“Where should I invest?”
This is one of the biggest questions investors face. While a savvy investor can profit in just about any market, we must recognize that each market comes with unique challenges and opportunities.
Real estate markets can be divided into a few different categories. This is where real estate investors should begin. Your level of experience, access to resources, and investment strategy will all inform your decision.
With that said, let’s talk about markets.
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Three types of investment markets
The distinctions between these market categories are not well-defined. Different people will categorize markets differently based on their understanding and definition of these designations. There may be overlap or a lack of clarity as to where a market falls.
It doesn’t mean they are wrong, only that our metrics are not standardized. This is why we look at a myriad of influential factors when categorizing a market, versus population alone.
Primary markets are fairly easy to define by their size alone. These are the largest real estate markets in the United States, including the likes of New York City, Los Angeles, San Francisco, Boston, and other exceptionally large, dense metropolitan areas. These markets tend to attract the kind of investors that have access to significant capital. Because the cost of living and level of investing tend to be high, so is the investor’s barrier to entry.
You may see primary markets referred to as “gateway” markets, though these terms are not always interchangeable.
Think of primary markets like a high rollers club. These are places that not only have a well-established and large population (often topping 5 million) but a long history as titans of commerce. This is where you’ll find high levels of investor activity, mostly from REITs, large private equity funds, and foreign investors.
This shows us that there are opportunities to be found in primary markets. It’s important to realize, however, that many of these opportunities will be out of reach for the average independent real estate investor.
Secondary markets are where our definitions get a little blurry. While some would say that secondary markets are those with a population between 1 and 5 million, this is not necessarily standard. What is more valuable for our purposes is the strength of the market.
Population and economic growth point most clearly to the power of a secondary market. These areas are more affordable than primary markets but are not lacking in amenities or opportunities.
Markets like Houston, Dallas-Ft. Worth, Austin, Portland, Charlotte, and Nashville fall into these categories. At the same time, some of these markets have metro populations exceeding 5 million. However, they function more like secondary markets than primary markets in terms of investor activity, affordability, and accessibility.
Both short- and long-term investors have no problem finding opportunities in these markets. While competition is less than in primary markets, it can still be a frenzied investment environment.
Tertiary markets are typically considered to have fewer than 1 million people. These markets excel where stability is concerned.
While secondary markets can experience clear “booms” of economic activity and interest, tertiary markets are those with steady, reliable positive trends in population and job growth. They tend to be driven both by traditional and alternative economic factors.
By many metrics, my hometown of Memphis is considered a tertiary market. However, this is where the line can be blurry. Memphis topped 1 million in its metro population in 2003.
Tertiary markets are those that would not be considered “hot” real estate markets compared to most. Where they excel, however, is in their slow and steady growth that provides a more tempered, predictable investment experience—ideal for long-term, buy-and-hold investors. Here, competition is less of an obstacle.
Now that we have defined our terms, it’s time to talk about the trends that have bending investors and homebuyers away from primary markets and into secondary and tertiary territory.
A look at pandemic market performance
The consequences of COVID-19 have been serious. I never want to underplay the lives and livelihoods that have been devastated over the past year. In the context of the real estate market, however, COVID-19 has brought with it some very surprising consequences.
Then again, they may not be so surprising after all.
Acceleration of national trends
It’s important to note that COVID -19 did not create trends in the real estate market. It merely accelerated existing trends. One of these is the migration to secondary and tertiary markets.
The real estate affordability crisis in the United States is shockingly real. According to calculations presented in the above article from HousingWire, some 82% of working Californians could not afford a home by traditional affordability metrics. When the median home price tops $1 million, that isn’t a shock.
Price growth has long outpaced wage growth. Even as far back as recovery from the Great Recession, real estate agents bemoaned the lack of first-time homebuyers on the market. These would-be first-time homebuyers were millennials who found their finances crushed by underemployment, unemployment, and student debt. Buying a home just wasn’t a feasible option for many. That in itself put a damper on market recovery.
COVID-19 accelerated the shift from expensive primary markets to more affordable markets. This wasn’t true of homebuyers alone, but businesses, too. Experts suspect that our emerging work-from-home culture is here to stay, at least in some form or fashion, for the long haul.
Because home prices have been on the rise throughout the pandemic, which greatly impacted the livelihoods and wages of countless Americans, the affordability crisis has only worsened.
As a result, we’ve seen a migration to secondary and tertiary markets. While their relative affordability is a major incentive, so are their other qualities. Southern markets, for example, have a more temperate climate and reduced population density.
