Real Estate Investing – Why I Hate Class C Properties

by FI Fighter on October 23, 2017

in Real Estate Thoughts

When I first started out with real estate investing in 2012, it was during the depths of the bear market (post subprime financial crisis) when investors were still scared shitless and sitting on the fence (for the most part). Naturally, when people are too afraid to buy and there are tons of: foreclosures, short-sales, REOs, etc. it just makes for a very favorable buyer’s market where you can score even the best merchandise for pennies on the dollar.

I mean, I was only a rookie back then, so I didn’t know what on earth I was doing, but as I’ve learned over the years, the investing game has more to do with timing than brains… Literally, I could have thrown blind darts at ANY property, especially in a place like the Bay Area, and made life changing gains…

Naturally, when you have even an iota of success, your confidence starts to build up, and you probably think you’re smarter than you really are… Yup, I made that big mistake… I looked a gift horse in the mouth and tried to get more “creative”, instead of just ummm milking that gift horse dry…

What I foolishly decided to do was to venture out of state and focus on “better cash flowing” properties out in the Midwest…

Ironically, by trying to target after “better cash flowing” properties, I ended up securing even less cash flow than my Class A Bay Area properties spit out each and every month…

Now, I’m not trying to knock on the Midwest at all… With real estate, you can probably make most markets work, but you have to know what you are doing and have the right teams in place! I didn’t back then, and I still only sorta do today…

If you venture out of state and you don’t have boots on the ground, you’ll have to rely on other people to take care of your property for you… and as I’ve learned over the years, when it comes down to it, nobody gives a shit about you

It’s all about making $$$, as always… for them, not you!

So, that’s cool and all, because even if you’re getting nickel and dimed every step of the way, if the cash flow is great and the appreciation even better, over the long-term, you will come out ahead!

Now here lies the biggest problem with Class C properties…

They don’t ever go up in value!!!

For whatever reason, usually a combination of the following:

  • No jobs.
  • Terrible schools.
  • High crime rate.
  • Lacking infrastructure, amenities, entertainment.
  • Bad weather (much less a concern than the above).
  • Etc.

I was very naive back then (I still am today), but I had my EUREKA moment around 2015 when I realized that after so many years, despite my properties being fully leased up and cash flowing well that the market rents weren’t escalating anywhere near as fast I expected…

Nope…

There is a direct correlation between property value appreciation and rent appreciation! They go hand-in-hand. If you want MASSIVE cash flow, you should target properties that offer MASSIVE property value appreciation potential. Ignore this correlation at your own peril!

For instance, with my property in Indianapolis (which is actually more Class B than Class C), I initially started renting out the unit for $1,075/month… By the middle of 2015, I signed a new lease for $995/month

That’s right, I had to scale back in rent because the local market/neighborhood was so soft… Property values weren’t going up, and rents sure as hell weren’t either!

But despite that, I was able to luckily secure an awesome tenant, and things have been great ever since… They pay on time, don’t require much in the form of maintenance repairs, and I’ve even conversed with them and they are very respectful people…

Yet, here I am regretting this decision after the fact, knowing what I know today…

How come?

Straight up (and objectively speaking) — It’s just a mediocre investment and these are a dime a dozen out there!

Learn to focus on the BIG PICTURE!

In comparison… here’s what Class A looks like after 5 short years…

Rental Property #1 (2012):
Purchase Price: $315,000
Initial Rent: $2,090/month

Rental Property #1 (2017):

One thing I’m ALWAYS paranoid of with real estate is this — If rent appreciation can’t outpace the deterioration of your property/structure, it’s a losing proposition!

You will have to pay the piper at some point down the road, eventually… With Class C, most likely even 20-30 years from now, the property still won’t be worth much (my Indy property has appreciated by like $5k in 4 years… My last Bay Area rental that I won in 2015 is already up over $200k in less than 3 years, in contrast), so if it’s dilapidated, you’re going to have to rehab it back up to stuff (which will probably cost tens/hundreds of thousands of dollars) to continue collecting a return from it… If you were to sell it back “as is”, it won’t fetch much…

Class A properties, on the other hand, you’ll most likely be able to rent them out for 20-30 years, run them into the ground, and still come out ahead even if you don’t want to rehab them… I mean, I’ve seen the most filthy/disgusting single family houses in the Bay Area fetch over $1 million… easily… sold “as is”… and there were bidding wars for it!

 

With Class A properties, it’s the land that is valuable, not the structure/home itself!

 

That’s the key difference and a major takeaway that I’ve learned over the years…

 

Bottom line — We all want shortcuts in life! Why would you not? Why make things harder for yourself?

 

I do NOT believe that “slow and steady” is the right plan of attack/course of action towards achieving early FI and sustaining it for perpetuity… it’s just far too inefficient and painful. Remember, don’t listen to what the turnkey promoters are telling you, they just want your $$$! 😉

 

There’s just too many things that can (and do) go wrong, especially with real estate… Don’t even get me started with my Chicago properties which are an even bigger headache to deal with…

 

Ideally, what you want to own are properties that outperform so drastically, that even if you have to spend an insane amount of $$$ towards deferred maintenance/repairs, in the long run, you’ll still come out miles ahead!

