Successful real estate investing relies on several factors, but as the old adage goes, “location, location, location” is top of the list. But “location” is a broad term, and evaluating the right place to invest your dollars in real estate means identifying the right market in both the macro and micro senses.
On today’s episode we talk about the factors that make up a good market for your investment dollars.
If you missed our last episode, be sure to listen to A Wealth Capture Machine.
Enjoy the show!
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How to Choose the Best Market for Your Real Estate Investment
Welcome to Passive Real Estate Investing. I’m your host, Marco Santarelli. On today’s episode, we’re going to talk a little bit about choosing the best markets for your real estate investment. My sixth rule of successful real estate investing is to take a top down approach. What that simply means is that you start by selecting the best markets that align with your investment goals. It’s a mistake when investors focus solely on the property and pay no attention or regard to the market or the neighborhood that it’s in. The property cannot be moved, it’s rooted within a neighborhood and within a market.
If you have problems within an area or declining population, declining job growth, all that kind of stuff, it will ultimately affect your property, your rents, your tenants, the longevity. The best approach again is to first choose your city or your town, whatever that market may be, consider the health of that housing market, its local economy such as unemployment, population growth, the job growth. From there, you can narrow things down to the best neighborhoods and then finally picking properties within that neighborhood. Considering all these things is very important.
Today, I want to just talk about these things in a little more detail. Successful real estate investing relies on several factors but the old adage is: location, location, location. For many people, that’s usually at the top of the list. Location as you know is a broad term and evaluating the right place to invest your dollars is really a matter of identifying the right markets in both the macro and the micro sense.
Some cities simply provide better opportunities than others based on factors like the relative cost of housing to the average income, the availability of good jobs and demographic trends. Within each metro area, there are many local real estate markets just like Atlanta or Dallas or Houston. They’re made up of smaller micro markets or suburbs. It’s like one city after another, after another. At that level, factors like the quality of schools and neighborhood safety and access to amenities like parks, shopping and entertainment and a whole host of other variables come into play.
Choosing the right markets for your investing needs involves several considerations. Some of which go beyond just the property and the neighborhood itself. Here are some guidelines to help you ask the right questions as you determine where to invest. You want to start with your goals. Are you investing for the long term or trying to achieve a shorter term boost in value? Various markets throughout the country will produce more consistent cash flow per dollar invested but the properties may not appreciate much. Some of the markets that come to mind will be Memphis, markets within Alabama, some of the areas within the mid west. Other regions will exhibit strong trends for appreciation and value but may not cash flow well due to the high cost of properties relative to rental rates. This is what you know as the rent to value ratio, which I’ve covered in multiple episodes of this podcast.
Investing for cash flow tends to be somewhat more reliable and predictable while investing for appreciation tends to be more speculative in nature. Where you’re at in your retirement savings path and how your retirement plan fits into your overall wealth portfolio as well as things like risk tolerance and the amount of available capital you have will all shape this decision. Consider this when you’re thinking about markets and investing in real estate.
Following that, you got to ask yourself a question of whether you should invest locally or in out of state or remote markets. Many investors want to be able to see their investments or rely on their expertise and their local market to manage properties. This is great if your market and your investment goals match up. That is not always the case. In fact, most of the time, it’s not the case. If you live in a high cost city like San Francisco or Washington DC, the real estate market can produce some positive opportunities but only if you have significant capital to work with. One option is to participate in a partnership with multiple investors to acquire these properties. This is essentially a syndication. That comes with its own set of challenges.
In many cases, it ma be better to evaluate other markets that fit your goals more cleanly. If you do choose to look beyond your local market, it can be helpful to consider cities where you have connections or maybe you’ve lived there in the past. That shouldn’t be your deciding factor. In fact, that really shouldn’t drive your decision. An economic analysis of a market is much, much more important than feel good reasons like, “My cousin Joe or John lives there or I could keep an eye on things.” That just doesn’t make sense to be able to drive by a property if it’s not really producing a rate of return and cash flow for you.
Next, you want to take a top down analysis. When evaluating a city or a region to invest in, start at the big picture level to determine the right geography for your needs. Then you drill down into the neighborhood level. When looking at a metro region, there are a wealth of statistics available to you to help you determine the viability of a market.
Here’s just a quick breakdown of the types of data or the categories that you can look at. There are really two broad categories. One is the economic factors and the other is the real estate factors. When it comes to economic factors, you could look at how many people live in that market. Is the market or the area large enough to provide a diverse rental population? Obviously, you don’t want to be in a small town where there’s as very small rental pool.
Second is the population expanding or contracting. This is an important factor because cities experience growth. Growth is a good thing but a declining population is generally a sign of economic decline and may bode very poorly for your investment prospects. If the population is stagnant, meaning it’s not growing or contracting, that’s fine because you’ll still have that same rental pool and it’ll be fairly consistent. If it’s expanding, that will push demand and that will drive prices up both in rentals, in sales and likely increase the size of the rental pool. Ultimately, that can and will push rental prices up.
