Out of State Investing - Choosing a market
As the markets heat up and cash flow becomes more difficult to find in certain markets, it is common to think about investing in other markets. The market that I am in is trading at historically low capitalization rates, rents are at record highs, buildings are popping up left and right, renters are paying nearly 40% of their income in rent and their isn’t much value add left to be had.
Recently, I was looking at a 100 unit building in my market, ran the numbers and looked at the comps. The building had potential! I could drastically raise rents with a light upgrade to the units. I then asked the broker the whisper price and to my shock, he figures it will sell for $14 million. This puts us at a 3.4 cap on the purchase and after all the renovation and value add, we may be able to get it to a 5 cap. After all of that, I could turn around and sell it for around a 5-5.5 cap. This is a great deal for someone that is looking to lose money, especially as cap rates move back toward the mean.
My market is hot, but I still constantly look. There are deals that are being sold with some meat of the bone for the buyer, just not a lot of deals. For me, it was choosing to stay in my market and switch to office, retail, industrial, etc or to stay with multi-family and go to a different market. I chose switching markets.
How do I chose a market?
1. Job creation is probably the most important factor. If the city you are looking at is not creating jobs, then don’t invest there. Jump on to the internet and type in the cities you identified as potentials and type in keywords with “job growth,” “new companies,” “employment data, “future growth.” You can may also find a metropolitan council, chamber of commerce, etc report. Other good sources are your local real estate brokers or the national brokers such as Marcus and Millichap, CBRE, Colliers, etc. Go on to their web pages to find detailed reports of the market you are interested in. The Bureau of Labor Statistic will have great information as well as your local government branches. A few important factors when looking at job growth is where are those new jobs located (your property should be close) and what types of jobs are coming. If your target city is heavy on manufacturing or one industry, be careful.
2. Increase in population goes along with job growth, but the most important factor is to understand where the increase is happening. Every city has a path of progress and possibly a few paths, but they also have areas of decline. Just because your city has high job growth does not mean that people will want to live in your building. Take Chicago for instance, there is job growth in downtown and the northern suburbs and some south suburbs, but there are large parts of the city that hold limited low paying jobs and have little reason to attract good tenants. The result is declining neighborhoods with declining buildings and value. You can buy a building in those areas that show on paper a 10% cap, but in reality they will result in poor performance and will continue to get worse. Again talk with Real Estate brokers, look on loopnet demographics search, go to the crime maps, talk with local government to find out their economic plan and redevelopment zones. Lastly, look for areas labeled “Art’s districts”
3. Buildings coming to market and permits pulled will need to be examined. Be sure that the city you are targeting can absorb the future supply. Too often late in phase II and early in Phase III we see more units built than people coming into the market. This happened in the early 90’s and again in 2005-2008, so pay close attention. Also pay attention to the trend of the market. Right now we are trending to a renter nation, but pay close attention to see if that shifts back to a home buyer nation.
4. Government planning. What is the city and non-profits doing to bring in business? What types are they targeting? You will want to look at the comprehensive plan and the path of progress. If the government is not trying to attract jobs, then you may want to stay away from that city. Look for cities that are easy to move to and have a good workforce. Also, cities that have economic development areas and are easy to deal with.
5. Affordability is a key factor in picking a market in my mind. This tells me that as a property owner you have room to raise rents. As the economy improves and incomes go up, people will be fine with paying more in rent. This is especially true in cities where rent is low and yet housing in comparison is expensive to buy. You can search online for housing affordability in your markets and also look at the median rent vs the median income. If the median income is more that 33% of the median yearly rent, then you have an affordable rental market.
6. Absorption rate and vacancy rate. First you will want to look at how quickly the new units being brought to market take to become leased up. When a lot of units are sitting vacant that are newly built and large incentives are being offered that is a bad sign. The second part is looking at the vacancy rate in the market and sub market. Look for the historical vacancy rate and the current rate. I would analyze on whichever is worse. The important factor in this is looking for a vacancy rate that is decreasing, meaning people are moving into the buildings vs. moving out. Brokers are a great source for this information along with property managers.