Warning: The Market You Should Be Buying in Has CHANGED!

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Did you know that the dynamics of markets (a.k.a. cities) for real estate investing changes? They change all the time actually. One year there may be a market that everyone is buying in, like an investor feeding frenzy, but that market will change, guaranteed. Especially if it experienced an investor feeding frenzy.

If you are already trying to tie what I’m saying to your situation and it’s not making sense, it may be because you only invest in your local area. If that’s the case, that is totally fine. This explanation is more for those who are willing, or interested, to invest outside their local market.

A Quick Blurb on Investing Outside of Your Local Area

This could easily turn into a long blurb with a lot of arguments back and forth about whether it’s better or safer to invest in your own backyard vs. invest long-distance, which is likely to forever remain a heated debate, but I’m not going to hit that here. Of course a lot of that debate will hit on too, where is your own backyard? If it’s somewhere in random Arkansas in a cute little suburb, it might be just fine to invest there. But if Los Angeles is your own backyard, it doesn’t make so much sense.

But regardless of all the different sides of the debate, I want to point out one argument for investing outside of your local area, which will lead further into this discussion about the markets. That argument is-

If you always want the best possible returns on a real estate investment, you have to be willing to change what market you are buying in because the best market to buy in is always changing.

The Dynamics of a Real Estate Market

For simplicity purposes, understand that I am talking only to the investing side of real estate. What I say may or may not be different if thinking of real estate as a whole, but know that I am thinking of investing markets. Also to keep it clear, I’m thinking mostly of rental properties. For flipping or any other facet of investing, you’ll have to adjust the information accordingly.

The most basic way to think of a real estate market is by picturing a bell curve.

picture

You’ve probably thought of real estate in bell curve fashion already because of the famous line- “buy low and sell high”. That means buy when the market is at the bottom of the curve and sell when it’s at the top. It’s probably the most fundamental rule in real estate if you are seeking to land a profit. This rule pertains to what I’m about to explain as well, so keep it in mind. What I’m going to do though is change the wording a little bit. I want you to look at this bell curve and think of it as an “Expansion Cycle”. A market is going to expand and contract continuously. The level of that fluctuation is actually what can make a market so advantageous for investors. The fluctuation in the picture above suggests a fairly dramatic growth and decline. If you continue the line on further and that same pattern continues, you have a market that grows hard and dies hard in terms of real estate. The alternative to this pattern is a much flatter line. It still grows and declines, but at much less dramatic levels.

Both versions of the Expansion Cycle, the more dramatic one and the less dramatic one, exist in real life real estate markets. Remember how Phoenix, Memphis, and Atlanta were sooo popular for investors at one point? Investors are even still buying there now, but remember a couple to a few years ago when those cities were all the talk? They were like the hot spots, had to buy there, feeding frenzy markets. Do you know why those cities became so advantageous for investors? It is because those cities followed the more dramatic bell curve version of the Expansion Cycle. Those cities, when the big market crash happened, crashed HARD. What was pseudo different about those cities than other markets that crashed so hard was their potential for extensive growth back up the Expansion Cycle. This assumed growth was due to industry, job growth, population growth, and other factors that showed solid evidence that the city would not only recover from the crash, but recover to very high levels. Some cities around the nation may have crashed hard but they didn’t, and still don’t, have the industry or population to support a bounce-back. Phoenix, Memphis, and Atlanta did.

So during those “feeding frenzies” you heard about in those three cities, the cities themselves were at the ‘bottom’ of the bell curve, and investors had every reason to expect a big bounce-back. That is how a dramatic Expansion cycle works- the bottom of the curve is considered the Infant Stage and the top of the curve is considered the Mature Stage.

Related: 1st Quarter Housing Report for 2014: Dallas, Texas Continues to be One of the HOTTEST Markets Around!

What about the more flat-lined bell curve though? Where does that apply? Well, the best example is the Midwestern cities. Indianapolis (“Indy”), Kansas City, places like those. A flatter bell curve-shaped Expansion Cycle suggests a much more stable market. Stable in the sense that a crash there isn’t going to be as dramatic or detrimental as with other markets. For example, Indy only declined about 7% during the big crash a few years ago, which in comparison to most cities, was very minimal. Indy is also considered to be the #1 Most Stable Real Estate Market in the U.S. This conclusion is based on the lack of severity in fluctuation of that bell curve, if you were to draw one. That’s how all of these things tie together.

