6 KEY Attributes that Affect the Risk Level of a Rental Market

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These market factors will directly impact the chance of success and level of risk you are going to take on if you buy a rental property.

While you may buy into a market that shows more unfavorable for one or more of these elements, it doesn’t necessarily mean your investment will surely fail, but it may increase your risk.

Remember, everything in real estate (and in life, kind of) operates on a risk spectrum. The most general theory, to explain this idea, is: buy something expensive in a nice neighborhood and you are least likely to experience problems. Buy something super cheap in a scary neighborhood and you are most likely to experience problems. Those are the far ends of the spectrum. It’s not to say if you buy the expensive investment that you will never have a problem, it’s just less likely. Similar in the bad neighborhood, it’s not a guarantee you will have problems, it is just more likely.

For this list, I want you to look at it this way:

  • If the market you choose to invest in has positive checkmarks next to each of these attributes, you are minimizing your risk.
  • If a lot of or all of these attributes are negative for a particular market, you are maximizing your risk.

Again, not to say there is a guarantee how an investment will turn out one way or the other, it’s just about playing the odds and knowing what factors increase and decrease your risk.

The 6 Key Attributes that Affect the Risk Level of a Rental Market

Okay, are you ready? When looking at a market that you might want to buy rental properties in, be sure to consider these 6 KEY attributes of the market which could affect your investment risk:

1. Price-To-Rent Ratio

This means, can you make enough in rental income to cover all of the expenses associated with the property, including mortgage, taxes, insurance, management fees, repairs and vacancies. All of those should be covered by the rent you collect from the tenants and you should have some left over to pocket as profit. If you have to pay so much for a rental property that the rent won’t cover the expenses and even leave you some extra profit, it means the price-to-rent ratio of that property or area is not advantageous to investors. Some markets in general have bad price-to-rent ratios (like LA or NY), and some may just have certain areas of the market that have bad price-to-rent ratios but others work fine (like the super exclusive neighborhoods in a market are unlikely to be profitably from a price-to-rent ration perspective, but the middle-class areas down the road may be great for it).

2. Population

Is the population increasing or decreasing? Why does it matter? Well because if a population is decreasing, it means people don’t want to move there, so who is going to rent your property? The size of the tenant pool isn’t going to be increasing if a population is decreasing, the quality of people who are living there may not be the most stellar, and if the population is decreasing, won’t that eventually lead to more houses than people? That will affect vacancy rates. If you choose a market with a consistent increasing population, you are increasing your chances for having a bigger tenant pool, likely higher quality tenants to choose from, having more people means more housing is always needed, and it’s just more comfortable to think that you own a property somewhere where people actually want to move.

3. Jobs

 What is one of the best ways to support an increasing population in market? Have a lot of jobs available for people there! People go where jobs go. If there are no jobs, there are going to be few people. Jobs and number of people are directly proportional. So the more jobs, the more people, meaning population increase, meaning the benefits stated above.

Related: Great Job Markets Usually Mean Great Housing Markets,

4. Industry

 What are jobs tied to? Industry. Every job is part of an industry. The more industry options you have in a particular market, the more jobs there are likely to be and those jobs bring in more people. But then the additional bit about industry is that, preferably, the market you are looking at supports multiple industries. If a market has one huge industry and that industry does in fact produce a huge number of jobs, which we’ve already established is a good thing, that is great but what if that one industry crashes? With one big swoop, all of those jobs we were reliant on are gone and boom, there go the people. Remember Michigan with the automobile industry? It was devastating to the whole state, certain cities more than others, when the automobile industry tanked because that was the main big industry there. There is no way to predict the future of any one industry, so if you choose a market with several big industries, you are helping cushion yourself should one industry go out, because the others that are there can carry the weight of jobs. If the market you buy in only has one major industry, you are increasing your risk tenfold because you don’t know what may happen to that industry at any time.