 

Just think about the prime real estate markets out there: Bay Area, NYC, Seattle, Vancouver, London, Sydney, Hong Kong, etc…

 

People fight tooth and nail to win a piece of this stuff… You almost can’t fuck things up b/c your combination of rent appreciation + capital gains are out of the stratosphere!

 

And one other thing I’ve learned since I quit my job, when I’m out traveling, or out in the beach far away somewhere else in the world, the last thing I want to have to deal with are tenants and property management….

 

When you stick to Class A properties, you get the best of all worlds…

  • Massive capital gains appreciation.
  • Massive rent appreciation.
  • Highest quality tenants.
  • Easy and painless exit strategies (you’re not trapped inside Hotel California).

I mean just think about it… If rents are outrageous and property values are outrageous, and your tenants are getting a slight “discount” from you, are they really going to complain and give you a hard time? If your tenants know they are easily replaceable and you can find a new tenant on Craigslist within 5-10 minutes of posting an ad (at even higher rates), who do you think wields all the power?

 

You do!!!

 

That’s how you win in real estate… especially if you’re a lazy landlord (like me) who doesn’t want to deal with property management on a daily basis…

 

And if you ever want to sell?

 

With Class A it’s super easy and straightforward…. You sell back to a homeowner (many of whom will overpay and compete in bidding wars to win)… With Class C, you’re probably going to have to offload to another investor (who will no doubt want to rip you off and get the best deal for themselves).

 

Look, I’m making a sweeping generalization here, but what I’m saying will more or less hold true if you’re going to try and stereotype things… I’m not saying you can’t make Class C work, and many people most certainly do, but it’s just not easy… Quite frankly, I’m really over the “hard work” phase, and I know my own preference is to stick to Class A because I want to go on auto-pilot 99% of the time… With Class C, if you want to excel at it, you will need to take on a full time job, or be monitoring operations like a hawk…

 

Thanks, but no thanks…

 

I much prefer low-hanging fruit…

 

I want MASSIVE upside potential and a million exit strategies that all point to me coming out a winner.

  • Sell?
  • Keep renting?

It doesn’t matter… With Class A, you win! Either way… It’s awesome beyond comprehension to own assets that other people (especially the wealthy) deeply covet; you get that with Class A, not with Class C!

 

Class A is where it’s at… In my eyes, if you can buy right (timing is the tricky part), Class A real estate is as bulletproof as it gets to helping you achieve and maintain early FI for perpetuity.

 

Since Class A is not affordable in most markets right now (not by a long shot), I’m going to do what many real estate investors junkies refuse to do… be patient and bide my time.

 

Markets are cyclical, and what goes up will come back down again.

 

Lather. Rinse. Repeat.

 

Fight On!

 

P.S. Yes, I am very adamant and I have a very strong opinion about this subject matter (formed through personal experience). My biggest investment mistake ever was investing in Class C rental properties out of state! I don’t mean to come off so “in your face”, but seriously, I need to tell it like it is. No bullshit from me. If even just one person out there appreciates and grasps the underlying message I’m trying to deliver here, it’s all worth it. I don’t care for being politically correct.

{ 13 comments… read them below or add one }

1 SundeepNo Gravatar October 23, 2017 at 8:46 pm

Makes total sense. I’m down here in San Diego, and the properties that go up the most down here are all in the Class A areas, but since San Diego is San Diego, most of the homes in the county have also experienced massive appreciation.

That’s the one thing that kept me from trying an out of state (midwest most likely) rental…the lack of Class A places.

Great points on Class A tenants tending to be less hassle too, although I’m sure there are exceptions to every generalization.

Reply

2 FI FighterNo Gravatar October 23, 2017 at 10:33 pm

Sundeep,

Yeah, there are pockets in the Midwest that are Class A and have appreciation potential but you have to do your homework to pick those pockets out.

It’s very tough to generalize, and I’m not out to write a book here with this post, so I’m kind of forced to… but I think the overall message rings true and that’s what I’m trying to stress here.

Cheers!

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3 JoeNo Gravatar October 23, 2017 at 9:49 pm

Are you sure prices will ever come back down? They’ve only done so once in the last 50 yrs, maybe longer.

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4 FI FighterNo Gravatar October 23, 2017 at 10:34 pm

Joe,

If prices don’t come back down, well, it is what it is… I’m trying to be disciplined with my investing approach and not chase assets up to the moon. It’s interesting how human psychology works… at market tops we think prices can’t ever fall, but at market bottoms everyone is scared to buy…

If real estate prices never crash again, I’ll just have to try and locate other more appealing investments that offer a more favorable Risk/Reward… Easier said than done of course.

Take care!

Reply

5 MikeNo Gravatar October 23, 2017 at 10:09 pm

Do you have a near term exit plan for your midwest properties?
What type of issues have you been seeing with those props?
Just curious, thanks!

