7 Ways to Pick a Real Estate MarketJan 09, 2021
Any course on economics will teach you that an understanding of the fundamentals of supply and demand is critical. When the supply of a product goes up, demand lowers the cost of that product. Why? Because those demanding the product now have more options among suppliers, allowing them to dictate values in their favor (yielding better pricing).
The opposite applies as well. When the supply of a product goes down, all things being equal, demand will increase the cost of that product.
In real estate, decreasing the supply (to the point where the market is largely affected) is nearly impossible. You don’t tend to see large communities abandoned or made unusable. But you do see developments of new construction homes, condos, or townhomes, which increase supply.
What happens if the demand line increases at the same rate the supply curve does? In this case, pricing would remain stable as the increase of demand is directly correlated and balanced with supply.
Because demand in markets can often change quickly due to factors of large employment growth, birth rates, new universities or expansions, new infrastructure making livability easier in an area, lower taxes, better climates, etc, the demand line can quickly outpace the supply line.
Moving to a new city or state takes a lot less time than it does to build a home. So if a metro sees a sudden uptick of in-migration, builders soon realize that they cannot keep pace, and a rapid increase in market price results. The value of real estate goes up.
So look for areas that have growing populations that also have some restraints to growth (rapid urban sprawl and land availability). The demand on housing inventory for rent or for sale will keep the pressure on price. That pressure will push it up over time due to the scarcity of options for local consumers.
Some of you probably live in an area of the country that is struggling to get people to stay. If you're not sure how the demand looks in your area, try looking on google and search for the population history of the market you are looking in. You should be able to easily see a recent 15-year snapshot and observe the trend of population growth. Compare this to the US as a whole. You want to be investing in areas that at a very minimum beat out the US population growth average.
The last thing I'll mention here is the importance of knowing WHY an area is growing. Is it birth-rate, a hot retirement destination, an energy boom, a university, or a collection of solid key indicators?
Once you know the source of population growth, you'll need to decide whether that source of population feeds into or hurts your business model. It's important to understand whether this growth rate is likely to continue and what is driving it. Is it sustainable? Is it crash-resistant?
What if you wanted to sell burgers out of a food truck and you knew you had an extremely lucrative recipe? Your plan out how you're going to park outside sporting events, parades, and the local food truck hangouts...
But in order to make these burgers, it's going to cost you quite a bit per meal because the quality is high. But that’s okay because you knew you had buyers that would pay $10/burger so you'd still make a healthy $5/burger in gross profits. Not a bad business model if you can answer the need for volume and other fixed expenses (labor, insurance, taxes, utilities, maintenance, and incidentals).
Then one day, a law is passed that declares that burgers are getting far too expensive and are out of reach for consumers. This law determines that no burger can sell for more than $5.50/burger and the law will be enacted this year.
What is your business now worth?
You were making money and doing well. If you had to drop prices would you still survive and be able to provide the same quality burger? Are your patrons going to be ecstatic thinking they now get a quality burger that used to only cost $10, and now they get it for only $5.50
The answers may seem obvious. We all know that pretty soon you will either close up shop and do something else or immediately look for ways to cut costs and change your inventory.
These types of regulations don't just hurt you. Every vendor that you relied on to put your ingredients together now has to find a way to make ends meet within the new regulations. If before, you had a business worth selling, it's now all washed away with regulations.
You have no equity.
While your investment was thriving, you enjoyed spending extra earnings on items that generated value in the community. Like going to the movies, traveling, buying a new car... You can no longer afford that lifestyle and now all those businesses suffer as well.
This is exactly what Portland did in 2019.
A couple of years ago, Oregon decided that the cost of living was too high in Portland and that it would be best to implement "rent controls" to their real estate. Keep in mind this in a city that is already highly regulated and land-locked within the city limits. Landlords no longer had the ability to determine the fair-market value of their rents by choosing a price that yields a less risky tenant without risking too high of a vacancy rate.
When deciding on a multi family investment property, it is important to understand whether the state or city you want to invest in has rent control like I mentioned here. Look up local landlord/tenant laws. You want to be able to hold a deposit when a tenant damages your property, evict them when they don’t pay, inspect when you need to enter (with appropriate notice), and treat the property as though you have rights.
After all, we call them property rights for a reason and you are investing in the ability to make decisions.