To further tie these together, let me give you a top-level view. Let’s say you want to buy a rental property and are trying to decide what market you want to buy in. You have two options for markets:

  1. A market that follows the dramatic bell curve
  2. A market that follows the flatter version

If you buy in the more dramatic market (and I assume you are buying smart and buying at the Infant Stage of the cycle), you are likely to see a significant amount of appreciation with your investments because it is likely to follow a more dramatic rise to the top of the cycle. If you buy in the market with the flatter bell curve, you aren’t likely to see a lot of appreciation, if any. The trade-off here is risk. While the more dramatic market is likely to grow harder, it is also susceptible to harder crashes as well. The flatter market isn’t likely to help you with appreciation as much, but it’s also going to withstand a crash better too. So in deciding where to buy, you have to decide a) what you want more in terms of appreciation potential and b) how much risk you are comfortable taking. I personally go for the appreciation potential cities over stable markets. Why? Because worst case, if the market crashes, I just don’t sell the property. Value of a property only matters if you are buying or selling. But if a property appreciates, I can use that equity to fund more investments. But that is my personal comfort level, there is absolutely nothing wrong with choosing the stable route if you prefer.

So now you understand how a real estate market works. How does this, or how should it, impact your investment purchases?

Where to Buy Investment Properties

You already know to ‘buy low’, which means, buy at the bottom of the curve. In the Infant Stage of the Expansion Cycle, the potential for growth/appreciation on your investment property is maximized. Also maximized is your cash flow because you bought the property at the cheapest price you could. Excellent! You can also buy at any other point in the Expansion Cycle, especially because it can be hard to time the Infant Stage sometimes (not so much from the perspective of seeing one but maybe you don’t have the money just yet to buy or you aren’t comfortable with it enough yet to hurry and make a decision). So yes, you can buy when a market is not in the Infant Stage, absolutely. It is not as advantageous to your wallet as it would be if you bought sooner, but as long as you are still looking at positive returns, go for it.

In thinking of some real-life examples of the difference in stages of the expansion cycle:

  • Chances are you will always be able to buy in Indy and see positive returns, no matter where on the bell curve the market is. There are some exceptions to that of course, but for the most part, whether the cycle is in the Infant Stage or Mature Stage, buying investment properties in Indy is likely to be fine.
  • Phoenix was huge for rental properties a few years ago. The returns were high and the appreciation potential was even higher, probably the highest of any market. Once Phoenix hit the Mature Stage on the Expansion Cycle, however, you could no longer get positive returns on rental properties. Phoenix was done as an investors’ market.
  • Atlanta, while very much following the same pattern as Phoenix, also experienced a lot of growth following the Infant Stage, but whereas in Phoenix you could no longer get positive returns, you still can in Atlanta. However, fact still remains, Atlanta is now much closer to the Mature Stage than it was a couple years ago which does make it less advantageous than it was when it was at the Infant Stage.

When you are analyzing a market for possible investment, you want to think about where it is in the Expansion Cycle and what that means. Where it is may or may not impact the worthiness of the investment, but regardless it should be considered.

Related: The Best (and Worst) US Real Estate Rental Markets in 2014

Moral of the Expansion Cycle Discussion

My reasoning for going through this explanation with you, and don’t take this personally if you are who I am about to address, is because I continue to meet several people who are dead-set on buying in Memphis and Atlanta. Now don’t get me wrong, and I should probably put this in bold letters, Memphis and Atlanta are still fine places to buy rental properties, but they are not the same markets they were when you initially heard so much about them as being the best places to buy and everyone was buying there and the best deals were there. If you choose to buy in Memphis or Atlanta and your decision to buy there is based on good reasoning, then I support you all the way. The investors who I am addressing here are the ones who are dead-set on buying in either of those cities simply because they heard that they were the best markets to buy in. That advice was from three years ago. You have to understand that what is accurate three years ago (sometimes even only one year ago) is not necessarily accurate today. Sorry to tell you, you missed the boat. Not the boat of positive returns, but the boat of insanely out of this world returns. If we are talking about Phoenix, you actually did miss the boat altogether, but Memphis and Atlanta still have deals. They just aren’t what they were a few years ago. Which is fine and I can’t emphasize enough that both of those markets are still investor-advantaged markets. But both of those markets have long been taken out of the Infant Stage because of the feeding frenzies that happened there, both by individual investors and hedge funds. Inventory has gotten very low in comparison to what it was, which caused prices to rise significantly, which has caused a decrease in returns from what they were when the frenzy was going on.

