Hello my friends. Welcome back to Passive Real Estate Investing where we dive into the world of real estate investing among other related topics. To help you with your real estate investing journey, today we’re doing something a little different. We’re going to take a trip down memory lane and showcase an important episode from the past on what we call our throwback Thursday episode. Now, whether you’ve been with us since the beginning, which goes back to 2015, or you’re tuning in for the first time, this episode is a must listen, we are revisiting one of our more popular episodes from the past, and believe me, what we discussed back then, whether it’s six months ago or six years ago, is just as relevant today. So sit back, relax, and let’s rewind the clock for this great episode. Enjoy.
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Throwback Thursday Episode (The episode originally took place in the year 2018)
This episode is part of our Throwback Series and may include references to older content such as webclasses, events, promotions, or links that are no longer active or available. While the conversation and insights still hold value, please note that some information may be outdated.
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A Large And Growing Population
Let’s talk about the seven steps for picking a strong real estate market. It’s a test. The first step is choosing a market that has a large and growing population. Population centers have upwards and downwards momentum. If a city is growing, it will likely continue to grow. A city losing population has a hard time stopping that trend. As a population center grows, the growth fuels itself. More people attract more people and the rate of growth can be dramatic. Currently, populations are moving away from small towns and towards larger urban centers. There is a highly educated entrepreneurial segment of the population that is moving from urban centers to small towns and telecommuting. In terms of total numbers of people, the safe bet is that bigger cities will keep getting bigger.
I like to break those down into three tiers: Tier one, two and three. This is just a general guideline. Tier one is the largest metropolitan areas like Los Angeles, Chicago, New York, San Francisco. The secondary markets are the Tier two markets are pretty much the bulk of the markets out there. You’ll find them in the Midwest and Southeast. They’re peppered all around the country. Tier three markets are the smaller, lower population, outskirts, large towns, small cities. Numbers change from market to market, but don’t get fixated on whether it’s a Tier three or Tier two market. You need to look at a lot of different elements such as whether the population’s growing and the other elements. These are the facets you need to consider.
When it comes to large and growing populations, there’s a lot of free information on the internet that you can look up on population trends or housing trends. There are two big websites, which are the government websites which are the Census.gov and the Federal Housing Finance Agency, FHFA.gov. These are two sites that are chockfull of all kinds of information about every market all around the country. If you’re doing general searches online for population growth or population trends, just use the name of the city followed by those keywords, will pull up all kinds of information. There should be no shortage of data at your fingertips to look at what markets are doing, growing or shrinking.
Diversity Of Employment and Job Growth
The next factor is the diversity of employment and the job growth. Job growth for me is important because if you have jobs, you have people that can afford to pay their rent and their mortgage, also having job growth draws or brings people into a market. People are attracted to an area, primarily because of jobs. Many people would prefer to live in the beautiful mountains than the suburbs, but there are very few jobs in the mountains. If you look for job growth, you will find population growth and increased capacity to pay. That’s what we want as landlords or people who invest in real estate. When we lease that out to tenants, we want people who have the capacity to pay.
Where there is population growth, you will have increased demand for housing. Increased demand along with the increased capacity to pay means that higher rents and sales prices are almost inevitable. If you are an investor, these are great things. You want markets that have diverse employment, which means that they cover a lot of different sectors and good job growth. What I mean by diverse employment is that you want to see manufacturing, healthcare, finance, hospitality. You need a diversity, not markets that are what I call One Trick Ponies, where it’s heavily based on oil and gas. If prices of oil come down, jobs are basically eliminated. They cap wells and people are laid off. You don’t want that, you want job growth and diverse employment.
Low Cost Of Living Compared To The National Standard
Number three, choose a market that has a low cost of living compared to the national standard or the national average of the national median. In tough economic times, companies that do business on a national level will save money by relocating to low-cost business-friendly areas of the United States and sometimes even abroad. We always hear about jobs being offshored. For example, many Americans are relocating to Texas. This has been going on for over ten years. I remember the first person that told me they were moving to Texas from California was back in 2003, 2004. At that time, I thought he was a little nuts, but I realized that he was moving because he can get four times the house for the same price and the cost of living was lower. Many Americans are locating to lower cost markets like Texas because of the low cost of living and the quality of life is high. That is where jobs are headed and it’s been going on for many years.
Workers and employers are leaving states like California, New England and other high-cost areas in the US and then relocating to where it’s more affordable. Affordability plays in heavily. If you look at housing in parts of Los Angeles, they’re ten to twelve times the annual wage or the median income of the occupants. If you take a look at other markets like Dallas, where housing is only about four times what the annual wage is for a resident there. Most Americans are tired of being house poor and they long for a return to the day when a single income is enough to be middle class. The middle class is slowly but consistently shrinking.
Families are making housing choices primarily on the proximity to their job and secondarily on the overall affordability of the area. A housing price to income ratio that’s less than three is considered very affordable. If affordability is below three, in other words, housing is three times your annual median income, that’s very affordable. If it’s three to four times, it’s moderately affordable. If it’s four to five times, it’s moderately unaffordable. If it’s over five times your income, that’s considered severely unaffordable.
