Last night a good out of area friend called me at home (yes, phone on a landline…not email, text, Facetime, IM, Facebook or any other numerous ways to communicate) to get my advice on a possible rental house that just came on the market. My friend has some capital that he wants to redeploy to real estate rather than leaving it in the stock market. He forwarded an email from a real estate agent on the opportunity. After doing my back-of-the-envelope calculations, and speaking with my friend in more detail, I quickly concluded that I didn’t think it was a “good” investment for him, and that I didn’t think key points with the original investment thesis applied to my friend. Although the agent wasn’t wrong in his statements per se, it didn’t apply to my friend’s investment profile and situation. The recommendations applied more for an owner occupied buyer rather than a financial investor and could have caused headaches for him at an unattractive financial return.

Below is an edited version of the email and I will attempt to address some of the sections that I reference with names, city and some other details altered to protect confidentiality.

I saw a 2-bedroom/1-bath 900 square feet house today listed at just under $600k. One of the lowest priced SFR for sale in (above average neighborhood). As we discussed, the other (really desireable and one of the best neighborhoods in the area) neighborhood you are contemplating, I believe to be at the peak of the market, too expensive, and with little upside. There is much potential for appreciation with this bungalow and this particular area. The cap rate won’t be that great on it. The play here is that if you add square footage to this property and double the size, this could become a $1 million dollar house. The condition is good overall and livable. It would be perfect for a small family to live in and then down the road add an one or two bedrooms and another bathroom or two. The street location is good with many over Million-dollar houses. If you added an extra couple bedrooms and a bath approximately doubling square footage, it would sell for $900k. Do note that many builders can build for around $125 a sq. ft.

First, let me emphasize there are NO right or wrong answers. Second, although I know a bit about the area where my friend lives, I am not an expert, as I do not live there or buy/sell houses there. With that being said, the points I make below still apply to my friend’s situation as my statements are not geographic specific.

So where do I begin?

1) The opinion of whether the market and the specific “best neighborhood” is at the peak or not is irrelevant when comparing cities in the same vicinity. If one attractive city is near the peak, then the city next to it which is also a good city also would be at the peak or vice versa. The overall market of those cities will be highly correlated at close to 1.0. It wouldn’t affect which city to buy in if they are fairly similar and right next to one another. One city won’t go up while the other city goes down. For example, in SF Bay Area, if Palo Alto represents a highly desirable city, its values will still be highly correlated with neighboring Menlo Park, or even San Carlos.

2) This is actually 1a. Regardless of one’s viewpoint of near term market appreciation potential, what the agent didn’t factor in at all is that my friend is looking at this investment as a LONG TERM (20+ years) rental hold set up through retirement. The asset will appreciate over the course of 20 years. Then the questions become, is one city going to appreciate faster than the other in terms of valuation, rents or other financial factors. The agent’s statement that pricing is at its peak implies his assessment of near term pricing – not long term.

3) The cap rate won’t be that great. That’s an understatement. I did a quick calculation on this and I estimate the cap rate on this deal “as is” to be between 0.5-1.5%. That is horrible for a “cash flow” oriented investor. I won’t go into details on cap rate as there are many, many factors that go into it. Cap rate generally is inversely correlated with attractiveness of the neighborhood/house/street/etc. As an example, Palo Alto will have one of the lowest cap rates around compared that to a house in city with many foreclosures like Stockton or Tracy which will have a high cap rate (8-12%+). A cap rate of ~3% is considered low but typical for a house in a super strong, high demand city with strong school system, etc. that is renovated and in move-in condition. Pitching a 1% cap rate deal on a 2 bedroom less than 1000 sq. ft. bungalow?

4) Doubling square footage and altering it from a 2/1 to a 4/2.5 would increase price from $600k to $1 million. That statement in itself doesn’t lend credence. How much will it cost to double the sq. ft.? Is that even possible on the lot? The $/sq. ft. actually decreases in that statement so why does that support this as a good investment? There isn’t enough data/calculations/analysis to provide support on an investment thesis with that generic statement alone.

5) Builders can build for around $125 per sq. ft. That is a totally misleading statement. My friend has a full-time corporate job. He is NOT a builder, doesn’t have builder pricing for materials and labor. And the data being reference is for big builders, likely not even realistic for a general contractor. A random consumer can’t come close to adding sq. ft. to a house by hiring a General Contractor, Architect, etc. and doing the work for that dollar range. The number cited could have gotten my friend into trouble had he relied on the number for his analysis.

6) And finally, notwithstanding statement 5 above, my friend wouldn’t want to do a MAJOR construction project. The house he recently sold was an awesome house in an awesome city in which he received multiple offers and did well on the house in terms of price. Although the house was in solid condition, he could have done a few small projects like updating the bathrooms, refinishing the hardwood floors, or even done some work to the kitchen. Any updating effort prior to listing the house would no doubt yielded a positive Return on Investment. But he is a busy corporate executive with no interest in a house project. Would he really consider going through and doing a tear down major construction project that is really only (possible) play on what the agent is pitching. And even if they were prepared to do that, I’m not even sure there is enough profit margin to go through that major effort, financial investment and higher risk to even consider it.

Thus, the one statement that may be accurate is the sentence on being “…perfect for a small family to live in and the down the road add on….”. That is probably the target buyer on this house, not for a small financial investor that just want to re-allocate some money to a property that is in good condition in a good neighborhood that will generate solid cash flow and not cause a lot of headaches. The opportunity just doesn’t make sense from a financial return perspective or a good fit in terms of my this particular investor’s time horizon and investment profile.