The Skinny:
The real estate world likes to preach the “location, location, location” aphorism but in reality it is overrated and often irrelevant, good real estate investments can be found anywhere.
Age Old Wisdom That Isn’t Really Wise:
Whether it is from your local real estate agent or a large real estate investment firm, everyone in the field likes to place a big premium on location. For residential homes, it simply must be in a great school district and have easy access to the town amenities. For large office or apartment buildings, it simply must have great transportation and be in a highly sought-after submarket. Location, location, location is probably the most famous real estate related quote if I had to guess. The problem with it is that it is very overrated when it comes to making good investment decisions.In a vacuum, of course it makes sense to buy the best located real estate. It will be the most desirable product around and will therefore have plenty of demand. Your buildings will be consistently filled with high-quality tenants who are willing to pay top-dollar rents. In other words, it is low risk to own these. However, real estate investing is not set in a vacuum and your job as a real estate investor is not only to go with the least risky opportunity. Your job as a real estate investor is to provide the best risk-adjusted return possible for you and your investors, which I fervently believe cannot be found in the best locations and is why I believe this age-old maxim is overrated.
Since well-located real estate is perceived as low risk, there is a ton of competition from buyers who want to own them. These are often pension funds or UHNW investors who need to have the best assets for their portfolio. Their analyses will not be very rigorous, and due to the inevitable (often ego-fueled) bidding wars, assumptions will get stretched beyond the realm of reality. They will justify their high prices by saying “it’s great real estate” or some other nonsense. The issue is that this overpayment drastically increases the investment risk by creating a high likelihood of underperformance.
This happens not only with “crown jewel” type assets but more generally in any sought-after area, especially high-growth gateway markets. Buildings in these “primary” markets are priced at lower cap rates than secondary and tertiary ones because of a lower required return (due to the lower perceived risk) and higher growth expectations, both of which push down the cap rate. Said differently, they are more expensive. Many investors in these markets are even willing to take on negative leverage (where the interest rate on your debt is higher than the cap rate of the property!) for an extended period because of their belief that the market will continue to outperform. Notice anything strange about that statement? These investors are relying on the market to justify the overpayment. Does that really sound low risk?
Aside from market recognition and getting egos fed, these investments often end up being precariously perched from the start. Well-located, high-quality assets are referred to as “core” deals and usually only warrant a return of a 7-8% IRR in a base case. The issue is what happens in a downside case. If you stretch to win a deal (which is usually the case since these are so competitive) then the base case is usually wishful thinking to being with. If you needed to underwrite 4% rent growth for 3 years just to get a 7% IRR, you are stuck with a <6% if you only get 3% growth and <5% if you only get 2%. This is not very impressive and is the opposite of an asymmetric mentality. Might as well look at highly rated corporate bonds at those return levels.
The point here is not to knock core buildings. They are often good assets that will rarely get zeroed in a recession and are indeed stable, which is what many investors want. Not everyone needs the highly sought after 15% net IRR / 2x multiple over 5 years. The point is that they do not offer the best risk-adjusted return in the game and that you can find much better investments “in the sticks”.
Fundamentals, Shmundamentals:
Having worked in the institutional real estate world, I can tell you that there is an obsession with the so called “fundamentals”. Everyone wants to see a market with a great economy, growing population, diversified employment, and if you are fancy maybe even a “supply / demand imbalance”. These are well founded because they do have a statistical correlation to rent and value growth. However, this type of data is not proprietary and it becomes obvious when a city meets these favorable requirements. This will spread like wildfire with everyone rushing to get a slice. We have all seen this happen in places like Nashville and especially both coasts of Florida.
The problem is that there is a conflation between market-level fundamentals and deal-level fundamentals. Ironically, when everyone rushes somewhere to capitalize on great market-level fundamentals, the deal-level fundamentals pervasively suffer due to elevated competition and irrational exuberance. The deal-level fundamentals are what matter. You are ultimately investing in a specific asset, not a specific market. In a highly rated market, there are plenty of good deals but very few great deals. Consistently finding great deals is what defines a successful investor.
