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).
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.
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.
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.
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.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.