Stop Investing in C and D Class Neighborhoods: 3 Reasons Why

I can already hear the boos and chagrin. Before you get too worked up, let me define my definition of the asset classes in Indianapolis.

A Class

  • Highest purchase prices
  • Best restaurants, schools and most qualified rental applicants
  • Typically low risk, low reward

B Class

  • Moderately high purchase prices, slightly older homes
  • Desirable neighborhood, mostly “middle class” rental applicants (some “working class”)
  • More ‘hipsters’/millennials as prices more affordable for first time home buyers and urban professionals
  • Typically moderate risk, moderate reward

C Class

  • Affordable purchase prices, older homes with some deferred maintenance issues
  • Mostly working class, crime might be a concern for some renters in this area
  • Typically high risk, high reward

D Class

  • Dirt cheap prices, oldest homes with many vacant in the area
  • If you don’t lock your car, your valuables will 100% be gone — check that, your car probably is gone altogether
  • Highest risk, highest reward

You can also check out this BiggerPockets post by Brandon Turner which describes asset classes.

Middle Class single Family Home

Now that we’re on the same page, let me give my pitch.

Higher Total Return

As many investors simply analyze a deal based on cash on cash returns, I rarely hear investors talking about the total return metrics. I’m going to start with the big guns – the numbers. Let’s start with a breakdown of the three total return levers.

  • Mortgage Paydown
  • Appreciation
  • Tax Advantages

Let’s look at an example of a B deal LIV frequently sources and a common C class deal and how total return may affect the long-term returns. I’ll assume 20% down payments on 30-year, fixed, 5.5% interest loan.

Example: B deal versus C deal

B Deal  

ARV: $175,000

Rent: $1,625 per month

Cash Flow: $350/mo

  • Mortgage Paydown
    • $140,000 paid down over 30 years
  • Appreciation
    • Assume 3% appreciation over inflation year-over-year
      • 2048 value (today’s dollars): $424k
      • Gain: $249,000
  • Tax Advantages
    • I consider all tax advantages “icing on the cake”. I let my CPA be the expert here.
Total Return Estimate:
    • Cash Flow: $126,000
    • Gains (plus tax advantages): $389,000 (mortgage paydown plus appreciation)
    • Total return estimate: $515,000
  • Yearly return: $17,166 per year
  • Cash on cash return: Incalculable if you successfully force equity with a rehab
      • With a $43,750 down payment: 39.24% total return year-over-year

C Deal

ARV: $47,500

Rent: $650

Cash Flow: $100/mo

  • Mortgage Paydown
    • $38,000 paid down over 30 years
  • Appreciation
    • Assume appreciation is 0% over inflation
      • 2048 value (today’s dollars): $47,500
      • Gain: $0
  • Tax Advantages
    • I consider all tax advantages “icing on the cake”. I let my CPA be the expert here.
Total Return Estimate:
    • Cash Flow: $36,000
    • Gains (plus tax advantages): $38,000 (mortgage paydown plus appreciation)
    • Total return estimate: $74,000
  • Yearly return: $2,466 per year
  • Cash on cash return: 26.67%
      • With $9,500 down payment: 25.9% total return year-over-year

With a Niche Rental Audience, Create an Unfair Advantage (Lower risk and higher return)

LIV targets urban professionals who rent with roommates. By targeting this rental segment, LIV is often able to achieve above market rents for its clients. Fundamentally, this increases the investor’s return, while maintaining the same risk profile. Simply put, it allows our investor clients to purchase properties in A and B areas (low to moderate risk), often times renting to urban professionals for above market rents (moderate to high returns).

On the flip side of the coin, it’s much more difficult to rent to a niche market when marketing C and D rental properties. In my experience, about 1/10 tenants are qualified to rent a C and D property. Property management will spend most of its time qualifying prospective tenants and dealing with a higher volume of tenant issues and repairs. They won’t have the time or resources to focus on a niche rental audience.

Use the BRRRR Strategy to Force More Equity

After reading #1 in this list, would you rather make a projected $17,166 or $2,466 per year in estimated value? It’s not a trick question. Using the popular BRRRR strategy, you could have $0 cash in the deal and still realize this whopping yearly return.

Over and over again, I hear investors say something like, “I’d rather get started with a $30k property because it’s a safer investment – if I lose, it’s only $30k”. I cringe every time. Fundamentally a C class investment is a “high risk, high reward” investment strategy. It’s not a safer investment, it’s actually riskier due to higher vacancy risk, turnover costs, etc. Plus, it’s MUCH less likely to build massive wealth creation (i.e. $17,166 per year versus $2,466).

By targeting a B asset in Indianapolis, for example, an investor can layer on the BRRRR strategy to rehab the property and drive immediate equity.

B+  deal –

Purchase price: $90,000

Rehab cost: $40,000

All in cost: $130,000

ARV: $175,000

Rehab Equity Estimate: $45,000

I’ve pitched my case. What do you think?

 

Liv

Liv