If you look at an area without the shiny market-level fundamentals, there will not be many others looking at it. Maybe the area is out of its prime and the population is stagnant, or it is simply located too far from a major urban center to have any recognition. Does this mean that it is automatically a bad place to invest? Absolutely not. On the contrary, it is probably a good place to invest because of reduced competition. While I would recommend avoiding places with high crime or other structural issues, there are countless under-the-radar markets where you can gain an edge and consistently find great deals. Do not just blindly pursue good fundamentals, because in many ways they are irrelevant, and they are certainly not a prerequisite for success.
Focus on Deal-Level Fundamentals:
Once you find a secondary or tertiary market that you can truly make your own, then you can focus on what really matters, finding great deals. You will not need to stress over whether the population is growing or if rents are expected to rise because you will be able to identify opportunities that perform well without relying on broader trends that you cannot control. You will only pursue deals that have a great risk / return profile with a large margin of safety.
Immerse yourself in your market and become completely fluent in it. Master its neighborhoods, amenities, and residents as well as metrics such as rents, cap rates, and margins. The old phrase “big fish in a small pond” is very fitting because that is exactly what your goal is here. While some poor investment managers are overpaying in major markets because they need to beat out 20 other bidders, you will be generating off-market leads because you will be one of just a few players. This “power” will only snowball as you increase your holdings because you will become the go-to guy / gal for brokers and sellers. In an ideal scenario, you would get a first look at every deal before it hits the broader market. Furthermore, because of your operational experience and mastery of the market, you will be able to pretty much immediately notice a good opportunity. The chances for mispricing are much higher and you will be ready to pounce on them like the arbitrageurs of a bygone era. Again, while investors in major markets will be praying that market rents increase enough to justify their overpayment, you will be buying deals that provide a strong return simply through an outstanding entry price. I strongly believe that the success of most deals is determined at acquisition when you can secure immediate “built-in” equity, aka riskless profit. On the flip side, if you make a mistake at acquisition, you will be playing catch-up for the remainder of the hold.
While you certainly could “buy and hold” if you get a deal at a big enough discount, you should also always seek to make your deal even more powerful by having a business plan where you can directly add value through your own hand. Whether it is capex / renovations, better operations, or simply some new identity or flare, this is where you can use your pride of ownership to expand the return potential and amplify the positive effects of a discounted buy. I try my best to hammer this home in my high floor / high ceiling post.
Informational Inefficiency is King:
The reason you can find plenty of great deals in secondary and tertiary markets but will rarely be able to in primary markets is due to one simple but powerful reason, informational inefficiency. A market is said to have informational efficiency if its prices reflect all available information. For example, stock prices are mostly informationally efficient because of the sheer amount of coverage, data, and trading that goes on in them. You have thousands and thousands of professional investors analyzing publicly available data and trading based on their findings. This causes valuations to be tightly bound and makes it very hard to gain a competitive advantage. There is a whole academic debate on this, but the data generally shows that it is difficult to outperform in the stock market.
Real estate, on the other hand, is very informationally inefficient, which means there are a lot of opportunities to outperform, that is unless you are in a primary market! Why? Well just like a stock market, popular markets get a lot of coverage and there are many buyers and sellers scrutinizing every transaction. As previously mentioned, bidding processes often push valuations beyond rational levels due to emotions and other non-rational drivers. Pricing inefficiencies are quickly rectified. Secondary and tertiary markets do not have a constant flow of data or a crowd of willing buyers and sellers. These are often sleepier places with many non-professional participants, which inevitably leads to informational inefficiency and the opportunity to outperform. In more sinister sounding terms, while insider trading in stocks is super illegal, it is 100% legal in real estate and is therefore something that you can seriously profit off of without ending up behind bars like Gordon Gekko.
Summary:
Location, location, location is not the mantra to follow if you are looking to consistently find great real estate deals. Instead, you should aggressively pursue smaller markets and do everything you can to avoid competition and do everything you can to take advantage of mispricings. The two-pronged strategy of discounted buying and controllable value-add business plans is a surefire path to success in the real estate game.