5. Vacancy

The most costly expense on a rental property is vacancy. Vacancies can range from basic tenant turnover ever couple years to flat out there is no one to move into your property. The latter being the worst case of course. In that situation, you could completely lose your backside if a vacancy goes too long. The best way to prevent vacancy as much as possible? Buying in a market that is booming with people so there is always someone needing a place to live, which goes directly back to jobs and industry again.

6. Tenant Quality

Where there are few jobs, little industry, and a decreasing population, there is likely a general lesser quality of people in the area. Not that everyone there will be bad, but those who are of higher quality in a declining market, probably own their own house so won’t be renting, so who does that leave to rent your property? Versus a growing booming market where people flock to. The tenant pool is going to be much larger and more diversified in terms of quality of tenants. The growing markets are probably more expensive so not everyone can buy, even if they are great people, versus the declining markets which are likely much cheaper and easily affordable.

Related: Tenant Screening: The Ultimate Guide

If you notice, some of these are really sub headers to the others. They are still worth pointing out specifically though. If I were going to choose only two attributes I look for in a market that I’m considering buying rentals in, it would be price-to-rent ratio and population. Those two are really the highest-level attributes of all of them. The price-to-rent ratio is more stand-alone but the population is fairly dependent on jobs, which is dependent on industry, and then vacancy and tenant quality roll in under those as more of resultant attributes. However, each attribute individually affects the risk level associated with a market. The fewer of these that are bad in a market, the less the risk. The more of these that are issues, the higher the risk.

Returns will always look higher in riskier markets. It’s fine if you choose to go to those markets for buying rental properties, but at least understand where the trade-off with returns and risk falls. Why do you think $30,000 properties always show higher projected returns than $100,000 properties? It’s because of the risk trade-off. The cheaper property will be riskier than the more expensive property.

With any investment method you pursue, it’s fine to choose whatever buying criteria you feel most comfortable with. There is absolutely nothing wrong with buying the $30,000 property in a declining market, but understand where the risk in buying that property lies so you can better counter the risk as best as possible.

Always fully understand the factors that go into risk levels and returns so that you are fully equipped to make an educated decision on which route you want to go for buying.

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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.

18 Comments

  1. Yo Ali

    Personally I’m not a big rental type of guy due to the other bigger risk of renting out a property. I’m more of the lease to own person who love to get the tenant buyer in the house with some form of skin in the game. That at least eliminate damage to the property knowing one day they will own it.

    So that’s comes back to rent which if you buy right, then no matter what happens you should still be able to capture that spread. Somethings are out of your control like, population or the decline in quality jobs. The real estate industry is profitable but it does take work, this is why everyone is not built for it.

    Question Ali..How many rentals do you have at the moment?

    Love the post Ali

    Antonio Coleman “Signing Off”

    • Haha…signing off Antonio. I don’t usually say exactly how many rentals I have unless it’s under more personal circumstances. I have enough to have experienced all sorts of ups and downs and to understand a lot about them though.

      I’ve done lease to own before, I love the concept. It does pose a lot of benefit like you say!

  2. To me, vacancy is never a risk. You can always increase demand, by lowering price. Whether or not your expenses allow it is another story. Vacancy is the number one avoidable expense as a landlord.

    Tenant quality is the largest risk. All other factors should be mostly known going into the property. And tenant quality can also be controlled, no matter what a typical PM would say.

    • Perfectly stated Eric!

      That is the number success factor in my years of experience. I half-jokingly tell our clients that you “live and die by your property manager”. Assuming you have a good property in a desirable neighborhood, this becomes the key to you long-term success (and reduced stress level).

      Continued success!

  3. You forgot one key attribute – supply risk. Can developers flood the market with new product that is going to make your units seem old and dated. Or what happens if there is a slow down in the economy and the market has tens if thousands of new units to fill – vacancy will skyrocket. Vegas and Phoenix were examples of this only a few years ago. Manhattan has less population than 110 years ago but has been a far better market than say Houston, which has had a steadily increasing population, but has seen very little in the way of price increases over the years.

    Demand is only half the equation. Everyone seems to forget that.

