You’ve seen it over and over: People posting on the BiggerPockets message boards about some investor buying a deal that doesn’t hit the 1% rule. Or the 2% rule, or the 50% rule. The list goes on.
Super-competitive properties are going for so much more than you think they are worth, and certainly more than what would cash flow based on the numbers you’ve run. You ran all the BiggerPockets calculators and checked Rentometer and AirDNA, and it just doesn’t make sense. Who are these people, and why are they overpaying for these properties?
Overpaying—Is It a Thing?
Let’s get one thing out of the way: There is literally no such thing as overpaying for a property. As soon as escrow closes, that property becomes a new comp, and, by definition, it’s worth exactly what the buyer paid for it.
The industry has decided that value is determined by an appraiser. For residential properties, those appraisers use comps (not cap rates—that’s another article) to determine their opinion of value. Make no mistake: It’s nothing more than an opinion.
If they are appraising the property next door to the one that someone just “overpaid” for, that purchase price establishes a new, higher value for homes in that neighborhood. Therefore, that price that was paid for a property literally increases the value of the subject property itself and all the surrounding properties simply by paying more than we might think it’s worth.
I’m not saying this is an investment strategy; it’s just how the game is played. That being said—why on Earth would people pay THAT much?
Why Do People Buy Investment Properties?
Boiling it down even further: There are many reasons people buy investment property, but it boils down to three main drivers: cash flow, equity, and tax benefits. Each benefit has a different psychology behind it, but what many people don’t realize is that as you progress through your investing career, your resources, comprehension, and goals will change. They should change. It’s absolutely a good thing.
As newer investors, we typically focus on cash flow because there are many markets in the country where you can see immediate returns, at least on paper. That’s what investors are looking for—at least in the beginning. Heck, you are likely on BiggerPockets because you have had enough of the rat race, and you know there is a better life waiting for you—it’s just a matter of finding that path.
The thing is, that path requires you to have tangible, immediate income so that you can pay your bills as they come in, survive, and support your family. Changing the trajectory of your future and your children’s future isn’t quite on the horizon yet. Cash flow is that bump you need to make that step, and there’s nothing wrong with that.
But that equity—that’s the real game changer. Once you have established enough cash flow to cover your living expenses and can breathe a sigh of relief, you’ll start thinking about what’s next. A property with modest cash flow is awesome, for sure, but scaling that model to the point where it changes your family for generations is really difficult to do.
That’s when the value of equity starts coming into play. You can get great terms borrowing against equity. Equity allows you to start scaling either through leverage or 1031 exchanges. You can’t 1031 your cash flow into large multifamily properties, but you certainly can do that with equity.
What about those investors who buy properties that don’t meet the numbers that you think they should? They’re buying because they think that property will be more desirable in the future, and they know that causes rents to rise over time. They’ve learned their market well enough to be able to predict a property’s “highest and best” use and are willing to take on bigger risks in exchange for bigger rewards when they get there.
In addition, as you learn more about your market, you’ll start seeing trends where you can get ahead of the path of gentrification. You might be in tune with upcoming zoning changes.
Maybe you’ll notice that a house in the worst neighborhood in town is getting bid up because savvy investors know that the density in the neighborhood is going to increase within the next couple of years. That lot might allow only one or two units now, but in a few years, maybe you could build a 12-unit apartment building. If you have the resources to sit on the property until then and build to get significant returns, why not?
Understanding and planning for the future highest and best use of a property is an advanced skill, to be sure, but there are plenty of investors who use this strategy.
Think of it this way: If you didn’t need that $200 per month in cash flow, would you still buy it rather than a property that you thought would be worth 30% more in five years? For example, if you bought a B duplex in a decent neighborhood for $300,000 and figured it would be worth $400,000 in five years, broken down by month, that would give you monthly equity growth of $1,666. That’s significantly more attractive than $200 per month, especially when the property and tenants are much easier to manage, and rents go up by around 5% per year.
Those low cash flow deals will cash flow over time and provide you with equity and future leverage. If you learn your market well and start moving toward those types of deals when the time is right for you, you’ll make big gains in a much shorter period of time. A few years is nothing in real estate investing—remember, this is a marathon, not a sprint.
I can hear you screaming right now: “Buying for appreciation is gambling! Cash flow is guaranteed income!”
There is no such thing as guaranteed income in real estate investing. I know very experienced flippers who have lost hundreds of thousands on flips decades into their career. I know plenty of people who have invested in high cash flow markets and been burned by bad tenants, high vacancy rates, lazy property managers, and money pit properties.
There are no guarantees. We are all gambling every time we write an offer. It doesn’t take much to eat up $200 in monthly cash flow—one simple repair by a plumber will do it, not to mention if you need to buy a roof or replace a sewer line. Don’t get me wrong, cash flow is great, but again, there are no guarantees.
Once you have built up your equity and cash flow to a point where you are essentially financially free, you might need to take a closer look at that tax bill. That check can be a painful one to write, especially if you have liquidated a property or had a few successful flips. Now it’s time to buy some properties that can put a serious dent in that tax bill.
Cash flow and equity aside, knocking out a major tax bill can give you the best ROI of all, but you can’t do that without the income to support such a purchase. What a great problem to have! There is so much income that you need to buy a property to mitigate your tax bill. If you’re in a spot where these are the conversations you’re having, you’ve made it.
The Bottom Line
I can tell you from experience that there are hundreds of thousands, if not millions, of real estate investors out there who have never heard of BiggerPockets, they don’t know what the 1% rule is, and they think BRRRR is something you say when you finish a day on the slopes in the Swiss Alps.
These people are your competition, and they have different resources than you—millions of dollars sitting in a brokerage account, less stress, more equity, and higher income—and they don’t have the burden of needing to use the BiggerPockets calculator before they make an offer. They are very likely your competition and have a different itch they need to scratch than you do.
If you need cash flow now to get to the next step, find some people in your market who are already doing what you want to do and partner up—work for free, add value to them, and learn what you need to do to get to that next level. With enough work, sacrifice, and calculated risks, you’ll be buying some of those deals that don’t cash flow as you say “BRRRR” to yourself while hitting the slopes from your Swiss chalet!
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.