Tags: worst house in neighborhood | zillow talk | spencer rascoff | stan humphries

Why You Shouldn't Buy the Worst House in the Neighborhood: Excerpt from 'Zillow Talk'

By    |   Monday, 02 Feb 2015 11:21 AM

Excerpt from ZILLOW TALK: The New Rules of Real Estate by Spencer Rascoff and Stan Humphries

"It’s the Worst House for a Reason: Why You Shouldn’t Buy the Worst House in the Best Neighborhood"

Some proverbs offer sage counsel. A bird in the hand is worth two in the bush. Cleanliness is next to godliness. Even a broken watch is right twice a day. Luck is what happens when preparation meets opportunity. These are wise words to live by. But one saying that needs to have its proverbial status revoked is the well-known real estate adage, “Buy the worst house in the best neighborhood.”

Proponents of this strategy contend that buying a bad house in a good neighborhood is a surefire investment. The higher value of the surrounding homes, the argument goes, will elevate even the worst home’s value. A great neighborhood is like a rising tide: It will lift the price of all the houses in it. This advice has been offered, exaggerated, and accepted for decades.

As far back as the late 1970s, newspapers have profiled investors who cite their worst-house‑in‑the-best-neighborhood strategy as the guiding principle of the real estate game. In 1987, a Chicago Tribune article, entitled “Buy the Worst House on the Street,” asked readers, “Would you spend $1 to make $2?”

In 2010, Rich M. bought a fixer-upper in Seattle’s Capitol Hill neighborhood. After renovating it, he sent the before and after pictures to the home improvement magazine This Old House, winning a spot as a finalist in the annual Reader Remodel Contest. The pictures ran with the caption—what else?—“Worst House in Best Neighborhood.” Even British artist David Hockney shared his opinion on the matter: “Always live in the ugliest house on the street—then you don’t have to look at it.”

From CNN Money, to Investopedia, to the late Robert Bruss (known as the “Dear Abby” of real estate), the so‑called experts have done their best to convince the rest of us that purchasing the best possible neighborhood’s worst house is a smart move. But are they right? Is buying the worst house in the best neighborhood a wise investment or is this strategy a real estate myth?

Here’s how we used data to separate truth from adage. Step one was to take a hard look at the cheapest 10 percent of homes in a given ZIP code. We wanted to start with a real understanding of what buyers are getting when they purchase a home that is priced well below a neighborhood’s median value. So we compared the appreciation rates of the bottom 10 percent against the rest of the homes in their respective ZIP codes. This let us see how the bottom 10 percent of homes performs relative to those of their neighbors.

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If the adage were true, the bottom 10 percent of houses would need to perform better than the more expensive homes in their neighborhood. Faster appreciation would indicate that buying the cheapest house in the best neighborhood is a strategy that really does pays off. But—alas—it doesn’t. Instead, we found that only rarely does the bottom 10 percent outperform the top 90 percent of houses in a ZIP code. On average, these bottom-tier homes do neither better nor worse than the others. Looking at those numbers, we might have concluded that buying a neighborhood’s worst home is therefore a neutral investment strategy—a myth, but not a harmful one. It doesn’t maximize returns. But it doesn’t cost buyers either. Then, however, we dug a little deeper—and we saw that buying the worst house in the best neighborhood can actually backfire. That’s because the more affluent a neighborhood is, relative to its greater metropolitan area, the worse the homes in its bottom 10 percent tend to perform.

In short, the nicer the neighborhood, the bigger the myth! Take the case of two imaginary families in the Dallas metro area twenty years ago: the Neimans and the Marcuses. Both were scouring the market for a new home. The Neimans were young, in love, and hadn’t amassed much in the way of savings. In fact, they weren’t even sure they could afford to buy. But then they found it: the perfect little bungalow in Eagle Ranch, a suburban neighborhood in Fort Worth. Sure, the house was in the bottom 10 percent of houses in the neighborhood. But the neighboring houses were so great!

Meanwhile, the Marcuses had been saving a little longer and were in a position to make a larger investment in a more expensive house. They could easily afford one of the nicer properties in Eagle Ranch, but instead, they decided to buy one of the worst homes in North Dallas, a more affluent neighborhood than Eagle Ranch. It wasn’t their dream home. But they figured that the pricier surrounding homes would pull the property value up. After all, Mr. Marcus told Mrs. Marcus, “You should always buy the worst house in the best neighborhood!”

You probably can guess what happened to the Neimans in Eagle Ranch. Even as the rest of the homes in their neighborhood appreciated in value, their house continued to lag behind by about 4 percentage points. But that’s not nearly as bad as what happened in North Dallas. There, the Marcuses watched in horror as their home underperformed its neighbors by a whopping 20 percentage points. In other words, neither family found buying the worst house in the best neighborhood to be a winning investment strategy. But it turned out even worse for the Marcuses in North Dallas.

All of which raises an interesting question: Why does the bottom 10 percent of homes perform worse in a better neighborhood? The likeliest explanation is that there is less demand for lower-priced homes in nicer neighborhoods. As one might expect, in fancy areas, fancy homes are in the highest demand. Imagine, for example, that you’re trying to sell a $375,000 co‑op in Park Slope, a neighborhood on the western side of Brooklyn, which the New York Times described a few years ago as “both haunt and hatchery of New York’s smuggest limousine-liberal yuppies.” The median list price of a Park Slope home is typically six times the national average—and twice the price of the co‑op in question. And buyers there aren’t messing around.