Is the economy diverse? One company or one industry market can take a big hit if that one employer base goes through difficult times. A city with multiple economic drivers will be far more stable and more likely to grow. The more diverse the economy is, the more economic sectors there are, the better off you’ll be. That just leads into more stability for that market.
Are wages rising, falling or stagnant? Again, this is just another trend that you could look at and follow. All this stuff could be searched online. If you see wages rising in a market, that’s usually a good sign. It just means demand is high for employment so employers are looking for more talent. In order to get that, they have to sometimes increase their wage or the salary that they pay in order to attract the right types of people or enough people for that matter.
I remember through a recent boom, one particular city, the McDonald’s was advertising a starting salary of $15 to $18. This was McDonald’s. That’s because there just wasn’t enough people to be hired. Everybody was hiring. That’s something to look at. Lastly is, what is the unemployment rate? Is it high? Is it low? Is it trending up? Is it trending down? This ties into everything we just discussed as far as wages rising or falling and whether the population is expanding or contracting. If a population is growing, then you’ll see the unemployment rate drop.
Now, let’s consider some real estate factors. Once you find a market or a couple of a markets that look positive at the economic level, it makes sense to start looking at the general housing market in that area. Some of the questions to ask here include, what is the ratio of owner occupied homes to rental properties? Areas with a higher percentage of renters will obviously create a bigger pool for you to choose from and more demand for quality rental units.
Now, you don’t want to be on extremes here. Often you’re going to see the ratio of owner occupied homes to rental properties anywhere in the 40% to 60% to 70% range. If you are in neighborhoods that have owner occupied homes that are above 70%, you’re in a premium area and the higher that number is, the more of a premium area that neighborhood is. Keep in mind that when you get into areas like that, you’re going to find property values are much higher than the average or median home value for that market. That just make sense. The more expensive a home is, the less likely it’s going to be a rental property or tenant occupied.
You want to look at the rent to value ratios. A general rule of thumb is that the monthly rents should be at least one percent of the property value. Again, it’s a general rule of thumb but if you buy a property for, let’s say, $250,000 and it only rents for $1800 a month, the likelihood that you will see positive cash flow is pretty slim and you will be banking on appreciation at that point. That’s not something I recommend you do anyway.
You want to look at vacancy rates and the time on market. A property purchased at a bargain rate is really no good if you can’t find a renter for it. Evaluating trends in the number of vacant properties and the average time to fill a vacate rental can be critical. Your property manager or the property managers in a market can provide you this type of information. There are websites that will also give you vacancy rate information for neighborhoods. I think the most timely and local information will be from boots on the ground and that will be property managers in a particular area.
Housing sales statistics. Even if you are looking at a long term buy and hold, the ability to sell a property and receive a reasonable price is critical to your exit strategy. I know most of you are not looking to flip property or sell a property in the short term. You’re probably looking at a very long term horizon and possibly holding property forever within your estate. You could look at trends by looking at the month’s supply of inventory and the time on the market and the asking versus sales price.
If you see a lot of supply then the turnover is slow. If you see a small level of supply like four months or less or inventory, that’s a brisk market that would be a seller’s market so the turnover is fairly quick. This stuff doesn’t really make a lot of difference to you in the short run because odds are if you do sell the property, it’ll be years down the road. Those things can change because nothing is ever static or in equilibrium when it comes to real estate. Once you have used these above metrics that I just talked about to identify a possible market at the regional or even the city level, you can then zoom in and focus on the local and neighborhood level criteria that fit your investment goals.
There’s two more categories here that I want to talk about briefly. One are regulatory factors. Some markets are more friendly to real estate investors than others. If you take two individual properties with similar dynamics such as cost, condition, rental potential, you can see very different results based on the things like taxes and whether the landlord-tenant laws are more or less favorable. It really pays to understand things such as the property taxes in the various markets. Some states are very high and some counties are very high, some are very low. Now, this is just one line item, it’s just one piece of the puzzle so keep in mind that it’s not the only factor you should be looking at, but it’s something to consider.
You want to look at property insurance rates for the area especially if you’re in a high wind or potential flood zone. Municipal landlord taxes, this is not common but something to consider. Most importantly I think are the local landlord and tenant laws because you want to know how easy is it to evict the tenant should you have to or should your property manager have to if need be. Where you want to be are in markets that are landlord friendly, not tenant friendly. You want everything, the law stacked in your favor.
Local market factors is that last category here. You’ll want to reevaluate most of the above, these real estate factors I just talked about, at a more local level. You want to look at things like neighborhood safety, the quality of schools. That’s not always important especially on the lower end, B, B minus neighborhood type properties. You will rarely find great school districts. They’ll be good but they won’t be great. Keep that in mind just so you’re not trying to chase after a property that is below $100,000, let’s say with stellar school districts. That is not that common.
