How Do Real Estate Markets Differ and Which Should You Buy In?
I get asked quite a bit… “Well how do I decide which market to invest in?” Great question, how do you know? The first step is to narrow down the markets that will be advantageous to invest in at all. For flippers, this isn’t as big of a deal because you can flip properties in just about any market. Some markets will be better than others, but you can really do that anywhere. More so for rental properties, it’s imperative you find a market that will actually put a profit in your pocket.
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The primary factor in an advantageous rental market is the price-to-rent ratio. You have to be able to rent a property for enough money to cover the cost of the purchase of the house and all expenses, and then hopefully have some left over for profit. I talked about this concept in more detail in The 5 Fastest Ways to Lose Money with a Rental Property. Note the example of an Atlanta property versus a Los Angeles property to understand this concept.
So, let’s say you have found a handful of markets that have good price-to-rent ratios and, therefore, can definitely put a profit in your pocket. Of those markets, how do you know which to choose? For the purpose of this article, I’m only going to look at known (as of today) investor-advantaged, larger markets and compare the advantages of those in order to explain how the benefits of various markets differ. I’m only going to look at the larger markets to keep it simple. There are many smaller markets out there that would be great for investors, and you can apply what I’m about to say to those.
Different Markets, Different Perks
You are looking at your handful of investor-advantaged markets. You may already have a list that you gathered yourself, maybe some experts suggested various markets, or maybe just from reading BiggerPockets you have taken note of several popular markets that a lot of people seem to be working in. We already know the price-to-rent ratios work in these markets, so that is one perk. What are other perks that may be present in a rental market?
- Price. Some markets are going to be more expensive than others and some may have a really cheap entry price. You may be restricted as to your purchase price due to how much capital you have to invest, so price may have to be the deciding factor when it comes to choosing a market. But, as I’ll point out, you’ll realize you usually get what you pay for.
- Cash flow. This is probably one of the most obvious perks that people want. If there is no cash flow, there is no point in buying (unless you just get warm fuzzies in your belly knowing you own property in a really cool place, likely a beach city or somewhere you want to vacation). Since the price-to-rent ratios in all of the markets we’re looking at are good, all of the markets are expected to cash flow. So no problem there, but realize different markets cash flow different amounts.
- Appreciation potential. As I say all the time, never buy based solely on appreciation potential. That is called “speculating.” Ask all the speculators from pre-2009 how well the market crash served them! So while I never advocate buying for appreciation potential but, rather, always buy for cash flow, some markets do have significantly more potential for growth and appreciation than others.
- Age of property. This wouldn’t seem like it should matter, but it certainly does when it comes to what you will need to expect for maintenance costs. An older house, even if it’s in decent shape, will cost you more money to maintain throughout the years. All houses will need maintenance but the newer the property you get and the better built, the less you will have to spend in this department. Some markets have notoriously newer houses than others.
- Quality of the neighborhood. The age of the property may even be semi-representative of this. Not in all cases, but oftentimes. What are the typical neighborhood qualities of a particular market that you would be buying in, in order to turn a profit? Profits can be made in both higher-quality neighborhoods and lower-quality neighborhoods, but there will be differences in the level of effort you have to put forth in order to make properties in different types of neighborhoods work.
- Industry. Another major factor that goes into determining an investor-advantaged market is one that not only has good price-to-rent ratios, but also has enough industry to support population sustainment and growth. If you buy rental properties in a market that has only one major industry, and that industry goes bunk, what happens to your investment? Michigan cities experienced a lot of just that over the past few years and some people think North Dakota with the oil boom will experience that once the oil gig is over. There are some seriously enticing deals for investors in ND right now, with extreme profit margins and cash flow, but if the oil boom disappears, what else is in ND that people will want to go there for? Not to say you are in the wrong to buy there but be wary of what will happen to your property should the oil folks go away. Same with Vegas. Vegas has one primary industry (if you group them together)- gambling and entertainment. The bad thing about gambling and entertainment? In a market crunch, people stop spending money on gambling and entertainment. Effect on Vegas? Pretty substantial. But if you find a market with multiple big industries, you are staying safer because if one industry flunks out, you have others to keep the town running.
That is just a general list of factors I look at in a rental property market. Now, how do those all tie together? Understand there will always be trade-offs. You can buy a cheap property forecasting extremely high returns, but understand that your risk will be the highest in that case. Or you can buy a more expensive property with lower returns, and your risk will be much more minimal. You can’t have the best of both worlds- cheap properties, high returns, no risk. It doesn’t work that way. Here is a visual of the scale I envision when thinking of this-
Draw a straight line through the two lines at the price point you wish to buy and that will show you the relative associated risk. As always, nothing is absolutely certain here. You can easily buy a cheap low-quality property and have huge success with it. You can also buy an expensive really nice property and it be a total failure. This scale is not an indicator of guaranteed success, but rather an indicator of the risk you are taking on at each end of the spectrum.