Let’s look at Los Angeles, the median home value is about $533,900. Let’s look at median household income, it’s about $62,000. It’s simple math, we just divide one into the other, $62,000 into 534, and we get 8.6 times. That’s the metro area. There are pockets that are ten to twelve times the annual income, the annual wage or even more. At the metro level, it’s 8.6, almost nine times and that is severely unaffordable. Look at Dallas. The affordability ratio in Dallas is only 4.2 times, that is great even though Dallas has been appreciating strongly over the last three, four years. The median home value in the Dallas metro is $266,000 and the median household income is under $63,000. It’s 4.2 times.
Let’s look at another market. The third one is Memphis. The median home value in metro Memphis is $162,400 while the median household income is $51,450, so about $$52,000. If you do the math there, you’ll see that the affordability ratio in Memphis is only 3.1 times, that is considered very affordable. This is the differentiator in different markets. You want to choose a market where it has a lower cost of living because that means that people are able to better afford housing whether they’re purchasing or they’re rentals. If the median home price is more than five times the median income, those buyers will be required to use far too much of their income for housing and they will not qualify for mortgages.
Cash Injection Into The Baseline Economy
On the one hand, that’s good, if you’re a landlord because that means a larger tenant pool, but the flip side of that is that the numbers in those markets don’t make sense. Those are often what I refer to as Cyclical Markets. Many of those cyclical markets often become bubble markets. The next element is cash being injected into the economy or money flowing into that market. I can refer to this as Cash Injection into the Baseline Economy. Every town and city need something that draws outside cash into the community. One of the economists that I like, Richard Maybury, calls the injection of cash into a community a cone. He says, “Conventional wisdom says that when the government expands the money supply, the money descends on the economy in a uniform blanket. This is wrong, the money is injected into specific locations causing hotspots or cones.” That quote was an excerpt from one of his books called The Clipper Ship Strategy.
He talks about examples of cones. The recipients of federal stimulus packages are one example of a cone. Natural resources like oil wells are a cone. Destination tourist attractions like Disneyland or Disney World are a cone. Agricultural exports like the wine in Napa Valley are a cone. Cones draw money into the community. Every city needs workers like nurses, librarians, firefighters, waiters, and waitresses. These types of jobs are support and service occupations, and they exist to serve a local population. They’re not the reason money comes in, but when money comes into a market and creates an economy and there’s growth, you need that second-level of employment. These are support jobs or support staff.
They do not import fresh cash into a local economy. They’re there to service the cones, they don’t create the cones. Without a natural resource or commodity to import cash into a local economy, the service and support jobs will quickly dry up. Those secondary or support jobs exist because of the primary industry and the primary jobs that are in that market. Service and support jobs recycle money between themselves. A large percentage of what these workers spend leaves the local economy in the form of food and clothing, imports, taxes, traveling abroad, so money can flow back out.
Without a regular injection of cash coming in from the outside world, all of the cash and jobs will eventually leave a local economy. It leaves behind are those desolate gas station towns that cling to the side of an interstate. Get your investment dollars as close to the cone as possible. An oil field worker is closer to the cone than an oil field worker’s barber. The injection of money, the cone, created by oil consumption will keep the oil worker employed. When the general economy gets tight, the oilfield worker’s personal spending may not be enough to keep the barber in business. For instance, North Dakota had small towns all over and there was an oil boom, but there was no housing. There were a lot of jobs and growth, but there was no housing, so the housing market exploded. They couldn’t build fast enough. Then they got to the point where they were building enough inventory and the oil prices dropped. They started capping wells and laying off workers. The workers left to go to other cities or other markets for jobs.
You had all this excess inventory, prices came down and vacancy rates skyrocketed. That’s what happens when you have all these jobs leave. The cone disappeared and you had all these secondary support jobs disappear with it. I like investing in lower-middle to the middle class, which are mainly blue-collar areas close to manufacturing and distribution centers. Manufacturing and distribution centers are reliable cones, so the jobs and tenants they attract are fairly stable, they’re semi-skilled and well-paid.
This is not the be all and end all. This is a general guide for me, but this is what I like to follow. I like to say that these are your B+ and A-type communities and neighborhoods and you can even classify that as a market. The government has an unlimited ability to inject money into specific locations, creating some of the largest cones. Government spending comes and goes at the whim of politicians. If you are investing near a large government cone, just make sure that there are at least four additional cones, in other words, baseline industries in putting money into the local economy. When the government cone moves on, you won’t be stuck in a declining or decimated housing market.
There are a few single cone towns with sole employers like a military base, college or steel mill. For example, North Dakota which was a One Trick Pony Market, it was all heavily based on oil and gas. All these other jobs exist to serve the population at that baseline employer or that baseline level. The housing values of that one horse or one trick pony towns are tied entirely to the success of a single industry, which is never a good environment to be in if you’re a real estate investor. You want real estate investments in diverse economies and in markets that have multiple cones. There’s an industry and there’s an economy there that’s drawing money in from the outside. When we’re talking about cash injections into the baseline economy, it’s important to understand that even if it’s at a 40,000-foot level, the concept of money coming into a market to keep the economy growing and afloat. If it’s a little too complicated, you just need to understand that you want to be in a strong growing market.