Reply

6 FI FighterNo Gravatar October 23, 2017 at 10:36 pm

Mike,

For now I’ll let them cash flow but I may re-assess and try to sell them off if I can and an opportunity presents itself.

With out of state issues, it’s the minor maintenance/repair bills that add up, lots of nickel and diming… In Chicago, it’s things like city violations, abatements, lack of appreciating rents, high property taxes, etc…

The juice is definitely not worth the squeeze as far as I’m concerned.

All the best!

Reply

7 MikeNo Gravatar October 24, 2017 at 8:49 am

I feel you. Thanks for the reply and keep fighting the good fight!

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8 Oliver @ Appreneurinvestor.comNo Gravatar October 23, 2017 at 11:57 pm

What about looking at it as wealth growth vs wealth preservation?

Class A markets are banking more on appreciation which has a higher chance to win big (and grow wealth) vs Class C markets (in the midwest) are slow and steady cash flow (to preserve wealth).

Different tools for different goals.

There was a good podcast on a teacher from San Diego on Biggerpockets the other day who made a good amount in appreciation (wealth growth). He later sold for a huge profit and invested in apartments in Ohio for cash flow (wealth preservation). So he made his fortune/profits from appreciation and then moved his assets into steady cash flow for financial freedom.

Thoughts?

I personally would do both with my nest egg (and I am). Get some cash flow, but also do the appreciation play. So far I’ve made a significant amount more in Class A, but its nice to have some boring steady cash flow from my Class B/C properties.

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9 FI FighterNo Gravatar October 24, 2017 at 12:11 am

Oliver,

To me, it’s a bad trade to sell out of Class A to “boost” cash flow with Class C… One may argue it’s wealth preservation, but I just see it as being a raw deal… My Class A rentals generate far better cash flow than my Class C stuff.

In my eyes, Class A properties preserve wealth much better than Class C… You get the potent combination of property value appreciation and rent appreciation.

Unless you are a pro at property management and have boots on the ground, I just don’t see how you can maintain operations efficiently enough where the rent appreciation greatly outpaces property degradation/deterioration with Class C… Class A bails you out if you run your property into the ground b/c it’ll be easy to sell to a homeowner at a nice juicy profit… Class C, it’s tougher to add value since the land itself isn’t worth much (if anything)…

That’s just my take on it, and keep in mind I am speaking more along the context of noncommercial residential real estate…

Frankly, I don’t want to do much work either, so Class C really has no appeal to me.

All the best!

Reply

10 Financial SamuraiNo Gravatar October 24, 2017 at 1:27 am

I have to agree with you. That said, I’m reinvesting the proceeds of my class a property in the heartland of America through a real estate crowdfunding fund So I don’t have to do any work. We’ll see how that goes. The fund returns target is 15% a year.

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11 Midwestern LandlordNo Gravatar October 24, 2017 at 8:44 am

I definitely agree with you. I have seen direct examples of class C properties being a nightmare. Some investors start with class B or C because that is what they can afford. They cannot afford class A right away. Then they trade up to class A when they can make it happen. Typically banks / secondary market want 20% to 25% down. You can’t play the class A game if you don’t have the money or credit to get involved. Not everyone is lucky enough to have a high paying job.

The low interest rates though are a game changer as well. Why invest in class B or C when you can leverage debt at such low interest rates? I want as much debt as possible under those terms with only the best properties available. The other thing to note is the following: We live where we live. Typically investors are much more comfortable investing in their back yard. And it may be in a low growth area like the Midwest. You brought up this point but I will emphasize it as well; The class A deals in hot markets are just not available anymore. The condo you listed above with a value of $660K and monthly rent of $3,150 is not a good deal anymore. I would not buy it as an investor. The total return moving forward (given the current entry price) may even be negative if there is a slight downturn. And there is no cash flow, probably negative cash flow (at that price point). Obviously you agree as well but it just goes to show valuation matters. Amazon is a great company but not necessarily a great investment at the price today.

One thing that Midwest markets offer is less competition. What my strategy has been is to purchase class A properties in my market and utilize as much 30 year low interest fixed rate financing that I can. As such, I get the best tenants available in the marketplace. This has produced substantial cash flow. I also don’t have to pay any management fees. More property appreciation would be nice but it is probably not in the cards anytime soon. And for the folks that consider life as a landlord is undesirable; I guess it is all about perspective. Many of these folks have to work 40 and 50 hour work weeks. Put up with a lot of BS from the boss. Have to work weekends. Have to scramble to find a new job when things go bad. I don’t suffer from any of these problems anymore. I have an independent income stream paid for by a lot of folks. Many weeks I put in less than 10 hours of work. Primarily bookkeeping and meeting people. Maintenance work is all contracted out.

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12 ChenNo Gravatar October 27, 2017 at 5:44 am

Why not just sell these properties?

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13 No Nonsense LandlordNo Gravatar October 27, 2017 at 6:16 am

I have done well by re-positioning a Class D property into a class C+. Property values are headed up.

You need to buy right when you buy on the lower end. Class A properties do not stay Class A forever. And with rents out stripping incomes, it cannot last forever.

Reply

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