Conclusion- Be fully educated on where you are buying and more importantly, why you are buying in a particular market. Don’t rely on expired data or information. Moreover, believe it when you hear that your time is limited to buy in particular market! People aren’t telling you that just to get you to buy fast, it’s a reality in some markets. Dallas? Dallas this year has been crazy! Inventory has gotten minimal to none. Several investors wanted to buy there but inventory ran out. Literally.

Any guesses as to where the next big investor market will be? We know Phoenix, Memphis, and Atlanta happened, Dallas happened this year… where is next?

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About Author

Ali Boone(G+) recently left her corporate job as an Aeronautical Engineer to work full-time in Real Estate Investing. She began as an investor only two years ago but managed to buy 5 properties in just 18 months using only creative financing methods. Her focuses have been on rental properties and overseas investing in Nicaragua.

19 Comments

  1. Hi Ali,

    Now that I understand the macroeconomic state of the U.S. Market, where would you see is the next diamond in the rough? I live all the way up in. Canada but we basically have our REI cities that have proven to be great hubs for certain strategies. Should the real estate investor, wait to find that next city or should they continue to forge ahead in the familiar neighborhoods they know and understand?

    • My two cents… The real estate investor should not wait if they are ready to purchase more income property. So, it’s not a question of whether or not to buy, it’s a question of WHERE to buy. If your “familiar neighborhoods” make sense on all levels then stay there, but if not then it would be prudent to look elsewhere — where your capital will produce better results for you.

    • Great question Jaime. As Marco says, I don’t think you should ever wait if you are ready to buy. Prices will only get higher the longer you wait and what if that ‘next big market’ doesn’t happen like you planned, you’ll just have been sitting around for nothing. It’s always better to have your money working for you. Just because you buy now in one market doesn’t mean you can’t change markets later, so I would buy when you are ready and then if the ‘next big market’ comes up, switch markets if you want to. As far as where I see the next diamond in the rough, I have no idea :)

  2. Wherever there are mortgages, there are foreclosures. Wherever there are foreclosures, there are distressed sellers. Wherever there are distressed sellers, there are opportunities.

    It’s getting in front of the opportunity that makes the best deal.

  3. Ali,
    Great article, however I would add to your analysis of tradeoffs between appreciation and cash flow tradeoffs, when purchasing a property.

    If one is building buy-n-hold cash flow portfolio .. someone put it “perpetual ATM machine” .. than appreciation potential perception in the market drives the prices up to account for this potential, thus depressing cash-flow metrics .. which is fine if appreciation is one’s game.

    However, when one is after “ATM” strategy, they pay for appreciation that they are unlikely to use. I am an exhibit one in this sense .. the properties that I bought in LA between 2009 and 2013 almost doubled .. but it does not do me any good, unless I sell and destroy “ATM machine” function :-) .. and incur huge tax issue, unless there is an immediate roll-over opportunity.. on the other hand .. there is not much to buy in LA that makes any sense .. unless one is an wide eyed speculator..

    So, I am looking around for the markets that offer healthy cash-flow without a perception of appreciation .. so I would not pay for something I am not planning to benefit from.

    • Great considerations to put out there Leonid. Good perspective on the reality of what can happen with different methods, thanks for sharing!

  4. Good article. I agree that “the best market to buy in is always changing”, however, I think the article puts a little too much emphasis on one facet of the investment decision (appreciation potential) which cannot (and should not) be made in isolation. The other facet that MUST be considered, and I would argue it could be considered in isolation regardless of the market cycle, is the rent-to-value ratio of the property within its market.

    It would be a mistake to “invest” in a market in any stage of its ‘expansion cycle’ if the rent-to-value ratio was so low that it did not cash-flow or produce a rate of return in excess of the rate of inflation (in real terms).

    For example, the last two years in most areas of southern California have been tremendous appreciation plays for the (speculating) investor, but there would be little to no cash flow if financed, and pathetically poor returns if purchased all-cash (a bad idea)!

    Many investors also make the mistake of buying where other investors go. This is a dangerous herd mentality that I’ve personally seen put hundreds of invests in dangerous positions, leading to negative cash-flows and far too often into foreclosure.

    I’ve invested out-of-state for almost 11 years and have made it a business practice to analyze the market conditions of over 400 metro areas throughout the year.