Now let’s combine everything so you can see how it all ties together. I’ve admitted in the past I’m a total PowerPoint nerd and will take any excuse possible to get to draw something in it, so I’m giving you a graph to look at that compares different investor-advantaged markets. All of these markets are good markets for investors right now (as of today). If you were to buy in any of them, you are likely to be making a solid investment (as long as you buy right). But I’m going to show you the differences in the markets. Like, since they are all good markets, which do you choose because what are the differences? This graph is a little busy, but bear with me. You’ll see I included all of the factors I mentioned above for comparison.
The higher the bar for each factor, the better, except for price (hence the rainbow color in attempt to differentiate that one). This is also a very casual graph based on what I am currently seeing amongst the markets and the available properties… it is far from exactly accurate. This is a very general depiction of the factors (“perks”) going on with each market.
Usually people care mostly about purchase price and cash flow. You will see those as the first two lines for each city. After those two you will see the other factors I mentioned previously, such as appreciation potential, age of property, quality of the neighborhood, and industry. Can you start to see the trade-offs? The lower the price, usually the higher the cash-flow but much lower on the other factors, which increases risk. The higher the purchase price, the lower the cash-flow but the better the other factors. All of those other factors contribute directly to your risk.
So now what? Well, decide what is most important to you in an investment property. Is it low purchase price? Is it cash-flow? Is it appreciation potential? Let’s say it’s cash flow. Looking at the graph, Indianapolis, Kansas City, and Chicago are your best bets. From those, you can rule out Chicago if you don’t have a lot of capital to start with because the purchase prices there are significantly higher. Then if you are down to Indianapolis and Kansas City, you can then look at the remaining factors and see which you are more comfortable with. I personally would go with Indy because I like the strength of industry there better than in Kansas City. Albeit the industry there is much lower than other markets, but it’s the highest of the cheap high cash-flow markets. What if higher quality is what you want rather than just high cash-flow? I’d say Dallas and Chicago, with Atlanta not far behind, are your best bets. Dallas and Chicago have much more appreciation potential than Atlanta (since Atlanta just finished out much of its hayday), but Dallas has really low cash-flow (thank you Texas property taxes and insurance!) and Chicago has a higher entry point for purchase price.
I want to show you what I consider to be two very opposite ends of the spectrum: Indianapolis and Dallas.
Look at the difference in cash-flow of these two markets. You are basically looking at one of the highest cash-flowing markets and one of the lowest. Ignore purchase price for now and look at the other factors. The cash-flows are dramatically different, but then look at the appreciation potential, property and neighborhood qualities, and industry. Here’s where the trade-off happens. You can get really high cash-flows in Indy but you are also missing out on some major quality and potential (relatively). You can get all of that quality and potential in Dallas but you will be sacrificing cash-flow to do so. If we put these two cities on the scale ‘o risk, it might look like this:
Notice Indy still isn’t too far to the left because it is a good market to buy rental properties in and far from the riskiest place you can buy in. It’s a great market actually. But if you compare it to what you would be getting with Dallas, you can see where that risk level differs due to the factors I mention.
There is a trade-off to everything in real estate investing. To any kind of investing and, quite frankly, to everything in life. You can buy the cheap flat-panel TV and it may work just fine for 10 years to come, but the risk of it not working that well is higher. Or you can buy the super expensive 3-D flat-panel TV and it falls apart in a week. The risk of that happening is much lower, however.
So, as you look at markets for investing, you first need to decide what is most important to you. Choose the markets that are good for that factor you are most concerned with and then wean them down from there. Don’t pout when you can’t find a market with the nicest houses, the highest returns, and for the lowest prices. If there was one market that was that good, everyone would have bought it up by now! Although admittedly Phoenix, Memphis, and Atlanta all went through a phase of being nearly just that (great returns for great properties for great prices), but we are past that phase now. This also goes back to the famous 2% rule. Yes, you can hit the 2% rule all day long, but you will be sacrificing major quality to do so and increasing your risk. Three years ago you wouldn’t have, but the market has changed and now you’ll be taking on much more risk.
I hope that helps in learning to choose a market. Pick your most important ‘want’ first and figure out which markets best support that, and then buy away! There is enough to go around for everyone. Okay, well not as much now as there used to be but you can still buy plenty.