Vital Market Characteristics for Successful Long Term Investing (and What to Do in Their Absence)
The best real estate investing strategy for regular investors I outlined a few weeks back can produce some outstanding results. When it’s executed with discipline without sacrificing its high asset quality standards, an investor can acquire and methodically pay off a portfolio of real estate assets over 10-15 years. In so doing, they could quadruple their capital base and draw a six figure income before taxes at retirement.
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But as impressive as those numbers are, there is a catch: this strategy is not “one size fits all” and it is not applicable in all markets.
In fact, a common response I get from readers is that as enticing as it sounds, it just isn’t possible in the market where they reside. The reasons are many. In many of these markets, prices are from Mars, rents are from Venus. In others, prices are low but the wounds of the recession are still bleeding the local economy dry in high unemployment and poverty. And finally, in others – Landlords are viewed and treated as evil tyrants sucking the blood of their tenants (I’m paraphrasing).
So then, two main questions arise:
- What market characteristics are vital for the successful implementation of a long term investing strategy?
- What to do if your market doesn’t offer those characteristics?
Market Characteristics – Macro
First, we have to take a careful look at market characteristics at the macro level. How does your state fare in terms of job creation, population growth, unemployment rate and economic diversification? These make up the economic foundation on which to build a healthy long term portfolio. (One note of caution here: The potential for appreciation is never a substitute for good fundamentals.)
The local economy’s ability to create jobs impacts your prospective tenants’ ability to find and keep a good paying job which in turn allows them to make rent payments on time.
Population patterns and unemployment rates are further macro indicators of the local economy’s strength. You want to look at this data against the backdrop of national numbers to see if your state is performing better or worse and why.
Last but not least, Houston in the 1980s and Detroit in 2008 are proof positive that one trick pony economies don’t fare very well in downturns. Houston learnt a painful lesson from that period and diversified its economy well to have a more balanced approach that’s serving us well these days. Detroit has made upward strides from the depths of the abyss but most of their recovery has come as a result of the improved situation of the Big 3. Things are definitely better than what they were but they’re far from being properly diversified.
Market Characteristics – Real Estate
The second aspect we want to take into consideration are real estate market characteristics. We have to take a close look at price/rent ratios, operating expenses as a percentage of incoming rent, vacancy rates and the availability of recently built properties in high quality locations.
In 2012, the second and third states that created the most jobs were California and New York. The same two states that sport some of the highest price to rent ratios in the country. So it’s not sufficient that the macro picture works – the numbers must work as well. As a general rule of thumb, any market with a price to rent ratio over 10 will make it impossible for positive cashflow to materialize with few exceptions.
Another concern is the percentage of incoming rent “eaten” by operating expenses (property taxes, insurance, association dues etc). Some states have much higher property taxes and home insurance rates than others. In general, any scenario where operating costs exceed 40% of incoming rents will be devoid of cashflow unless a huge down payment is made.
What about vacancy rates? It’s important to have the correct expectation of how much money will be consumed by vacancy in any particular year. You want to invest in markets where average vacancy rates are low because that indicates healthy tenant demand.
Last, we must assess the availability of reasonably priced, recently built properties that cashflow in our local market. In this respect, some investors are done in by high prices, others by primarily old properties.
But as important as any of these macroeconomic and real estate market characteristics are on their own, it’s how they work in combination that really makes the difference. It’s not enough that your market offers favorable conditions in one or few of these factors. Everything must work well together for the market to be suitable for a successful long term real estate investing strategy.
What if Your Market Doesn’t Meet the Standard?
Invest out of state. Or don’t invest at all. But for the love of God, don’t try and make it work in a market where it won’t work. It’s been tried and it has failed every time. Don’t buy a “cashflowing property” in a market where properties don’t cashflow unless you plan on buying an AK-47 for the purposes of collecting rent. I know it’s scary to invest in properties that you can’t drive by whenever you want. But a truly successful real estate investment is one where you have no reason to drive by it at all (think about it – and click here to tweet this quote!). Times have changed and today there are systems you can implement to make your out of state investing easier. Take the time to speak to investors who have taken the leap and they will tell you about how they’ve never looked back after the first one. They will tell you that once they saw what they could buy for the money, it was an absolute no brainer.
It comes down to a choice between guaranteed failure and scary success. You pick.
Photo: Ms. Phoenix