    Understanding where a market is within its local cycle helps increase the total return on investment (ROI) when you ultimately realize those capital gains, however, we stress to our clients to focus on good markets and good neighborhoods, but ONLY when there is positive cash-flow and acceptable returns.

      • Hi Curt,

        There is no ONE website that provides all the information needed to evaluate every market. I’ve had to aggregate the information from multiple sources then analyze it, which is very time consuming. Some of the many sites include freddiemac.com, economy.com, realtytrac, brookings, bls.gov, as well as a couple of proprietary tools.

        Until recently, I published an annual report titled, “201x Housing Market Forecast (Appreciation Edition)”. Here is the link to last year’s edition:

        http://www.NoradaRealEstate.com/Reports/Housing-Market-Forecast/

        Going forward we are planning to retool this report into a free light version and a paid full version. I’m still working out the details of how that will work, but my plan is to make it an annual subscription for all ~400 markets. No idea what to charge for all that information, but I’m open to suggestions. :)

    • Hey Marco,

      What kind of metrics are you looking at for each of the Metro areas as well? I’ve been making lists of all the different kinds of metrics I could possibly track, but I have a feeling if I don’t narrow it down to the metrics that matter it’ll be just like standing in front of the proverbial fire hydrant. So far I can think of the following, what are your thoughts:
      Jobs
      New Housing Starts
      Demographics
      Local Government (special rules about permits, zoning, etc.)
      Housing Inventory
      Foreclosure rates
      Median Income levels
      Renters v. Owner Occ.
      Etc.

      • I can’t answer for Marco Doug but your list looks great, at least for things I look at. The only three things I would add is:

        1. Population trends (which is kind of just the summarized picture of jobs and new housing and such), make sure it is positive.
        2. Industry, how many different industries are there creating jobs?
        3. the most important- the price-to-rent ratios. Make sure you can get positive cash flow.

      • It’s easy to get lost in a sea of data, especially if one doesn’t know how to interpret it. Your list is good, and they all play a role in how a market behaves.

        The demand for property in a market is what will be the primary leading indicator of price movement. At the heart of it is internal population growth, household formation, net migration, and demographic trends (i.e. baby boomers).

        Jobs and job growth drive the net migration patterns. Affordability supports the overall demand. If the trends are in your favor, then the likelihood of that market appreciating is higher.

        In the short-term, the current month’s supply of housing will usually indicate the direction of property values. As a general rule, 5 to 6 months of inventory is considered to be a normal or balanced market. The lower the supply, combined with demand, the higher the upward pressure on price.

        • Awesome, thanks for the list of resources guys. It’ll take awhile to wade through it all and make sense of everything but it gives me a really good head start. I appreciate it.

    • There are definitely several factors in play with any market, price-to-rent ratio being the biggest and definitely appreciation should never be counted on if you are buying for cash flow. All factors should be considered in a decision of which market, and realizing those factors change throughout the markets’ cycle is critical and should be looked at. Good put.

  5. Great introductory article on market cycles. Hopefully in part 2 there will be a discussion of how to determine, in real time, where any particular market is in it’s cycle and which are the best data points to use in tracking that cycle.

    This is very important because the best returns (aka alpha) go to those who do their own research. If your strategy is based on “I heard city X is a good place to invest” then you’re already part of a herd, and I’d say you can use herd and heard interchangeably as a reminder to do your own research.

    You may do ok trying to steal some alpha with the Burger King approach (put your stores across the street from McDonalds) but your best chance in the long run is to get there before everyone, especially the institutions. If some guru is already running bus tours for buyers you know which end of the herd you’re in and it’s the one where your view is everyone else’s butt.

    Good hunting-

    • Kenneth James on

      Giovanna,

      Great point. I agree doing your research is paramount. I also agree, learning how to conduct it properly is most important. I wonder about listsource.com as a tool (??)

    • Lol, Giovanni, I love your wording. Herd and heard is one I never heard of, but so true (and funny) and great point about which view you are looking at if you are too late.

      What you say is true, but I don’t think that necessarily following the crowds or if you are later to the game, that you are getting a bad deal. There is a reason the herds go where they go- the investment potential there is amazing. There is usually enough to go around, so even if the hedge funds and tour buses are there already, it’s not too late. Now, if you are still trying to buy there after the tour buses have stopped, you did probably miss the boat.

      The argument could absolutely go either way, but in this case, I don’t think there is a wrong answer.

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