The math behind discovering a new neighborhood

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As prices continue to rise for the kind of beat-up, badly managed assets that are our bread-and-butter, we are spending more time looking at new neighborhoods.

Am I going to tell you which ones I’m focusing on? No, because a bunch of people who compete with me read this blog.

But I will share with you the way that I think about these things.

There is an equation that underpins our whole business: (rent – operating expenses) / (acquisition price + rehab) = yield

1. The cost of renovating a building doesn’t change much, no matter where you do it. No one charges you less for washer / dryers because you’re putting them in Compton, or more for ACs because you’re putting them in Beverly Hills.

2. The operating expenses don’t change much, no matter where in the city you are. You pay roughly the same amount for property taxes, water, management, repairs, etc. wherever your building is.

Given that your rehab and operating expense stay proportionately the same, what does move around?

1. The acquisition price of the building. Obviously, in the equation above, the lower the acquisition price, the smaller the denominator, and the higher the yield (all things being equal).

2. The rents. The higher the rents, the larger the numerator, and therefore the higher the yield (again, all things being equal).

What does all of this mean? Because all the stuff in the middle (the capex and the opex) doesn’t change much, you need to look for neighborhoods where you can buy cheap and rent expensive. Those are the areas where you ought to be able to generate excess yields.

The trick, of course, is to distinguish a truly improving neighborhood (one where you can buy cheap but rent dear) from a dumpy one (where you can buy cheap but can’t get the rents to work).