Why Investing in the Bottom of the Market Will Make You Rich
Many Investors dream of making the "Big Deal" - a deal that creates the proverbial money tree that will continue to grow cash for you for years to come. While trees that grow currency instead of leaves are impossible to find, there are investment opportunities appearing everyday that with a little knowledge and effort will continue to generate cash for years to come. The problem is that many of us look in the wrong places when searching for these opportunities.
One primary reason many investors miss these opportunities is due to the fact we are all bombarded everyday with advertising campaigns, slogans, jingles, and images that promote the ideas that "bigger is better", or "you get what you pay for" (meaning, the more costly something is, the higher its quality). While in many cases these ideas may make sense, when investing is approached from a business perspective these ideas start to break down. This problem is compounded for investors by gurus who promote expensive investment opportunities because they pay the guru larger commissions.
In business, the goal is to "buy low, sell high", "reduce costs" and "maximize profits". Most investors understand this, but some don't take this into account when considering potential investments. Whether due to conditioning, slick salesmanship, or just lack of experience, these investors fall prey to the idea that the value of an investment vehicle is directly related to its cost. Although it seems counter-intuitive, I will show you why there is more profit available in the lower end of the market than the higher end.
This principle appears to fly in the face of common sense, and it's easy to rationalize buying the more expensive investments. But let's consider this principle in a generic sense first. If you were to ask people which company is the largest retail chain in the world, many will (correctly) tell you it's Walmart. Walmart is known world wide as a discount retailer that focuses on the inexpensive. In fact, according to Deloitte - who compiles an annual list of the largest companies in the world, eight of the top ten in the retail industry are discount stores or warehouse clubs. High-end retailers such as Neiman-Marcus, Saks Fifth Avenue, and Nordstrom don't even make the top 100.
The car industry reflects this as well: according to the International Organization of Motor Vehicle Manufacturers, the largest car manufacturer in the world is not a company like BMW or Mercedes-Benz, it is Toyota. In the restaurant world, McDonalds is the largest. These companies, although in vastly different industries, have one thing in common - they capture the largest share of the market by providing the economical, not the expensive.
In the world of Real Estate Investing, this principle can be used to separate the great deals from the good deals. There are a lot of good deals available in Real Estate right now - the market is better for investors now than it has been in decades, and money can be made almost anywhere in Real Estate right now. Because of this, there are numerous Real Estate Gurus with secret systems, boot camps, seminars and classes just dying to show you the way. There are also many vendors with the ultimate investment property in the perfect market that is "guaranteed" to generate massive cash flow. I know - I've seen the webinars, been to the seminars, expos, and boot camps, and even taken some of the classes.
The thing I've discovered, though, is that many of these vendors and gurus cater to and target the amateur investor. Investors can be divided into two categories, the amateur and the professional. Before there is any misunderstanding, it needs to be said that when I use the terms "amateur" and "professional", I'm not speaking about the individual investor's knowledge, ability, or resources - I'm merely making the distinction between those investors whose primary source of income is their investments (the professional investor), and those investors whose primary source of income is derived elsewhere, and they invest the surplus (the amateur investor).
You can tell when a vendor is targeting the amateur investor when you examine the deal the vendor is presenting. When the vendor focuses on things like depreciation, principle pay-down, and equity appreciation to calculate an amazing return on investment (ROI), you can be fairly certain who the target audience is. These things are all important considerations, especially for long term growth, but for the professional investor, "Cash is King". Cash flow, and cash on cash return are the critical performance metrics when each investment property is examined from a business perspective. When you analyze an investment as if it were an independent business, it must be profitable by itself in order to survive. If an investment requires periodic infusions of capital to maintain it, you're not buying an investment - you're buying a tax shelter.
For a hypothetical example, suppose there were two vendors with investment properties for sale. Vendor A sells properties for $100,000 that rent for $1000 a month. Vendor B sells properties for $30,000 that rent for $500 a month. An investor could buy from Vendor A, and get a nice property in a good neighborhood that has a good ROI. But with the same capital, the investor could buy three properties from Vendor B, and still have cash left over. In addition, the investor's gross rent receipts will be 50% greater, and the investor's risk will be significantly less. A vacancy for the investor who bought from Vendor A results in a 100% loss of income, whereas a vacancy for the investor who bought from Vendor B only results in a 33% loss of income.
The key to take away from this example is the fact rent does not increase at the same rate as property values. Sure, more expensive properties do have higher rents, and that's part of what makes the "Vendor A" type deals so attractive. But when rent is compared to the value of the property, properties in the lower end of the market almost always have higher rents proportional to the value of the property. Since in most markets property taxes and insurance are proportional to the value of the property and management fees are a percentage of the gross rent, those expenses don't change the analysis. One expense that does make a difference in the analysis is maintenance and repairs. High-end condos, luxury apartments, and homes in upper class neighborhoods will have more costly repairs than homes and apartments in more affordable neighborhoods simply due to the cost of materials and craftsmanship
There is a limit to this principle in the Real Estate market. You can find deals that are priced so low, the numbers become too good to be true. In this case, careful examination of the property is in order. Is it in a neighborhood plagued by poverty and high crime? The risk may be high enough that the investment simply doesn't make good business sense. Is the property structurally sound? I know of actual cases where investors bought out-of-state investment property from major vendors where the property was condemned and then demolished after the property was purchased, but before the investor ever laid eyes on it.
The bottom line is, do your homework. Ask the vendor questions about the property. Inspect the property yourself, or hire a knowledgeable contractor or home inspector to examine it for you. Calculate the numbers yourself - not only will you have a better feel for the quality of the investment, the practice will make you a better investor in the future. And above all, don't just look for properties in the upper strata of the market - the real gems are hidden in the areas other investors overlook.