Real Estate Investing: Gentrifying Neighborhoods

What is the first thing you think of when considering a low-risk property with good returns? Most would-be real estate investors would say a Class A property. While Class A properties are perceived to be safe, they are also expensive because they are newer construction buildings with 100+ units that appeal to institutional and ultra-high net worth investors. That is also why Class A properties actually don’t have high cash flow.

Another consideration of Class A property is volatility. Class A tenants are paying the highest rents among all property classes. During an economic downturn, these tenants will typically seek lower rents, creating vacancies, , driving up costs, and decreasing NOI.

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What if a property had the perceived safety of Class A but with better returns? Sound too good to be true? With a little outside of the box thinking, more opportunities begin to open up without increasing risk or decreasing returns.

Neighborhoods in Transition

Neighborhoods in transition are often called gentrifying neighborhoods. These neighborhoods are moving from low-income demographics to higher income and more in-demand. Name brand businesses have started opening up and people are beginning to find the neighborhood safe and appealing. Identifying properties in these neighborhoods right when they’re on the cusp of transition can lead to some great diamonds in the rough.

Here’s how: Less in demand neighborhoods are usually made up of Class C properties. These are smaller, older buildings that typically suffer from mismanagement and deferred maintenance. Once the neighborhood begins to show signs of improving, properties will be undervalued…but not for long.

Purchasing properties at the right time, renovating its exterior and interior, adding amenities, better customer service, and more efficient management will all improve the property and tenant demand. These improvements can result in rent increases of 40% - 200%. Property improvements can move the classification from C to B. The class upgrade and increasing rents throughout the neighborhood result in improving cash flows.

Because these properties are basically at rock bottom valuations, there is little downside risk. Even then, if you’re catching the trend near its start, property values should still be undervalued.

Determining A Property’s Value with NOI and Cap Rate

With gentrifying neighborhoods on your radar, how do you determine if a property is a good value? A quick method for determining a property’s value is cap rate, which represents the return on investment if a property is purchased all-cash. Here’s how to calculate property value using the cap rate:Property Value = Net Operating Income (NOI) / Cap Rate

For example, a gentrifying neighborhood may have an established cap rate of 5%. Assuming the property you’re looking at has and NOI of $100,000, here is how you would calculate the value:

$100,000 / 5% = $2,000,000

Generally speaking, lower quality neighborhoods offer higher cap rates, and in turn, higher returns tom compensate for higher risk, while better or improving neighborhoods will see lower cap rates.

As a buyer, you want a higher cap rate while the seller will want a lower cap rate. Focusing on the investment, you will first need to determine the in-place NOI and compare that against potential NOI following renovations.

Increased Value through Cap Rate Compression

Going back to our neighborhood in transition, as NOI improves from increased rents and improvements to the property, and the neighborhood shifts from low- to high-demand, the area cap rate will compress, or drop. Here’s an example:

Before improvements to the property and neighborhood: $100,000 / 5% = $2,000,000

After improvements to the property are completed and units are rented at higher rates, the NOI may increase to $130,000, while the cap rate drops to 4.45% to reflect the reduced risk of the area and improved quality of the property. The effect on property value is significant, as shown below:

$130,000 / 4.45% = $2,921,348

In this example, property value has gone from $2,000,000 up to $2,921,348. This is the magnification effect resulting from cap rate compression.

Real estate investing is a leading wealth creation tool of high net worth investors. Successful investing requires due diligence, making it neither hands-off or passive. The old saying that hard work pays off is certainly true in this case.

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