You’ll want to look at things like access to transportation, proximity to shopping and recreation and other factors that drive that desirability. Investing in real estate is not really that different than any other type of investment. You want to identify opportunities and ones that present the maximum potential with the least amount of risk. Understanding a real estate market is a lot like evaluating a particular industry sector when it comes to investing in let’s say stocks or equities. You wouldn’t just decide to invest in Nike because you lived in Portland or Coca Cola because you lived in Atlanta. You would evaluate how the company’s stock is likely to perform based on many factors related to the industry, competition, regulation and the like.
If you apply the same kind of analytical reasoning to the real estate markets, you’re far more likely to find properties and opportunities that produce success in your investment plan. That leads to both the short and the long term success. Keep that in mind. We’re happy to discuss these things with you on a one on one basis if this is that kind of stuff that you’re stuck on or you’re considering. Or if you’re actively looking for a market, definitely speak to one of our investment counselors. We can help you get through the maze and identify the right markets that make the most sense for you.
I want to wrap up with a listener question. I got this actually today. The lady’s name is Hope. She writes in, “Hello. I’m a big fan of the podcast and I am very interested in buying property with you in the future but currently wanted some advice on property I have now in Chicago. I own a two bedroom, two bath in the downtown financial district in which I currently reside and was renting out the other bedroom. I’m currently looking for a new tenant but I’m also realizing that the property is not as good for investment as I had anticipated. I recently refinanced to a fifteen year at 2.7%, have about $70,000 in equity sitting but have $437 in HOA fees,” home owner association.
“I am only looking at being able to rent the place out for $2500 a month with parking. But my mortgage alone is now $2700, leaving me at a negative of about $700 a month.” That’s crazy. “The building as well has increased its fees to $500 per move in and out.” I’m not sure what that $500 is for but she concludes by saying, “I’m thinking I need to just get out of this building all together and take the equity. I have to invest elsewhere. I’d love to hear your opinion.”
Hope, thank you for your question. Interesting situation. What you didn’t tell me that I could probably guess is the market value of the unit, condo that you’re in. If you’re only able to get $2500 a month on a unit like that, I am guessing that you probably have a unit that’s probably in the $400,000 to $600,000 range. I’m just not sure where in Chicago you are.
The bottom line is this, you don’t have an investment here, what you have is a liability. It’s taking $700 a month out of your pocket. Essentially what you’re doing by renting out your second bedroom is you’re subsidizing your monthly mortgage payment, your monthly living costs. That’s all well and fine but unless you can actually move out of that property and continue to keep it and rent it out to someone else and generate a positive cash flow, it’s actually not a rental property or an investment property.
I really don’t like HOA fees, in fact, I don’t like home owner associations at all. In very rare exceptions will I actually like to have an HOA. I’ll call that a light HOA where they’re really just in charge of the roadways and the perimeter of the property, not so much the property itself. Paying $400 to $500 a month in HOA fees is very expensive. It’s kind of like what we have here in Southern California with our condos. You have no control over that. It could go up year after year and it probably will. If you miss a payment, they’re going to be after you. If you default after a certain period of time, they could literally foreclose on your condo and take it over.
My suggestion, and I don’t really want to tell you what to do, I just want to give you food for thought. This is a pretty large financial obligation. What you could do is if you can find an affordable place to live, you’re probably better off renting in the market you’re in than actually buying because it’ll make more sense. You’ll get more home for the dollar renting in an expensive market than you will be buying in an expensive market. What you might want to look into and consider is selling this property, investing the equity you have and finding yourself a nice rental to live in that is comfortable that will cost you less on a monthly basis. Something that is more affordable.
What you can do is you can take that equity, whether it’s $70,000 plus or minus and invest it in income producing rental properties that will generate $200, $300, maybe $400 a month in positive cash flow for you that will not only help you pay the rent of where you’re living, the new place of course, but you can also save up that rental income to put towards the purchase of more rental properties. However you want to do that is entirely up to you. Ultimately, you should be able to cut your living expenses, reduce your monthly rent compared to what you’re paying in this condo and generate yourself some rates of return and some income from rental properties.
You’re probably in a very good situation to do that. What I would suggest is you have a conversation with our investment counselors and possibly your CPA or if you have a financial advisor, just take some of that advice lightly. Think about this strategically and look at it as far as what you could do and where you could be in three years, five years, ten years from now if you take this alternate path.
Anyway, I’ll leave it at that. I don’t have enough information to get into any more detail with you. From what you’ve given me, it looks like you have a very good starting point to leverage that equity into income producing real estate and keep your living costs the same or lower by finding what make sense for you in your market. Anyway, I hope that helps. That’s it for now. Thanks for being a listener. We will be back next week with another episode. Have yourself a great week. Thank you.
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