! Tract hous­es purchased at reasonable discount prices are an excellent long-term investment when properly managed. But, if you’re in need of monthly income, this is not the investment to start with.
My suggestion is to concentrate on older residential areas first. Build a solid income and then gradually transition out to the suburbs, if that’s what suits you.
There is no one-size-fits-all in the real estate investment business. You must choose how and where to invest, based on your skills and avail­able funds.

The Myth of Location, Location, Location

When I first started investing in real estate, old-timers always used to tell me, “Son, there are only three things you’ve got to think about when you buy real estate—location, location, and location. If you do that,” they told me, “you’ll end up filthy rich someday.”

But without money coming in every month, small-time investors like me would not likely last long enough to reap the benefits of choice loca­tions. Not only that, but early on I didn’t have the green stuff to outbid my competition, even if choice locations had been my first priority. Don’t get me wrong here. I’m not knocking good locations. I’m merely suggesting that you may need to broaden your vision when it comes to buying income properties. After all, you invest in income properties for … income!

How to Calculate What You Should Pay

To show how to calculate what you should pay, we’ll use a six-unit apart­ment as our example. The property, however, can be two buildings, six detached houses, duplexes, or any combination. (One single-family house is not well suited for the GRM value measurement.) I’ll use the numbers from the GRM chart earlier in this chapter to illustrate how you can put big bucks in your pocket, once you get the hang of this.

Let’s assume we find a rundown fixer property in Redding that can be purchased for five times the gross rents. In Redding, as you can see by referring to the GRM chart, apartments valued at five times gross are renting for $325 per month. That means the purchase price will be approximately $117,000 (six apartments times $325 rents equals $1,950 per month, times 12 months for $23,400 annually, times a GRM of 5). As the chart shows, you can expect the property to be older, ugly, and junky with deadbeat tenants and lousy management. Heavy fix-up is needed— that’s the challenge, but it’s also an opportunity.

So, we buy and fix up the six-unit apartment. Rents are now $450 and the building is worth seven times gross rents. What’s a small, two-point increase in the GRM worth? I think you’ll be pleasantly surprised to find out that the new value is $226,000—almost double the price we paid. Also, the rents have increased $9,000 annually, which should put us well into positive cash flow! These are the kinds of numbers that turn poor fix-up investors into wealthy tycoons in the shortest time.

Don’t Count the Pennies Doing Fix-Up

By the way, most beginners figure too close when determining how much to pay and how much profit is involved. You can’t count the pennies in this business! That’s much too close for estimating. It’s quite common for rental property owners to get stiffed by tenants who don’t pay rent. Deadbeats almost always come with the purchase of low GRM properties. Still, all in all, low GRM properties are by far the most profitable proper-ties—when you know how to fix the problems.
The Value Difference Between Quality Buildings and Rundown Properties
Most folks are really surprised to learn how much difference in value there is between quality buildings and rundown properties. Playing with GRM numbers and figuring values will give you a good idea why fixers are such an attractive opportunity for profit-making.
There’s a tremendous markup in value between a 5-GRM property and one that sells for 10 times the gross rents. I will tell you now, before you start trying to calculate the numbers, that fixing up or attempting to convert a 5-GRM property to a 10 is generally out of the question. That’s far too much change to expect. You simply can’t make a silk purse out of a sow’s ear.

For one thing, the location of the property will limit you! For exam­ple, on the low-income side of the tracks, it’s quite reasonable that the highest GRM sale you could ever expect to find would be seven times gross rents—but that’s where the biggest profits are made. Conversely, in the Snob Hill section of town, you can’t buy a piece of property for less than nine or 10 times gross, even if it needs some fixing up. Furthermore, if you insist on acquiring properties in a more upscale part of town, you’ll certainly be pleased with the beautiful glossy pictures they make; howev­er, you’ll be a lot less happy with the money in your bank account! Folks who buy this type of property lust after prestige and those plaster of paris plaques you get from the Rotary Club!

