If you look hard enough, you can find real estate to buy in just about any market in the world. Still, there are declining market signs that might indicate it’s just not a good idea to invest there.
What is a declining market?
A declining market in real estate is when there are more sellers than buyers. People aren’t moving to the location or upgrading their homes by moving. As a result, it takes longer to sell a home, and property values are significantly lower than usual. These markets have high volatility, so it’s difficult to predict whether investors can ride it out and still make a profit.
Another term for a declining market is a bear market. A bear market is when the prices of an industry drop by 20% or more. It’s not ideal for the real estate investor, and you should do your best to avoid these markets.
Why do you need to know when a market declines?
Every real estate investor needs to know how to gauge if a market is declining. You don’t want to get stuck with an investment you can’t re-sell. Holding onto a property because you can’t sell it causes you to lose money every month.
Location is key in real estate. Not only are you investing in the property, but you also invest in its location. It’s important to know the future of the neighborhood and the local market you are looking to invest in.
Let’s go over the eight warning signs that a real estate market is declining.
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1. Declining population
For a variety of reasons, city populations expand and contract. Long-term population contraction is bad news for apartment investors. Like most businesses, it comes down to supply and demand. A declining population equals declining demand.
If people are moving away instead of toward a given market, there will be a drop in demand and buying transactions. As a result, vacancies can get a lot higher, and values will stagnate. This can happen in even wealthy and established markets where taxes are high and the population is aging.
Many cities in the United States are shrinking, and some have been doing so for a long time. Therefore, it should come as no surprise that cap rates for apartments in many of these markets are significantly higher than in markets where population growth is booming.
At first blush, those higher cap rates may seem to represent a better deal. However, it isn’t worth it when you factor in rent growth and occupancy rates over the long haul. More often than not, fair deals in safer markets outperform good deals in riskier markets. This may seem obvious, but it’s surprising how many people fail to make the connection.
If all of the younger generations, talent, and workers are moving away and are staying away, local real estate can become less profitable. A quick Google search can reveal which cities have consistent population growth over the last couple hundred years—and which are declining or may be boom-and-bust markets.
2. Super high vacancy rates
Investors always need to expect some vacancy. It should be a part of your projections, even if occupancy is at 100% upon acquisition. Vacancies unique to one building may not be a bad thing. They may be an opportunity to renovate or bring in better management to increase value.
Still, if one market is suffering an average of 30% or greater vacancy rates when the national or city average is 5%, there could be a bigger problem. It is definitely a red flag to watch for.
3. Declining property values
Unless you are a wholesaler who can get in and out faster than the market is declining, or you can buy at an incredible discount and hold out for cash flow indefinitely, it doesn’t make a whole lot of sense to buy a rapidly depreciating asset. If local property valuation has recently dropped by 10%–30% and that activity is just getting started, it’s no different from buying a new car, knowing it will be worth half as much once you drive off the lot.
4. Environmental hazards
To notice declining market signs means more than Googling the population and property values. Often, you have to know the neighborhood and do your due diligence.
Environmental hazards like contaminated groundwater, underground storage tanks, or industrial air pollution add to the more commonly inspected lead and asbestos issues. What appears to be a financially good deal in a growing, stable market could be located near a Superfund site. Without a thorough due diligence process, a buyer would pay the price for owning that “good deal.”
Remediation of such hazards isn’t always possible, and when it is, the costs can be enormous. That is why it is not uncommon to find highly discounted properties that contain environmental hazards. But don’t jump at the discount. The resale market is very limited for properties that contain environmental hazards.
5. Disrupted job market
Some markets can survive with little local employment. The Florida Keys and other markets driven almost 100% by vacation owners and retirees are examples of these exceptions. Still, they can be heavily impacted by disruptions in travel and vacation patterns, security crises, and weather. Singularity of jobs in a location could be a warning sign of a market that could decline overnight.
When we look at markets, we like to see diversity of job centers. We like a mix of government, private-sector, and higher-education jobs. By having job diversity, one avoids the risk of catastrophic loss when an industry goes belly up.
In the extreme, cities created by single job centers become ghost towns when massive unemployment occurs. Military towns and the destruction created by base realignment and closure (BRAC) back in the 1990s is a good example of this.
Today, all over this country, some cities derive significant portions of their economy from military spending. Cities like these can derive as much as half of their GDP from the military. Yet, no matter how good their present economic situation may be, they are always one BRAC away from complete disaster.
For the long-term investor, this serves as a sign that the market could decline at any time. Think of Detroit. When large automakers went bankrupt, it made a huge impact. While Detroit’s situation is improving 10 years later, it can still be a big risk to invest where a city is reliant on one major employer or sector.
6. Pro-tenant laws
When evaluating markets to invest in, population growth and employment rates are important. That being said, several markets have exceptional numbers in both of these areas that still aren’t worth investing in. Local and state landlord-tenant laws can make a big difference in success or failure in a given market.
A sign of a declining market could be changes in the legislature. Pro-tenant states can have rent control, extensive eviction requirements, and other obstacles that make it harder for owners to succeed. While those challenges are not necessarily unique, some areas take their pro-tenant stance to another level by doing things like banning criminal background checks. These laws can create a declining market, making it hard for sellers to succeed in them.
7. Unreliable government
You can find unbelievable promises of real estate investment returns in all types of exotic locations worldwide. But one of the main reasons global investors prefer America is for its safety and legal system. In many other countries, police and governments can effectively take control of your property and give it to someone with less money. There’s nothing you can do about it.
While this is mostly overseas, some US markets can be more prone to this type of activity than others. Look out for high levels of local government interference with landlords, especially when the city or county is grabbing profitable rentals from individual landlords to turn them over to larger developers.
8. Too rural
You can find super cheap deals if you go far enough away from the city. That’s largely because most investors stay away from those sub-markets, and most lenders won’t loan in them. Demand is too low. The potential buyer and renter pool is too low. Comps can be scarce. Reliance on annual crop production and profitability can be too volatile.
This can also apply to distant suburbs, which experience huge boom-and-bust activity when the market changes. When the economy is strong, people go there for cheaper properties and quickly flip houses and make some good profit. When the economy contracts, those areas can become the Wild West again.
Pay attention to market sentiment
Most real estate investors are hyper-focused on “the deal” (the property itself) and any discount to market they can get on the purchase. They want a good deal, they seek out a good deal, and they must have a good deal.
However, the terrific deals (e.g., assets discounted to market) are that way for a reason. Typically, they are more distressed—with deferred maintenance, tenant issues, or many other factors that compel the owner to offer the property at a discount. These deals can have a greater potential opportunity, but they also come with greater risk. It’s important to note whether you’ve scored a seriously good deal or whether you’re investing in a declining market.
As a serious investor, you will want to be aware of market sentiment. How are others feeling about the real estate market? Are they investing locally or looking for properties elsewhere? Do your research before investing in any one market.