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I’m going to take you back to “Data is Everywhere” and buying real estate. This is the second part of the podcast about using data in a systematic way everywhere.
In one of the previous podcasts, we talked about using data more systematically and that approach, and we did that successfully. Here, I’ll give you a little insight into how I dove into this area, in which I’m not an expert. It’s not my business.
Look for the pockets of opportunity
Concerning real estate then, I was trying to find a place that would offer an opportunity to buy real estate that I thought was worthwhile investing in because Los Angeles didn’t do it. The west side of the Valley didn’t do it. In addition, Southern California didn’t do it. Also, Central Valley didn’t do it. Las Vegas didn’t do it. Arizona didn’t do it.
Every time I went further and further away, I still couldn’t find anything that I liked. They’d offered a positive return on investment where I didn’t have to dump cash into the property every month. I hate real estate investing where you buy it, and then, instead of generating a return, you have to pay to hold on to it. That seems like a very, very untenable position, especially when markets can sometimes go down.
Don’t go into cash flow negative territory
And then suddenly, you’re hanging on to too much property that has not appreciated but has tanked in value, and it’s cash flow negative. That sounds like an absolute nightmare.
Along the lines of what type of property you’re looking for to do a successful analysis, you have to know what you’re trying to accomplish. For me, that was cash-on-cash, essentially, cash flow, positive cash return on investment. In real estate, they usually call that cash-on-cash.
Focus on cap rate
Many factors determine cash-on-cash in terms of many variables to run the analysis. So when I run a spreadsheet on a particular property, there’s much stuff going into it. However, if you’re trying to simplify growth and look at the levers that impacted it the most, the number one is cap rate. That’s the closest probably to what would generate good cash-on-cash for me.
So if it’s got a low cap rate (3-4% or something like that), I know it’s not going to generate a positive cash flow for me. If it’s got a high cap rate (10%, 12%, 15%), I know it’s going to generate sound, if not phenomenal, cash rates for me.
There are things like insurance and other variables that impact cap rate and, therefore, your cash-on-cash return, but they don’t vary that much by geography. So if I’m trying to find places in the country that will have an opportunity for a good cash flow for me, I don’t have to worry about many of those factors. Even things like the loan interest rate, the leverage you’re going to achieve with individual property, or a group of properties can significantly impact your cash-on-cash. However, again, they shouldn’t vary greatly by geography.
Determine where the lenders are
Some lenders only operate in these 12 states out of 15. That can come into play, so you might want to sort of move in and out a little bit. You’re looking at property that is in an LLC rather than in your name, and I had effectively eliminated in-state deals. Once you eradicate in-state contracts, you have a different set of lenders because the typical banks like the US Bank really won’t touch that kind of stuff where you’re an out-of-state owner.
That means the primary drivers for cap rate or cash-on-cash return are rent and price. Those are the two variables that matter the most. I narrowed it down to those two primary factors and found data on average rents and an average price across the entire country. Therefore, I was able to run an analysis for the whole of the United States.
Again, I kept this in the United States. I didn’t want to go outside of the US or the places that are a whole different kind of analysis in large part because you can’t access data as quickly for those places. They’re not as transparent. There’s not the same kind of data collection. I looked at sites like Costa Rica, and the data is just abysmal. I didn’t want to get into that kind of business.
You can get rent and the average price. Suppose you can get average rent and average price. In that case, you can effectively create a ratio with those two of rent over cost, which is not an insufficient proxy for cap rate, again, not an imperfect proxy for cash-on-cash because those correlate exceptionally well. Then, I sorted and grouped, sliced, and diced.
Segment by region
I found certain states and regions, metropolitan service areas and sub-areas, neighborhoods within MSAs that were much better or worse than others. I even looked at the historical price appreciation. If you have price data, you also have appreciation data (how much do those properties appreciate over time?) to look at the historical growth rate. After all, what I want to know is.
There’s a hypothesis in the industry that I think is relatively faulty that says, “Oh, even if you get a crappy return, like a cash-on-cash return, or even if it’s a negative cash-on-cash return like in Southern California. Well, don’t worry about it because it’ll just grow through the roof, and it’ll be worth so much more money over the course of a couple of years that it’ll make up for all of that.
You don’t have to worry about cash. Even if you’re losing money monthly, it’s okay.” I looked at historical growth rates on income properties in different geographical areas and how they related to cash-on-cash or cash flow or those ratios relative to the growth. What I found was that the hypothesis is false.
Crime rates vs. appreciation vs. investing preference
Yes, some areas are cash flow negative, that do appreciate faster or, at least, over the recent period, in the last 5 or10 years, have appreciated faster than the lower cash flow areas. However, it was not enough to make up for the inadequate cash flow. In other words, losing money every month after month after month, year after year after year was not made up for by the appreciation rate of those properties.
You’re better off having a high cash flow because the difference in appreciation rate between those two areas was not significant enough to justify it. That was very illuminating for me in going after this hypothesis and finding cash flow areas.
Once I had sliced and diced everything and found these areas, I had to add some other variables, things like crime. Did I want to buy into a property where there would be bullets going into the house? Did I want to be that kind of a landlord? The answer was “No.” So I started eliminating those areas.
Again, to be clear, if anyone wants to talk about this in greater detail, I’m happy to do this. There’s a whole political and socio-economic discussion around this kind of stuff and inequity in our society. I don’t want to go on that path for today.
Think three decades down the line
I want to say that I didn’t want to get into that kind of business because being what’s effectively called a slumlord can have very high returns, and that’s not consistent with my personal beliefs. I don’t want to do that for all kinds of reasons that I don’t think are healthy for society.
I also had to eliminate other areas like coastal areas, such as Louisiana, that essentially won’t exist 20, 30, 50 years from now. They can have phenomenal cash-on-cash returns in the near term but, I believe, effectively will have horrific, if not massively negative, equity price appreciation. You won’t have a property anymore in 20-30 years because it will be underwater.
After layering in that, I was left with areas that had much better cash flow. I decided to pilot and acquire the first one in the spring of 2019 and bought six more over the coming eight months. Then, the pandemic shut me down in March of 2020. Of course, the cash flow has been perfect for the properties. Appreciation has been excellent even before the pandemic.
Now, I haven’t gone back and analyzed, “Has the appreciation been as good as if I had invested in areas that had bad cash flow?” That would be an interesting analysis to do one day.
The moral of the story and all of this is, as a philosophy in our life, like our business, as our personal investing, what we are doing, we should be figuring out how to use data. Why? Well, to make ourselves more profitable systematically, whether it’s a side hustle like real estate, just investing your own money.
Moreover, whether it’s your primary business, whether that’s revenue cycle management, or your healthcare provider, or whatever that might be, this is really how we should be operating. So this has been a story about how I changed my approach to investing in my personal life to better reflect what we’re trying to accomplish in our main business at Apache Health.