Real Estate 006: Finding the Right Market

In my previous posts, I have discussed why I personally like to invest in real estate and talked about how to get educated before diving in. If you have decided that real estate investing may be right for your financial goals, next up would be finding the right market.

Before even zoning in on one market or another, there are key terms that you must understand: Cyclical and Linear type markets.

Cyclical markets are markets that have large fluctuations in housing prices during a bear and bull market. Its the high risk, high rewards market primarily found on the coastal regions: West (Seattle, Oregon, San Francisco, Los Angeles, San Diego) and East (New York, Boston, New Jersey). Investors in these markets will not likely target cash flow as rent to value ratios using the 1% test will be hard to find (ex: $500,000 home in Los Angeles will not rent for $5,000, it may rent for $2,500-3,000, which is a 0.5-0.6% rent to value ratio). Instead, investors in these markets will play the appreciation game, hoping for large gains in housing prices sometimes 15-30% greater than houses in the MidWest, or linear markets. 

Linear markets, on the other hand, are markets that do not typically see large fluctuations in housing during a housing boom, but do not significantly drop during the recession/correction like the Coastal Markets of California, San Francisco, and New York. These markets are primarily centered in the MidWest (Kansas City, Memphis, Texas, Alabama, Ohio, Indianapolis). Although they may not appreciate as much as cyclical markets, they will be able to have higher rent to value ratios and provide better cash on cash returns for an investor. 

There are many ways to analyze a market, but here are some of the criteria that I look for when researching a new market.

Location Location Location

You may have heard the "L" word more than once. I think this is true still to this day. There is a reason why companies such as Costco, Starbucks, and McDonalds spend hundreds of thousands of dollars analyzing data and the demographics of a neighborhood before opening a location. They know that good location is the key to success. Investors in neighborhoods have realized the "Starbucks effect" has fueled home appreciation in past years. Although it is impossible to guess if these specific areas will appreciate and develop better than other areas without these retailers, but you can make reasonable assumptions and mitigate risk. There are several factors that impact location: Population, Jobs, and Crime.

1. Population

There are many online resources for you to research data in a given market. I personally use www.neighborhoodscout.com, www.bestplaces.net and www.city-data.com to see trends in population growth and demographics (i.e. population by age, gender, marital and education status). Simply put, if a market is seeing negative population growth, it means people are moving out, and housing demand will drop, thereby resulting in lower rental rates and more vacancy. Furthermore, if there is a trend of an aging population or less families, it may also result in renters downsizing sq ft of their home and decreasing demand of standard 3-5 bedroom single family homes that may traditionally be rented to larger families.

2. Job Quantity and Economic Diversity

When looking at jobs in a given market, it is important to not only look at the number of jobs available, projected growth, but also economic diversity. Take a look at Detroit Michigan, for example, which heavily relied on success of the auto manufacturing industry that dominated the area. When those industries suffered and jobs were cut, housing demand and rental prices dropped more than other markets as people looked to move out to other states. States such as Kansas City, MO or Indianapolis, IN that had a well-balanced economy such as retail, manufacturing, transportation, healthcare, and education, suffered less dips in housing and rental prices. 

Do some research on the web to see if there are fortune 500 company presence in the market, are there contracts signed to open new fulfillment centers, new HQ by Amazon? In real estate, its not insider trading, its using information to make good judgment and decisions and capitalizing on trends and forecasts. More jobs also mean more people with steady income to pay rent and other bills.

3. Crime Stats

This is an obvious one, but something that investors may overlook when blinded by a "discounted" purchase price or home that they have fell in love with. Generally speaking, investors with properties in higher crime areas, may be starting off with higher returns on paper due to lower purchase price, and other factors, however, in the long run, you may end up with a lower quality tenant pool, more occurences of vandalism, and even loss of equity because home prices are negatively being affected. I personally use Trulia's crime heat map: https://www.trulia.com/real_estate/Los_Angeles-California/crime/ (Example of Los Angeles) and perform a detailed review of the property neighborhood and crime statistics, along with felons/sex offenders who may be present. This will also affect rent prices down the road.

Crime Stats are related to neighborhood class: A, B, C, but its also made up of other factors such as ratio of owners/renters and good school districts. With that being said, Crime stats should be carefully evaluated to make sure that you are not taking in too much undue risk.

4. County and City Taxes

Taxes are also an important part of your return on investment calculation. Depending on the region, there are different tax rates applied to your property. For example, there are regions in Memphis, TN that charge both a county and city tax: $685 and $550, and there are zip codes 10 minutes away that may only have county taxes $685. In this example, there is a huge difference of $550/year or $46/month per unit that can change a good investment into a homerun.

On the other hand, there are situations where your property may share the same street, but different zip codes that end up costing hundreds in additional taxes. For example, I was analyzing two rental properties in Kansas City and noticed the same company remodeled it, same age, number of rooms, sq ft, but one was $2K cheaper. Taking a deeper look, I realized that one had property taxes of $1,400 while the other had $450 because the county lines were drawn on the same street. Its important to factor in these information when calculating your pro-formas.

Please make sure you do your due diligence and talk to your CPA/Attorney/Financial Advisor before making any investment decision. 

Good Luck!