4 Submarket-Level Risks That New Investors Often Miss

by | BiggerPockets.com

As a principal in a private multifamily real estate acquisition and asset management firm (we buy apartments), I speak to real estate investors every day. The vast majority of them are hyper-focused on “the deal” (the property itself) and any discount to market they can get on the buy.

They want a good deal, they need a good deal, and they must have a good deal.

In many ways, I don’t disagree; I like a good deal as much as anyone else.

However, the really good deals (i.e., assets discounted to market) are that way for a reason. Typically, they are more distressed—with deferred maintenance, tenant issues, or a number of other factors that compel the owner to offer the property at a discount. These deals can have greater potential opportunity, but they also come with greater risk.

The following are four MSA/submarket-level risks that could make even the best deal a nightmare.

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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. Declining population equals declining demand.

There are many cities in the United States that are shrinking, and some have been doing so for a very 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.

On first blush, those higher cap rates may seem to represent a better deal. However, when you factor in rent growth and occupancy rates over the long haul, what you’ll uncover is that those higher cap rates are, in fact, nothing more than risk premiums.

In essence, it is a form of compensation for tolerating the extra risk inherent in contracting markets. 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.

Related: 5 Risks of Buying Rental Properties in Declining Markets

2. Environmental Risk

Some years ago, we stumbled onto what appeared to be a financially good deal in a growing, stable market. Not only did the investment look good on paper, it also looked good upon physical inspection. It was during our due diligence that we discovered that this property was located near a Superfund site with contaminated groundwater issues. Of course the seller disclosed none of this.

Had we not had a thorough due-diligence process in place to catch the various land mines that could wreak havoc on an investment, we would have paid the price for owning that “good deal.” The resale market is very limited for properties that contain environmental hazards.

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.

3. Singularity of Jobs Risk

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 that was created by base realignment and closure (BRAC) back in the 1990’s is a good example of this.

Today, all over this country, there are cities that derive significant portions of their economy from military spending. Cities like these can derive as much as half of their GDP from the military. No matter how good their present economic situation may be, they are always one BRAC away from complete disaster. In my mind, that creates unacceptable levels of risk for the long-term investor, regardless of how good a deal looks on paper.

Related: Limiting Common Risks Involved in Real Estate Investments

4. Legal Risk

When evaluating markets to invest in, population growth and employment rates are important. There are several markets that have exceptional numbers in both of these areas that I still wouldn’t consider investing in. Local and state landlord-tenant laws can make a big difference when it comes to success or failure in a given market.

Pro-tenant states can have things like 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.

For example, one major metro passed landlord-mandatory renter-relocation assistance. This law will require landlords to be financially responsible to fund their tenant’s relocation under certain circumstances.

In 2017, just one state away, another major metro passed laws barring criminal background checks.

Criminal background checks have long been the norm in our industry. Good landlords strive to provide a clean, safe environment for the residents who live at their properties. Background checks are a tool that assists them in meeting that obligation.

How they use those checks depends on their management style. Some take a hard-line approach and reject all tenants with a criminal history. Others are more moderate.

Working under the theory of disparate impact, many look to HUD for guidance on this topic. Striking a balance by being as inclusionary as possible while still safeguarding existing residents and property can be challenging.

Banning the use of all criminal background checks is extreme. It handcuffs owner’s rights and obligations to maintain a safe environment. I would think long and hard before investing in properties with laws like that, no matter how good the deal is.

Not All “Good Deals” Are Good Deals

As important as it is to pour through the financials and to know the numbers of every potential property that you are considering investing in, the fact remains that this business is more than just numbers on a computer screen. In fact, good deals in real estate often represent nothing more than a risk-premium. Perhaps you are particularly good at mediating that risk and creating profit. If so, then more power to you. If not, passing on that “good deal” may just be the best move you’ll ever make.

Are there any risks I failed to mention?

Share your thoughts with me below!

About Author

Dennis Bethel

Dennis is a principal in 37th Parallel Properties a private multifamily real estate acquisitions and asset management firm. With over $300 million in transaction volume and a 100% profitable multifamily track record, 37th Parallel Properties has become a trusted partner for accredited individuals looking for stable passive apartment investments. Dennis focuses on investor education and has authored the research paper Evidence Based Investing.

11 Comments

  1. Nancy Roth

    @DENNIS BETHEL

    Well said! These very important “big-picture” factors are often lost in the minutia of deal analysis. No matter how good everything looks on a spreadsheet, if you enter the wrong investment environment carelessly, the investment will do nothing but sap your strength, little by little. Yesterday I just sold off one of my last two rentals in Baltimore City–which checks two of your “don’t go there” boxes: declining population and legal risk. Some things are just not worth the struggle. Next, please.

  2. John Bierly

    The point about job singularity, with relation to the Military/government was true at one point in time, however the BRAC process you describe was the product of a unique set of circumstances (collapse of the Soviet Union and before the rise of China leaving the US as the worlds sole superpower). It allowed the military to close many legacy bases that had been hanging around since WWII which until then had been sheltered by the local congressional representative. It is hard to see, at least in my region (Western Washington) any remaining candidates for base closure unless you think there is some reason that force levels will be reduced significantly (I don’t). Consequently I have decided to invest in MF close to local bases – most military families are good tenants who pay on time.

    Private employers in traditional manufacturing company towns are of course a different story, despite the current administrations efforts to keep US manufacturing jobs, it seems like in the long run this process will only slow but not reverse – again to use my region as an example the high cap rates available in timber towns on the Olympic peninsula speak to ongoing job losses and consequent increasing vacancy rates.

  3. Jerry W.

    Dennis,
    I live in a state that has been boom bust for as long as I can recall. The mineral production field has dominated our economy. When fuel prices get very high, our economy goes wild, when energy prices are down we tend to crash. Only 4 years ago in Casper WY you could rent a shack for $1,200 a month and here were some very nice large apartment complexes built during that boom. Apartment complexes had waiting lists that took months to get into, and they charged pretty much whatever they wanted. Those same places are making half of the rent they made before and offer 1st months rent free, some offer first and last months rent free with a 1 year lease. I have now seen some of the older apartment complexes going up for sale. One very hard thing is knowing how long it may take for the economy to turn around. I am seriously looking at finally taking the next step to 30 or 40 apartment complex, but the fear of how long until the market stabilizes holds me back. They built some very nice places during the boom. The crappy ones have been shutting down, but how long until the very nice ones fill up and leave tenants for the ok units? It is a tricky market. Any suggestions?

    • Dennis Bethel

      Hi Jerry,

      You are smart to be thinking about markets before investing. No matter how good a deal is, in the end, the market always wins. Wyoming is a beautiful state, but by some estimates 70% of the economy comes from the energy sector. That is the definition of singularity of jobs risk. Energy is volatile, so when the price of a barrel of oil is low, you’re going to get hurt and when it’s high, you’ll prosper. Everybody is different, but if I wanted that kind of volatility, I’d just put my money into the stock market as it’s a lot less work than managing apartments. Have you ever considered investing outside of your home state in more stable markets?

  4. Wendy Hoechstetter

    A couple of major risks pointed out at our ACRE meeting last week for some regions (notably ours in the Pittsburgh area) include the risk of earth movement and mine subsidence.

    It’s difficult to impossible to insure against those risks, at least because the cost of the insurance is prohibitive, so you’ve got to do your due diligence to ensure that the property you are considering is not going to fall into a mine or slide down the hill – or have another house slide down into yours.

    Another thing that is critical to look at is whether or not the place is in a flood zone.

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