We know, too, that record-low interest rates have been a significant incentive for many to bite the homeownership bullet.
This isn’t just about home-buying, though.
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Rental performance in secondary markets
Two things happened in the rental property world throughout the pandemic. First, we saw the demand for single-family rentals surge. We also saw the under-performance of multifamily housing, particularly in primary markets.
The rise in demand for single-family rentals comes down to shifting priorities in light of the pandemic. Residents no longer feel comfortable in densely crowded cities in tight-packed apartments. Single-family rentals with private outdoor space, room for a home office, and distance between neighbors are more attractive than ever. Because these properties tend to be in the suburbs, they are that much more desirable in these socially distanced times.
Then there’s the affordability factor. Naturally, rentals of all kinds are more affordable in secondary and tertiary markets, and residents get more space for their money. As housing demand grew in these markets, the demand for rentals increased as well.
Real estate investors have their eyes on smaller markets. In fact, 60% of investors surveyed by Institutional Investor said they expect smaller cities to play a larger role in real estate investment in the coming years.
What about the risks?
Naturally, every market and every investment comes with its fair share of risks. There’s no changing that. As real estate investors, however, we can change how we manage and mitigate that risk.
Is the pendulum going to swing?
Our northern neighbors at the Canadian Imperial Bank of Commerce suspect that the growth in secondary and tertiary markets will be derailed as pandemic fears wane. Indeed, we will likely see a return to our primary markets as the economy recovers, conditions improve, and remote work comes to an end for most workers.
However, that doesn’t necessarily indicate a dip for secondary markets.
Remember, the pandemic didn’t create trends. It accelerated those that already existed. There might be some correction of the market, but the allure of secondary markets is unlikely to fade—particularly as the affordability crisis persists.
Managing your risk
As real estate investors, we can’t follow the whim of trends blindly. We can’t invest in a city just because of its name. Instead, we do best when we carefully evaluate our markets and the opportunities within them.
We don’t base our investment decisions on one year of wild market activity. Instead, we look to positive patterns that point to long-term strength and stability. If you’re looking for lasting power in a secondary or tertiary market, look for these qualities.
As a general rule, steady population growth over the years indicates investing potential. When the population grows, housing demand grows with it. This keeps the supply and demand balance in check. Population growth also indicates economic opportunity. Some other factors that drive population growth are the market’s quality of living, affordability, and safety.
Job & industry growth
A growing and diversified economy is critical to long-term strength in the real estate sector. A market can be strong, but if it lacks diversification, a downturn in the economy could spell disaster for the real estate market.
I like to point to Houston as an example of proper economic diversification. Even though oil and energy play a significant role in the city’s economic strength, Houston doesn’t solely depend on oil and energy. We’ve seen over the years how oil and gas prices have fluctuated.
There have been some hard times for those working in those industries and those that depend on them. However, because Houston has grown to have a diverse economy, the market hardly flinched. Houston emerged as a power player in the wake of the Great Recession and its strength and desirability have not faded.
Upward price trends
Buy-and-hold investors should look for balance in price growth for properties and rental rates. Ultimately, your success isn’t about how quickly the property appreciates. It’s how much it appreciates. When prices jump too high too fast, whether in buying or renting, it can cause a housing bubble. The hype around a market can lead to it being overvalued. This can throw your price-to-income ratio off.
In the same way, these white-hot markets can grow so fast that the average buyer or rental resident is priced out of the market. This hurts demand and tightens an investor’s margins.
Both the price-to-income and price-to-rent ratios play into the quality of an investment opportunity. Of course, there are many other metrics we have to consider, like cash flow and cap rate. What price-to-income and price-to-rent show us, however, is the sustainability of an investment.
As an investor, choosing markets that optimize your price-to-income ratio means that you can better scale and manage your portfolio. When we look at the price-to-rent ratio, we can determine the affordability of the rental. This is the median home price compared to median rent. As a tool, this ratio shows us the relative affordability of renting versus buying in any given market.
A ratio under 15 indicates relatively affordable real estate compared to rent price. High—above 21—indicates expensive property prices compared to rent. As a real estate investor, these numbers can help you see market demand and emerging trends.
Making a decision
These, among other metrics, help guide our decision-making. When you utilize the right numbers and look to telling market indicators, you can best determine a market’s suitability for investment. Remember, no opportunity is one-size-fits-all. As a real estate investor, make evaluations based on your personal goals, strategies, and ability.
Investing in real estate is not a speculative venture. We’re not jumping on fads. Instead, we target markets and strategies that have, over time, proven themselves reliable for building lasting wealth.
Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.