Buy Long-Term: Cash-Flow? Appreciation? Class A, B, or C?

This has always been an interesting question that I have spent a lot of time thinking about.  What class of properties should you buy and focus on?  Is it worth it to spend your time in the war zones chasing huge cash-flow?  Or work on the consistent returns and easy management of the Class A pile of rentals.

Class A properties – These are the properties that you have extreme pride of ownership over, when you are showing your friends what you do for a living these are the ones you go to.  The cash-flow isn’t as good as the other classes, but they are generally newer, require less maintenance, in better areas, easier to finance and easier to rent.  The theory is these properties will appreciate more (if we ever get appreciation again).

Class B properties – These are the middle of the road properties.  They may be a bit older or in not quite as desirable of a neighborhood.

Class C properties – These are usually the properties you will be bragging about the cash-flow instead of showing all your friends the property.  The appreciation might not be as good and they will usually be more of a challenge to find/manage good tenants and finance.

We did an interesting exercise about two months ago: I printed two copies of our rental portfolio and my partner and I ranked every property as an A, B, or C.  It was a very interesting thing to discuss, we answered the same grade on everything except about 5 of them.  The funny thing is, I found myself defending some of the lowest end properties saying, the tenant in that one is so good I don’t want them ever to leave.

Every investor probably has a different definition of what a Class A and Class C property is.  My definition is, if you are not comfortable getting out of the car during the day, that property is probably Class D to you.  The more properties you look at though, the less intimidating a group of gawking neighbors is.

I did an analysis to compare one property we own in each class.  I tried to pick our average deals, as we have a couple ‘great deals’  in each category that would throw things off.

First I want to explain how I quickly compare rentals.

The Simple Formula

Rental Income per Month / Total Acquisition & Repairs

eg: $1,100 / ($65,000 purchase + $10,000 repairs)

$1,100 / $75,000 = 1.4667%

Our ideal rental should show a 1.5%/monthly return or more.  This formula is similar but a bit more simple than the Gross Rent Multiplier.

Class A Property

Total Acquisition & Repairs: 124,000
Rent: $1,495
Peak Value: 345,000
Total Cost versus Peak Value: 35.9% ($221,000)
Rent Ratio: 1.2%
* we have a very hard time finding Class A properties that are at 1.5%

Class B Property

Total Acquisition & Repairs: 74,000
Rent: $1,100
Peak Value: 285,000
Total Cost versus Peak Value: 25.9% ($211,000)
Rent Ratio: 1.5%

Class C Property

Total Acquisition & Repairs: 58,000
Rent: $950
Peak Value: 192,500
Total Cost versus Peak Value: 30.1% ($123,500)
Rent Ratio: 1.6%

* I am not really counting on us getting back to Peak Value, I am just using it as a comparison for appreciation across the levels.

The interesting comparison is the Total Cost compared to Peak Value is actually a lot better on the lower end properties.  If you are using all cash, you can essentially buy two Class C properties or one Class A property.  For the Class A you would be collecting $1,495 rent, and for two Class C’s you would be collecting $1,900 rent.  But for the extra $400 you have two tenants, two roofs and two lawns.  You also have to find two good Class C deals, for every good Class A deal.

Our focus has been finding the biggest discounts compared to ARV first and worrying and focusing less on the Class of the property.  Right now we classify about 50% of our properties as B’s while A’s and C’s share about 25% each.  The other thing I like to do is ‘go after’ properties in neighborhoods we already own properties in that we really like (no matter the class).

If you are not wanting to be involved in the management process very heavily I would focus on Class A’s.  Otherwise, I think you should buy a little bit of everything.

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10 Responses to “ Buy Long-Term: Cash-Flow? Appreciation? Class A, B, or C? ”

  1. Tin says:

    Different view to look at thing!

  2. Mark in Fl says:

    Great webiste.

    I followed my mentor’s lead and invested in Class C properties in an area poised for long term appreciation.

    After doing this for twenty years I’m now sick of the management headaches involved with Class Cs and realize life would have been much easier if I’d invested in higher class properties.

  3. Mike Z says:

    The key is to get comfortable with your investments and make sure every deal is better than the last one … I really like the article

  4. Steve says:

    I was actually surprised with the results. I thought Class C properties would look much better. Although, $400 extra a month adds up when you do volume of properties (21% more rent).

    Mark, your response is particularly interesting. One idea is near peak… sell all the Class C and pay off the Class A’s.

  5. Anfel says:

    Steve – I agree with most points of your article. Thanks for sharing. However it has been my experience in our business that it isn’t necessarily the class of a property that creates ore work but whether the property is a single family home or a multi-family home. Multi’s provider the larger cash-flow in general but also require the most management. I’m willing (at this point in my life) to work harder for that paycheck but do believe the “old guys” in our business when they say get rid of your multi’s and own only singles.
    Who knows maybe in the future I will find someone young and willing to work like me to sell them off to for note income – hmmm…

  6. Angel says:

    Steve – I agree with most points of your article. Thanks for sharing. However it has been my experience in our business that it isn’t necessarily the class of a property that creates more work but whether the property is a single family home or a multi-family home. Multi’s provider the larger cash-flow in general but also require the most management. I’m willing (at this point in my life) to work harder for that paycheck but do believe the “old guys” in our business when they say get rid of your multi’s and own only singles. Singles will (for the long hold) will provide a better ROI.
    Who knows maybe in the future I will find someone young and willing to work like me to sell them off to for note income – hmmm…

  7. Steve says:

    We’ve looked at numerous multi’s in the same areas we own our houses and we have found:

    1. They don’t cash-flow as good as a house.
    2. They didn’t appreciate as good as a house in the last run up.
    3. They are harder to manage.
    4. They are harder to buy at a discount.

    I know you guys invest in a different market where these are not true. If I could get a good enough discount and/or a good enough cash-flow I would buy multi’s too but there doesn’t seem to be as much opportunity in California on those.

  8. Mark in Fl says:

    People are sorrier than ever out there and I’m tired of dealing with them and also having to wait years for payday.

    I’ve moved to flipping and having fun.

    Mark

  9. Mark in Fl says:

    No sooner than I say the above than I find and buy the perfect long term rental. It’s in the hottest area before the crash and we bought it for half of the assessed value.

    Code enforcement cited it for having rotten boards and scared the owner with the thirty days mandate to remedy and the owners took my offer.

    I have to admit there are certain class C houses in class A areas that one should hold.

  10. Wow, I’m late to this conversation, but I want to tip my hat to the analysis. Yes, cash flow is typically better the higher you go up the alphabet. You’re spot on with that point.

    I’ve found that people chasing the ROI often have no clue how to be a landlord in these challenging areas. I haven’t found a book that discusses the additional things needed to be effective in troubled neighborhoods.

    Hopefully, I can learn some good practices here on this blog.

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