Cheapest Property Will Likely Offer Best Selling Terms and Biggest Profits

It goes without saying, if you live in a trashy apartment, your rent will be a lot lower than if you live on Snob Hill. Naturally, apartment buildings on Snob Hill are worth much more than the ones at Scumbag Villa. Suppose there’s a six-unit property for sale at both locations. Scumbag has a GRM value of five times gross and units rent for $325 each. (Refer to the GRM chart earlier in this chapter.) The indicated value would be six units times $325 rent equals $1,950 per month, which is $23,400 annu­ally. Multiply this annual gross times a GRM of 5 for $117,000. Thus, each unit is worth $19,500. Doing exactly the same math for Snob Hill, which is valued at 10 times gross with rents of $525, you’ll find that each unit is worth $63,000.
Let me ask you this question: Which property do you think is more profitable—the $19,500 apartments that earn $3,900 annually or the $63,000 units that earn $6,300 annually? Looking at rent returns, you’ll see it takes five years at $3,900 to pay off the $19,500 units, but 10 years (twice as long) at $6,300 to pay off the $63,000 units. Although it’s very important, the “quickest rent pay back” is only one consideration.
Which property owner would you imagine is likely to offer the best selling terms; which would require the smallest down payment and pro­vide long-term seller financing? Which one would be the most motivated to sell? I’m sure you guessed right—it’s the owner who is selling the prop­erty with the most potential for upgrading and improving the cash flow.

Baseball legend Yogi Berra used to say, “Baseball is 90% physical, but the other half is mental.” Real estate investing is something like that! Buying income properties at the right price and terms is about 90% of a successful transaction The other half is doing all the things you need to do to make the property a profitable investment.

Jay’s Super Simple Profit Strategy: Up the Rents and Improve the GRM
My investment strategy is super simple: fix up rundown properties enough to improve the GRM by at least two full points and increase the rents by 40%—and that’s it! Increasing the rents and improving the GRM work together like two singers harmonizing. If one improves, it helps the other.
For example, in my town you couldn’t rent your apartment that’s worth five times gross for $450 per month. The value wouldn’t be there. That’s why $325 is the most you can get. Conversely, apartments that rent for $450 per month are worth much more than five times gross value when they sell. To be exact, they’re worth seven times gross rents, as the GRM chart shows.
If you do it right, you can almost double the value of a property with­out waiting around for regular appreciation or the passage of time! My strategy is called forced appreciation, because I force the property value to increase by improving the GRM.
By increasing the GRM value by two points, I can automatically raise my rental income by 40%. Both improvements result from four basic actions on my part:

I clean up the ugly property to make it more attractive in appearance.
I evict the problem tenants and the deadbeats.
I fix up deferred maintenance and make improvements to attract bet­ter tenants.
I provide the proper management to operate the property more effi­ciently.

That’s it! See how easy it is? In order to achieve maximum results with this strategy, it’s necessary to purchase low-GRM properties—maybe not the very bottom, but as near the bottom as your fix-up skills will allow. Naturally, your skills will improve with each new purchase and, eventually, you’ll end up just like me. No property is too bad, no problem is too tough, if the price and terms are low enough.
There’s a Time to Sell and a Time to Buy
Investing in real estate the way I do it—that is, buying fixer houses and so forth—will not be a profitable venture unless you can properly time your acquisitions and sales. Proper timing is worth big bucks!
For example, today in Southern California, three-bedroom houses that once sold for $375,000 might be a tough sale at $325,000! Some are down by $100,000 in areas where big defense contractors have laid off thousands of employees. The point is, you shouldn’t plan on selling when prices are down. Obviously, if you don’t sell now, you will need to rent your properties until the market improves.

