Which real estate markets are right for you?

TL;DR: Finding the right market for investment is as or more important than property selection. For yield oriented investors, focus on slow and steady markets – typically moderately growing, mid-sized second tier cities in the midwest, with a diversified employment base, like Kansas City, Indianapolis and Minneapolis. For appreciation, focus on the high income and growth markets – typically the expensive coastal cities like San Francisco, LA, New York, Seattle, and Boston. Remember that even within a given market, you can find a whole range of sub-markets with different characteristics, which require as much or even more research. Lastly, make sure the market you’re investing in fits your investment goals given where we are in the economic and real estate cycle. 

A rising tide raises all boats

– Proverb

Choosing the right market is key to great returns. Even the best property selection won’t help you if you end up buying in a an overpriced or declining market. But before you decide on a market, you need to have a clear investment strategy. If you haven’t checked out my post on different real estate investment strategies, go take a read now. Once you have your strategy, you should know whether you’re looking for yield, growth, or a mix of both. Every market sits somewhere on that spectrum, and knowing this will help you find the right markets for your strategy, and the current market environment.

Using market personas

To help with this, I have created ‘market personas’ to help me categorize different market types. Personas help because markets have similarities, and if you’ve seen one market of a certain type, personas can help you wrap your head around a new market you’re exploring. When looking at this, it’s important to remember that it’s not one-size-fits-all. A given market might exhibit characteristics of multiple personas, or might be transitioning between personas. You don’t need to use this as a hard and fast rule, but I think most markets can be described pretty well by just one or two of these personas.

Growth markets

There are two main growth market personas that I think of:

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Investing in growth markets can be a good long term decision if you have reason to believe growth will continue. But don’t expect yield in the short term, because these markets are too expensive for that. Also, consider where things are in the economic and real estate cycle. These markets can be volatile, and could experience significant declines if you buy at a relative peak – many of these markets lost 30-50% in value from 2007 to 2012. In early 2018, I would avoid these markets. They have gained anywhere from 80-120% in price since 2012, and while I believe many of these markets will continue on a good long term trajectory, the 3-5 year outlook is less certain. With interest rates rising, and valuations already looking stretched, many of these markets are priced to perfection. For these markets, I would wait until the next broad market correction to consider investment.

For a sampling of markets that fit these personas, check out this sheet. You can see how they compare across a number of key metrics.

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Yield & growth markets

There are certain market personas that offer a healthy mix of both yield today, and potential growth tomorrow:

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These are the goldilocks markets. You can find properties that will yield modestly today, and you can expect some amount of appreciation and upside over the long term. These markets tend to be less volatile as well, which means lower risk of losses if we enter another recession. While conditions in these markets are not quite right for them to become really high growth markets, they have a strong population and economic base that sustains them. In early 2018, these markets are a pretty good place to play.

Check out this sheet to see a sampling of markets that fit these personas.

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Yield markets

There are two types of yield markets – those that are stable and growing slowly, and those that are in decline:

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The slow and steady markets will offer compelling yields – often 10%+ cash on cash returns with modest leverage (75% LTV). But don’t expect them to have major price appreciation. As long as you pick a market that has modest growth, it will likely continue to track broader economic growth of the country. These can be good bets, particularly when the rest of the market is feeling overheated, as these markets tend to have limited volatility. The thing to watch out for here are the declining markets – these can be a yield trap. You might find a property that offers healthy yields on the surface, but those returns might prove illusory. The cost of maintaining the property and accounting for vacancies might quickly wipe out what yields you thought were there, and if growth continues to stagnate and property prices decline, you’ll be stuck with an under-performing property that is a pain to manage.

Check out this sheet to see a sampling of markets that fit these personas.

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Matching markets to personas

So now that you understand the high level market personas that are out there, you need to figure out how to characterize a market you’re looking at. To do this I look at market data across a few broad categories:

  • Long term market trend
  • Market volatility
  • Demand dynamics
  • Supply dynamics

These categories will help you slot a market into a persona, which will inform your long term risk and return outlook as we move through different parts of the economic and real estate cycle. If you want help doing this, you can check out the Ramen Retirement Market Selection tool which can help you create a market report like the one below (request access through google docs, or email me: ramen [at] ramenretirement.com):

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Long term market trend

To get a sense for a market, I want to know how big it is, and what population, income, and property prices have done over the last 15-20 years. This gives you a good sense of what the long term prospects are for the market. You really need at least a 15-20 year view on this, or else there will be too much noise from shorter term market cycles. The key metrics I track include:

  • Price growth from 2002-present
  • Income growth from 2002-present
  • Current population
  • Population growth from 2000-2010 and 2010-present

Together these help give a good backdrop to the longer term trends at play in a market.

