The issue with finding good real estate is that good real estate is difficult to quantify. Good investments in real estate can be attributed to a number of factors. It could be quantified by cap rate but how do you know which asset is better real estate between two cap rates? Could a 6 cap in Philadelphia be better than a 5 cap in NYC?
Many investors will tell you that cap rates are an indication of risk and therefore an indication of the quality of the underlying real estate. There's abysmal real estate in NYC that sells at low cap rates just because it is in New York City (location, location, location). These types of deals are usually more dangerous than buying good real estate in a tertiary market even though the cap rate is higher in a tertiary market. There is less competition in these markets and almost always more opportunity.
There's good real estate in every small town across the country. Good real estate is a relative metric with many meanings.
A market with higher cap rates doesn't mean all its real estate is bad real estate. Another reason why higher cap rates don't necessarily mean bad physical real estate is that cap rates don't always solely indicate risk. They also indicate future growth potential of a market. Just because a market is projected to grow slower than another market doesn't mean it is filled with bad investments or bad real estate.
Key Questions and Concepts
Here are some questions and concepts to think about when determining if real estate would make a good investment and be considered as good real estate:
- Locational Advantages
- Competitive Advantages
- Asymmetrical Leverage & Exit Options
- Upside vs Downside Scenarios
You want at least one of the above to be applicable for real estate to be considered for investment.
Locational Advantage
Looking for locational advantages means going on google maps / apple maps / bing maps (whatever you fancy) and looking around at the property and its surrounding area. After looking at the property and the surrounding areas, you should understand the amenities that make the area unique and if it is a good location. There are a lot of specifics to look for like:
- Proximity to public transportation
- Proximity to grocery stores
- Proximity to convenience (restaurants, gyms, stores, retail)
- Median income of the area
- Would you live there?
It should be clear that if the property has these advantages and some of these indicators outweigh the others. If you're buying beachfront real estate in Avalon, NJ you can be relatively confident that none of the factors matter and you're buying good real estate (this doesn't mean it will be a good investment!)
Competitive Advantage
Ask yourself what gives this property a leg up on comparable properties in the area. Does it have larger rooms? Higher quality finishes? Located on a bigger lot? More frontage on that lot?
If you were a tenant, would you rent there over a similar property somewhere else? Put yourself in the tenants' shoes and genuinely ask yourself whether you would rent this property compared to the rest of the market. Tenant willingness to pay higher rent will mean higher property values (based on income approach) down the line.
Asymmetrical Leverage & Exit Options
Asymmetrical Leverage can often be applied to good real estate investments. Asymmetrical Leverage is a strategy where the potential of an investment or activity is significantly greater than the potential for downside. Many different upside scenarios can benefit the investor versus there being limited downside scenarios.
That's because if the real estate is good, the land/building can be repurposed, enhanced or added to. The first is if the building can be repurposed. An example is an old church or school being repurposed to student housing or apartment housing or an office building can be repurposed to multi family. If the land can be repurposed there is another possible upside scenario. Another way of thinking of this is highest and best use. If the building were to be razed could I build something else on the lot that would have sufficient or even above average demand in the future.
This can be applied to the exit options as well since if the land/building can be repurposed there can generally be multiple exits. If the building or land can't be repurposed, enhanced or added to at all it's very likely not good real estate because of the lack of optionality.
Upside vs Downside Scenarios
As a thought experiment make a base case, a downside case and an upside case for the subject property. Ask yourself "Is there a world where the property outperforms its upside case? Is there a path to making a lot of money on this deal? How likely is the downside scenario?" Answering these questions will create realistic scenarios and help you understand if the subject property is worth pursuing.
If you think there is a limited chance that the property outperforms its upside scenario that's because you know that the real estate is not good. If you don't think the property can outperform the base case scenario then that is an admission to yourself that the property is not a good potential investment.
Your property analysis shouldn't be entirely numbers and excel driven. There are other factors that are just as important in the real estate investment decision. You can be a very successful real estate investor without being deep in the numbers and that's the beauty of it. For accurate valuations that consider both quantitative metrics and qualitative factors, professional appraisals provide comprehensive insight into property investment potential.