Don’t buy in a market that dictates your rights in such a regulated form that you end up welcoming bad behavior by "professional tenants" who know and work the system to their advantage. No one should be held hostage to their own “investment”.
I won't go through and list “good states” and “bad states”. It's simply too dynamic of a topic. A good rule of thumb though, (I don't want to get too political here), is that on average, conservative states like to preserve less regulation while liberal states tend to lean towards more regulation.
It's all about risk vs reward. Do your due diligence.
Similar to landlord and tenant rights is a market's business friendliness as a whole. What are the property taxes like for an investor in the asset class you are looking to purchase? You can contact the local assessor's office and get an estimate on the expected property taxes per property class. This will be very insightful as some states are disclosure states (the majority of them) which means the tax the previous owner has been paying based on the twenty years they owned it may change dramatically when a new owner (you) buys the property with a highly-appreciated price tag the assessor now has to chew on.
Another type of tax you’ll receive on real estate are transfer taxes. This is a local or state tax in addition to property taxes. It can be an additional cost of up to 2% of the sales price in addition to other commissions for real estate professionals and closing costs. This is very important and will definitely impact your IRR when calculating your exit fees.
It’s always important to understand the vacancy rates of a given market. If your market is experiencing population growth, this is a great start to limiting your market exposure to vacancy. However, that's not the only solution to a vacancy issue.
Vacancy is the most expensive cost to a real estate asset. It not only devalues your income, but it also devalues perception.
If you’re a tenant looking for a place to live and you find out the last building is taken and there is a waiting list... do you want to live in it more or less? That demand increases your perception of the value of your asset AND increases your curiosity as to why it’s in so much demand. There are multiple sources for vacancy rates with professional services, but none is better than taking a personal look through the competing listings surrounding the asset you are considering.
Your best bet is to visit a comparable property and simply ask what is available over the next three months, how long it took to stabilize, and what concerns they run into in the area. You don't have to act like you’re a tenant. Just come right out and say you’re a real estate professional looking for quality management relationships and looking to possibly invest in the area.
A healthy market will hover around a 4-6% vacancy rate. A really robust and undersupplied market will be less than 4%. One that is soft will be above 6%.
The higher the vacancy, the softer your price analysis will be because filling those units will require that landlords rely on incentives, lower rent, or move-in specials to get those units filled.
Lessen your expectations on the overall investment if the vacancy rate is over 6% consistently. Another factor to consider is asset quality, amenities, floorplan, and proximity to jobs, shopping, and transportation. A renter moves in due to convenience and pride of lifestyle, so choose locations where you’re close to the demand of your renter demographic. Create the lifestyle tenants are excited to boast about. This is often found in finish quality, amenities, and/or design.
Rent vs Own Affordability
Markets that have outpriced the affordability of homeownership like San Francisco, New York, and Seattle, tend to create strong rental demand because the gap of being able to afford a home or down payment is such a high mark to meet.
If the barrier to homeownership is high then it is easier to keep a large demand on rents. When looking at markets to invest in, don’t buy a project that costs you $100,000 per door if you could go out as a buyer and buy a similar product at that same price.
You need to see the cost of the rental unit be less than the comparable owner unit otherwise your rental pool will be buyers themselves. It won't be long before they move right out of your market which will soften rents, increase vacancy, and drive down market values on rental properties.
Annual Income Averages of Market
The markets we are attracted to have a median income range of $40,000-$70,000. This median income valuation range is above the mark of poverty in most markets (excluding such high-priced markets). In this range, a higher qualified employee with skills or a degree, and a dual-income household if married puts the household income at $60,000-$140,000 generally.
Proximity to Economic Districts
Renters are most often after lifestyle and convenience. Signing a lease to rent an apartment or townhouse is not a life-altering decision. It’s barely more than a date in the scheme of things. If there isn’t something inherently attractive in the appearance of your asset, then maybe you should pay a little attention to that property. Real estate that catches your eye (in a good way) in your first impression, will do the same to renters. A better-looking property is always easier to lease-up.
Once the first impression test is met, the location should be your next strong thought, especially in an economic cycle downward. Renters are seeking absolute convenience. How close is the property to their job, transportation, entertainment, shopping?
Even the nicest of properties, with a great price, is not worth the drive if it’s too far from the amenities tenants care about. Renters will keep shopping for convenience just like the prospective date will seek a great personality once the look test is passed.