Market volatility

Once I understand the general market trend, I want to know how volatile the market tends to be. This is not something people typically think about when considering a market, but it’s important to understand. You’re basically trying to answer a few questions:

  • How does this market respond during phases of rapid growth?
  • How does it respond during phases of rapid decline?

To answer this I look at a few key metrics around home prices and rental rates:

  • Price change 2002 to 2007 – major growth (MSA, City or Zip)
  • Price change 2007 to 2012 – major decline (MSA, City or Zip)
  • Price change 2012 to present – most recent upcycle (MSA, City or Zip)
  • Rent change 2012 to present – comparison to price changes (MSA, City or Zip)
  • Income change 2012 to present – comparison to rent and price changes (MSA)

As you can see in the Ramen Retirement Market Selection sheet, certain cities appear pretty stable – typically in the ‘regional growth’ or ‘slow and steady’ personas. They don’t go up as quickly during growth cycles, and they don’t experience as much decline during periods of contraction. A few good examples include Indianapolis, Kansas City, Madison WI, Lincoln NE, and Louisville KY. On the other hand, there are cities that tend to be quite volatile like Phoenix, Orlando and Las Vegas. These are what I characterize as the ‘speculative’ markets. They have wild swings both up and down. Granted, the long term trend seems to be toward growth, but they are also more susceptible during downturns.

Once you understand what kind of market you’re investing in, you want to understand why it might behave the way it does. Typically the more speculative markets include a mix of both strong population growth, along with relatively lax building regulations or constraints. The result is that during boom times, as more people move in, prices are apt to rise, but because there is easy permitting and little constraints to building, a state of overbuilding occurs, which results in over supply and eventually a more pronounced downturn:

The real estate cycle

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The more stable cities tend to be ones with modest population growth, which means they don’t experience the high highs, but they also avoid overbuilding and the subsequent corrections that come with that. They will tend to appreciate more modestly, but predictably, over time.

What does this mean for your investing strategy? Well, it all depends on your goals, but you will want to be wary about buying at the top in one of the speculative markets. Investing in the higher growth, higher volatility markets can be a very good thing if you can time it at the beginning of the real estate cycle, but buying at the top could mean your investment performs poorly and remains a cash drain for much longer than you anticipated. Moreover, if you’re investing with leverage (which most real estate investors are), a downturn could wipe out your equity pretty quickly in some of the more volatile markets.

If you buy into the slow and steady markets, you give up a chance at greater appreciation, but you also provide yourself a more stable investment – just make sure you’re getting paid today with a good yield if you’re sacrificing a chance at that growth.

Demand dynamics

Now that you know the general characteristics of your market, you will want to understand the current and projected demand dynamics. Real estate appreciation typically starts with an increase in demand. More than anything else, demand is driven by population growth, which is most often driven by job growth and economic expansion. So to get excited about a particular market, you’ll want to understand the population and economic prospects for the region. Are companies moving to the area? Is the local government actively promoting their region and welcoming employers? Are employers hiring? Are these jobs permanent and high paying? Will the types of future employees be able to afford the prevailing rent and home prices? Lastly, is there a healthy mix of industries represented to insulate the region from any specific shock or downturn?

You want to find markets where there will be lots of good paying jobs opening up in the future, so you’ll have lots of tenants who can afford to rent from you. To get a sense for these demand dynamics, I look at the following metrics:

  • Current / historical data
    • Population growth 2000-2010 (MSA)
    • Population growth 2010-2016 (MSA – latest census year available)
    • Current income levels (MSA)
    • Income growth since 2012 (MSA)
    • Price affordability – price to income and mortgage affordability (MSA)
    • Rent affordability (MSA)
    • Economic diversity – major employers by sector (Wikipedia, Chamber of commerce)
  • Projected data
    • Price forecasts
    • Rent forecasts
    • Job growth projections (Chamber of commerce, company announcements)

Most of this information is readily available from a mix of census data and Zillow Research, but job growth projections and economic diversity are things that will require a little more work on your part. To find information on economic diversity, I find Wikipedia to be a pretty good source of information, often highlighting the major company headquarters and the top ten employers for a given city. Job projections are a little harder to nail down, but you can start to get at some of this information by following regional / city related publications or contacting the chamber of commerce. Ultimately, if you’re at the point of considering a specific market, you’ll do well to spend the extra time researching on line and over the phone to confirm your expectations for a given market.