    • Sorry, Matt, but that’s not correct about Houston. Sure, it went through a down period like everywhere else in the country, but in the last two years it has seen a tremendous escalation in prices (http://gis.hcad.org/2014/8YrsStudy07-14PDF.pdf). Of all the places to single out, Houston seems like one of the worst examples. Indianapolis, on the other hand, has been god awful for appreciation (I speak from experience).

      • I am talking about the last 50-60 years. Prices have essentially gone no where in that time frame. Sure maybe there has been a bump in the last couple of years, but we will see when developers catch up with supply.

        • Matt, I’m not sure if you looked at the pdf I linked to, but in the last eight years Houston has experienced on average annual 35.8% appreciation – that is hardly “going no where.”

          And as Marco so accurately points out below, one should “base your decisions on the current market environment,” not 50-60 years ago!! I do agree supply is a concern in Houston (or any market for that matter),but I was responding solely to your claim about lack of appreciation there – sorry my friend, you are dead wrong.

        • Not sure where you are getting 35% annual appreciation over the last 8 years. That means prices are more than 10 times higher than 8 years ago? That is not the case at all. Houston was the big boom town in the 70s and developers flooded the market and oil crashed and it took many many years for the market to come back to those levels. Everyone is rushing into Texas like Phoenix and Vegas at the beginning of the decade. Prices rose there much more than Houston has seen the last few years. It did end well there at all and prices are not close to the peak and it may be 20-25 years until they get to that level and that doesn’t consider inflation. Doubt that will happen in Houston since prices haven’t gone up very much, but just ignoring supply is not smart.

        • Matt, the numbers are there for you to extrapolate, so if you can’t see that Houston is an appreciating market, then I can’t help you there. My point all along to you has been that you picked the wrong city for your compare and contrast example. There are a lot better examples of non-appreciating cities than Houston. And, Houston is not just an oil town any more. Far from it. It has thriving medical, technology, and service industries there, as well as one of the busiest ports in the nation – all of which contribute to a very robust economy and jobs – the reason why people are moving there in droves.

          I’m not disagreeing with your basic premise – to be aware of supply – just your choice of examples. And personally, I do think Ali addressed it in her vacancy section. Over supply almost always shows up in the average area vacancy numbers.

    • Good point Matt. The best way to help deal with supply risk is to still make sure you are in a market with an increasing population and lots of jobs, so there will always be people needing homes.

  4. Nice article. The real challenge for a buy and hold investor is knowing what the future holds (as with all investments.). Who saw the collapse of Detroit coming 40-50 years ago? Who is to say that 40 years from know California, Arizona, and Nevada won’t run out of water? Dallas might get too hot to be livable? Rising sea levels and increasing hurricanes might devastate coastal cities? I think there are a lot of risks for the long term buy and hold investor and the best anyone can do is understand the risks going in and plan around it.

    • Although it might be difficult to know precisely what the long-term future of a market holds, you don’t need to know what that is on a 40-50+ year time horizon.

      You base your decisions on the current market environment (market, neighborhood, property, returns, etc), followed by the short and mid-term forecast for the market based on its current economic and market trends.

      Then, if you see the market trends changing, and/or some sort of major market problem forming, you can sell out of that market and into a better market. Real estate markets move slowly enough that you can keep an eye on these things and make decisions before they become real problems for you.

      Continued success!

    • Totally agree Jesse. There is no way to know exactly what the future holds, so all one can do is try to mitigate as many potential risks as possible and go from there. Because no matter how much mitigation or prediction goes into something, there is no true way to really know. The absolute best way to deal with potential future problems is not to speculate, but rather buy based on stable fundamentals. Buying for cash flow is one of those, rather than buying for appreciation. Buying for appreciation can be a great thing, but the risk is much higher due to the uncertainties you mention.

  5. Ali –

    This is a great little list. There is so much to consider when looking at a buy and hold property. Looking at whether or not the population is stable is something that folks especially new investors don’t think about.

    Sharon

    • And surprisingly so many people don’t care if a population is steadily declining Sharon! That one alone seems like the common sense one to me.

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