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When you bought this house, you were so excited about finding a Park Slope home you could afford that you were willing to look past the fact that it was a dump. And, with the help of a contractor, you’ve made it much more livable. So you can’t understand why buyers aren’t biting. “Can’t they see what a steal this is?” you ask. Unfortunately for you, the truth is that buyers in Park Slope aren’t looking for a $375,000 co‑op. They’re in another stratosphere. A $375,000 co‑op isn’t even on their radar. And even if they somehow stumbled upon a home that cheap, they might be excited. More likely, however, they’d wonder what the heck was wrong with it.

And therein lies the rub. Because the people who follow this advice do so right in the very neighborhoods where the bottom 10 percent of homes will deliver the worst relative performance. By buying the worst house in the best neighborhood, they’re also buying the worst house where it has the worst chance of appreciating
in value.

BUY THE WORST HOUSE IN THE HOTTEST NEIGHBORHOOD

It’s become clichéd in itself to say that clichés endure because they represent truths. But given how deeply this myth has penetrated real estate investors’ philosophy, we figured there must be something substantiated about it. So we asked: Is there anywhere that a buyer can purchase a home in the bottom 10 percent and still turn a profit?

The answer is yes, there are conditions under which the bottom 10 percent of houses can outperform the neighborhood as a whole. But these aren’t the worst houses in the best neighborhoods; they’re the worst houses in the hottest neighborhoods. In a hot neighborhood, even the bottom 10 percent of homes can turn a cool profit. So what’s a hot neighborhood? It’s an up‑and-coming area that has seen five consecutive years of higher-than-average home value appreciation. If you get to one of these neighborhoods within the first five years of it becoming hot, you have a chance of snatching a property at a low price point that, with some tender loving care, will soon reach the mean of the ZIP code. This especially is true in gentrifying neighborhoods where demand for higher density development such as condos and apartments drives up prices for cheaper properties.

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Now Pittsburgh, Pennsylvania, may not be the first place you think of when you hear about a hot trend. But, using data from 2008 on, we can see that Pittsburgh’s historic district of Manchester is seeing this exact phenomenon play out. At the turn of the twentieth century, Manchester was a prosperous enclave of steel barons and other mansion dwellers. While some of their historic homes remain intact, many of them fell into disrepair as Manchester residents fled for the suburbs. But, by many accounts, the neighborhood is on the rise, experiencing a renaissance that is ushering in its second golden era.

And, during the past five years, Manchester property values have been skyrocketing.
Let’s imagine another hypothetical family, the Roethlisbergers, die-hard Steelers fans, who are looking for a fixer-upper to transform into their dream house. They’ve heard stories about triumphant homeowners who have scooped up older Manchester properties on the cheap and restored them to their former glory. And so they buy one of the homes they can afford— which, of course, is valued in the bottom 10 percent of Manchester’s homes.

Unlike the Neimans and Marcuses, the Roethlisbergers’ story has a happy ending. Manchester is so hot that the bottom 10 percent of homes are not only keeping pace with the rest of the neighborhood; they’re outperforming the more expensive homes by an average of 4 percentage points. On the banks of the Ohio River, a Cinderella story has come true: The worst house in the best neighborhood has turned a profit.

Unfortunately, even in hot neighborhoods like Manchester, investing in one of those bottom 10 percent homes only works if your timing is absolutely perfect. Missing the boat can be extremely costly, because in neighborhoods where appreciation has slowed after an initial spike, the bottom 10 percent of homes tend to underperform compared to the neighborhood average.

In other words, if you don’t get to the neighborhood while it’s still hot, any cheap house you buy will likely do even worse than homes in the bottom 10 percent generally do. We have a couple of theories about that, as well. One explanation is that a period of initial appreciation in a neighborhood can simply be a “false start”— an expected boom that quickly becomes a bust. People thought the neighborhood was going to be hot, but, for whatever reason, they were wrong.

Another explanation is that, after a fast start, the market is picked over. By then, all of the neighborhood’s investment or redevelopment opportunities have been exhausted—and the properties that are still cheap are cheap for a reason. Any home that could be replaced with high-density housing has already been identified, sold, and bulldozed to make way for a new building. This means the homes that are left are either in a horrible location or in such bad condition that no small amount of work will elevate their value to the mean of the ZIP code.

In short, they’re not going to provide a great return on investment. The Las Vegas Strip is an example of one of the worst neighborhoods in which to own the worst home. While the Strip once was a hot neighborhood, due to its proximity to many casinos and tourist attractions, its luck eventually went cold, as luck in Vegas is wont to do. Now, the bottom 10 percent of homes in the area are underperforming the rest of the neighborhood by a solid 9 percentage points. And buyers who took a gamble on one of those worst homes have learned the hard way that even in Vegas, the house doesn’t always win. Which brings us back to those kindly folks who always seem to have an aphorism for every occasion. Sometimes they’re not wrong. But that doesn’t always mean they’re right. Here’s what the data says: Buy a decent house in the right neighborhood. What’s the right neighborhood? It’s the most expensive one where you can afford a home that is not in the bottom 10 percent.

Excerpt from ZILLOW TALK by Spencer Rascoff and Stan Humphries. Used with permission by Grand Central Publishing. All rights reserved. Photo credit: Courtesy of Everett Collection.

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One saying that needs to have its proverbial status revoked is the well-known real estate adage, “Buy the worst house in the best neighborhood.” Proponents of this strategy contend that buying a bad house in a good neighborhood is a surefire investment.
worst house in neighborhood, zillow talk, spencer rascoff, stan humphries
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2015-21-02
Monday, 02 Feb 2015 11:21 AM
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