Supply dynamics

The last piece of the puzzle is supply. Even if a market has rapid growth in demand, if supply is easily added, or developers have overbuilt, then rent (and property values) will remain muted. To understand supply dynamics for a given market I will look at a few metrics that indicate how tight the current market is today:

  • Age of inventory for resale property (MSA)
  • Vacancy rates (available for large metro areas)

In addition, I’ll look at building permit trends to understand how much new supply is in the pipeline relative to regional growth:

  • Current building permits as % of population
  • Current building permits as % of population growth
  • Current building permits as % of peak permits from last 15 years

Lastly, I’ll consider whether there are any supply constraints that might restrict future building / expansion. These could be regulatory constraints around zoning or land use, or it could be geographic constraints like water, mountains, protected forests, green belts etc. The Bay Area is a great example of a region riddled with supply constraints. There is restrictive zoning, and NIMBYism from existing residents. In addition, the cities are often surrounded by oceans, mountains, and protected lands. Coupled with the explosive demand driven by the latest tech boom, it’s no wonder the Bay Area housing is going through the roof. These constraints are what has made investing in the Bay Area such a good investment over the last ~7 years.

Finding the right neighborhood

Once you’ve identified a market you’re interested in, you will want to take it to the next level and run similar analysis on the zipcode level. This will help you pinpoint the good neighborhoods from the bad. This is the final step before actual property selection. Some of the above mentioned analysis is available on the zipcode level (price and rent changes). One other resource I use for this is the Distressed Communities Index (DCI) map published by the Economic Innovation Group (note: tool doesn’t seem to work in Chrome – try Firefox). This will give you a zipcode level analysis looking at key indicators of economic performance, including: Vacancy rate, Employment rate (adults not working), Income levels, and Poverty rates.

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Source: DCI map

Another critical thing to investigate with any neighborhood search is crime and schooling. Those are two factors that will have a major influence on the type of renter profile the neighborhood will attract (and you will have to deal with!)

Crime: For crime data, Trulia is a great resource. From one quick view you can get a sense for which parts of town are a little rougher than others. Stay away from war zones – it will be harder to keep tenants, and they will tend to be harder on your property:

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Another good tool for this is Neighborhoodscout. Instead of giving a heat map, it provides a zipcode level view of things. From my knowledge of the Kansas City market, I actually think the Neighborhoodscout view is a little more helpful. But try them both out and see what works for you.

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Schooling: When it comes to schools, both Trulia and Neighborhoodscout have options, but I prefer Greatschools.org which lets you provide an address or neighborhood, and returns a list of assigned schools and other schools in the area, along with ratings and reviews:

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Bringing it all together

Perhaps the key takeaway here is that every market and every investor is unique. Given your goals, use the information above to find markets that will work for you. If you’re looking for yield, you will need to search through some of the lower growth, less volatile markets throughout the middle of the country. If you want appreciation, you can take your chances on some of the more expensive, high growth regions. Whatever you do, make sure you do it with knowledge of your investment goals and a view to where we are in the current real estate cycle for the US as a whole, and the market you’re looking at in particular.

In early 2018, we have enjoyed a long run of prosperity for the economy in general, and real estate in particular. We can’t say when this trend will change, but we can say that cap rates continue to compress, while interest rates are rising, and future economic growth seems less certain (this is a dangerous combination). We’re already close to full employment. We’ve already stimulated as much as we can with tax cuts, and quantitative easing is now going in reverse. This doesn’t mean we’ll have a recession tomorrow, but it does warrant caution. Certain high growth markets have almost doubled since the lows of 2012, while income and rental rates have only grown by 20-30%. If some of the factors driving that price growth unwind, it could leave more recent buyers with some steep losses. A more conservative approach in this market environment would be to invest for yield in more stable markets. Of course, that’s just the opinion of a guy who is focused on Ramen Retirement. This is not investment advice. Your mileage may vary.

Enjoy the journey!


 

Some cool visualizations!

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Source: Brookings

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Source: VisualCapitalist

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