Real Estate Prices Go Up and Down

The real estate market is cyclical! It goes up and down, like a yo-yo, and it always has! A 20% swing in the cycle can be worth as much as $40,000. That’s because, in a seller’s market, $100,000 properties can often be sold for $120,000. This happens when many buyers are chasing too few prop­erties. Conversely, the same properties can be acquired for $80,000 when times are tough and buyers are scarce. It goes without saying that own­ers who tailor their investment plan (buying and selling) to match the real estate cycles can greatly benefit their bank accounts.
I have long supported the proposition that mom-and-pop investors must learn good landlording skills in order to earn serious real estate prof­its. When the market is down, you want paying tenants renting your hous­es. Paying tenants will afford you the luxury of continuous income while you ride out the low cycles. With income, you can patiently wait to time your sales properly. Many investors continue to ignore this wisdom, hop­ing to earn big profits, regardless of what real estate cycle they are in! This strategy, if you can call it one, is akin to driving your car through stop signs everyday, hoping that no other driver will be coming the other way.
Rely on Cash Flow, Not Speculation About the Future
Most new investors spend far too much time trying to figure out the future of properties they’re interested in buying. This is actually unpro­ductive for novice buyers who have very limited knowledge about real estate growth and development.
I’ve purchased some dandy properties with future commercial zon­ing, which I thought would pay off big-time, like slot machines, whenev­er development came my way. Development came all right—but on the opposite side of town. My rental houses are still just sitting there doing the same thing they’ve been doing for years—producing cash flow!

When I look back at all the properties I’ve acquired over the years, it occurs to me that picking locations has not been my greatest strength. It’s not that I don’t have some good locations; I do. But, to be perfectly honest, they weren’t so hot when I bought the property. What happened in several cases was that new development sprang up around my older houses, creating much more desirable surroundings. There is simply no way I could have predicted this would happen when I bought them 10 or 15 years ago.

As I look back over 20 years or so, the most important thing I’ve ever accomplished with my real estate holdings was to buy them so they would pay me money every month—producing cash flow!
Overpaying—The Deadliest Investor Sin
Overpaying for income properties is probably the biggest single mistake an investor can make—especially investors who lack sufficient knowledge to recuperate from such an error! It’s not just new investors or first-time buyers who make this mistake. Many buyers with years of experience fall victim to overpaying when they purchase properties in unfamiliar territo­ry. It’s absolutely essential to heed the old adage about buying wholesale and selling at retail if you intend to make any serious money in real estate.
Here’s the bottom line—you can’t expect to make money in real estate unless you learn to pick out bargains and buy them at wholesale prices. You must lock in profits and future equity buildup at the time you buy. Learning to master this technique is not optional.
Let’s suppose you’re just starting out, like many others who seek my advice. You don’t have much money, knowledge, or experience. However, you’re sold on the idea that investing in real estate will make you wealthy and you’re very excited. You can’t wait to get your feet wet, so you race out and find a seller who will accept no down payment or very little cash. However, in your haste, you forget what I told you about the price—you pay the seller retail. That’s not what you should do. That’s what dummies do!

If you do start out paying retail, chances are you’ll never make a prof­it on the deal. To make matters worse, you’ll most likely have a negative cash flow every month. Plus, if you’re married, it will certainly put a strain on that relationship. The worst mistake income property buyers make, in my judgment, is buying income property that won’t produce income. Overpaying is like a fatal disease for many investors; but, unlike other fatal diseases, science is not working on a cure for this one.
Almost every investor I know has paid too much for income proper­ties. It happens quite frequently when we first start out. There is almost no defense against paying too much as least once or twice. I’ve done it more times than I care to admit. However, in my case, buying fix-up prop­erties allowed me to add value and improve the income stream more quickly than if I had overpaid for average non-fixer properties. By fixing and adding value to properties, I’ve always been able to recover from my overpaying errors much faster.

Investing Long Term for Future Growth

Life is full of compromises—and it’s the same way for investing! I’ll be the first one to agree that beautiful properties in top locations will increase more in value over the long haul. The sacrifice, of course, is that these same properties will pay you nothing while you wait!
You can overcome the problem by adopting a strategy to acquire two different kinds of properties. Why not start out with fixer-type properties that can provide a solid monthly income? You may call this Phase One. Phase Two can be a gradual transition into nicer properties, with better long-term profit potential. However, do this only after you’ve secured the money to buy groceries.
Each type of property has good and bad features. For example, small rental houses can earn twice as much net income as larger homes. Repairs and fix-ups are much more economical in small, not so perfect houses. Rough tenants can do far less damage in smaller units that are not equipped with modern amenities like many of the larger and newer houses.
For most of us, it makes more sense to buy cash flow properties with uncertain futures than to acquire high-potential properties without enough cash flow to operate them right now.
The top three reasons for owning and operating income properties are income, income, and income. Everything else starts with number four.

Read next Fixer-Uppers part 9

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