Healthy Ratio Between Rent And Purchase Price
The fifth thing you want to look at when it comes to choosing a strong rental market is having a healthy ratio between rents and purchase price. Common sense dictates that there should be a small premium attached to home ownership compared to rent. However, there are many high-priced real estate areas where it is drastically more expensive to own than to rent the same house. Think of Coastal California. Why buy when there is such a huge pricing disparity between renting and ownership? When the homeownership premium is too high, it encourages foreclosures. It encourages it in the sense that it becomes less affordable. People who do own it, if they can’t afford it, their home goes into foreclosure when there’s an economic upset.
If your home is declining in value and it’s much cheaper to rent the home, you will more likely to walk away from your home if you’re in a negative financial situation. The inverse of this statement is also true. If it is cheaper to own than to rent and home values are stable, you will do everything possible to keep paying your mortgage. In most of Dallas, for example, it is the same cost or cheaper to own than to rent. This substantially reduces the temptation and need for an owner to walk away, thus further perpetuating a cycle of stable home values and rents. That has been increasing because there’s been a lot of momentum here in the last few years. Stable appreciation and positive cashflow over the long-haul result in great cashflowing investment performance compared to the rollercoaster of price speculation that many so-called “investors” get caught up in, a repeat of what we saw in 2004, 2005 and into 2006.
In most recent real estate boom and bust states like California, Florida, Arizona and Nevada. These are the four main states that were ground zero for the housing market crash of ‘07. Many speculators ignore the fundamentals of cashflow and overpaid for properties relative to the cashflow those properties could produce. I refer to this as the Rent to Value or Rent to Price ratio. There was a buying frenzy that drove prices up. When the prices peaked, speculators ran to the exits and prices crashed because supply increased and demand decreased. That’s when you get prices crashing. You can make a lot of money in a short period of time if you know how to time the market and you’re a speculator, but you can also get crushed. We’ve seen this to the tune of millions of people. In real estate, when you’re focused on cashflow and creating wealth in the tried and true way. Over time, slow and steady always wins the race.
Access To Quality Of Life Amenities
The sixth point is access to quality of life amenities, things like arts, entertainment, warmer climates, and lower crime. We’re not talking not at the neighborhood level here, we’re talking about metropolitan areas and cities. People will move to a new area for a job, but they and their family will stay longer if there is a high quality of life. The United States is experiencing a population migration away from colder parts of the Northeast and parts of the upper Midwest into warmer climates. Not only are warmer climates more desirable to live in, they often result in less expensive real estate maintenance. Freezing temperatures are pretty hard on real estate. It’s easier on your house when you can have moderate and hot climates than cold freezing climates.
It’s not a lot of fun and it does create more maintenance. The access to quality of life amenities helps keep people in those markets stronger. I went to Shanghai and in China, they refer to the US markets that they have the most interest in as the Smile States. If you look at the US and you draw a smile, it’s the coastal markets on the left down throughout the south and along the right side of the Eastern Coast. They don’t necessarily like the far north, but they predominantly like the South. That shape of a smile is the reason they refer to it as the Smile States.
Comparatively Low-Cost Government
Number seven, a comparatively low-cost government. When you pay more taxes, you have less money to spend on other things. Businesses are attracted to areas with low cost of government. In places where taxes are low, businesses are more prosperous and profitable. Businesses are good for real estate owners. There are seven states with no state personal income tax, Alaska, Florida, Nevada, South Dakota, Texas, Washington and Wyoming. How can Texas, a state with no income tax, be always in the top states with surpluses and have low to no state taxes?
When the national economy is in shambles and 44 plus states are running major deficits, these are deficits at the state level. Texas has a history of conservative spending, balanced budgets, a reluctance to borrow money, and a very stable economy. If a government is continually borrowing to fund its operations, the cost of that borrowing is passed onto the taxpayers in the form of higher taxes and/or lower services, less or fewer services. When you own real estate, your silent business partner will always be the taxing authorities of the federal, the state and the local governments. I prefer that my business partner is as silent as possible. This is why I favor the states that have very low or favorable taxes and a business climate. Texas is one of those. Although taxes are becoming more expensive, it’s still a great state to invest in along with Alabama and many of the other states that we’re in right now.
I hope you enjoyed this week’s throwback Thursday episode. If you haven’t already, remember to subscribe so you don’t miss out on a single episode. We’re releasing one every week, sometimes two. If you have a question about real estate investing or finance, simply go to passiverealestateinvesting.com and click the Ask Marco button. I read all of them, I reply to many of them, and sometimes I cover them on the show, and I’m gonna try and do more of that. So, I am going to encourage you to go to passiverealestateinvesting.com and submit your question for Ask Marco. Lastly, help us share the show with other like-minded people that you know who can benefit from it as well. Just visit us on your platform. Most of you are on iTunes and leave us a rating and review. I would greatly appreciate it. I read them all and I will thank you in advance. And that is it for today. Thanks for listening. I will see you on our next episode.
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