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The Four Pillars of a Good Investment Market

posted Mar 22, 2016, 5:34 PM by Joshua Durrin   [ updated Mar 23, 2016, 7:53 PM ]

Diversification is the key to any good investment strategy.  Expand your base into different markets.

A common theme at the local REI club meeting in the current market I’m in is that there are no good deals available right now.  I’ve fallen into the trap of that depressed mindset myself on a number of occasions.  The truth of the matter, however, is that there are indeed good deals out there today, they just may not be worth the effort to attain. 

The consensus among my peers is that our local market is saturated with investors and novices alike leading to bidding wars on properties that appear to fit the bill for a good investment opportunity.  Couple the competition with a bustling local economy and a shortage of homes available and you have a case and point for the basic principle of economics, prices rise when demand is high and supply is low.  Thus, the competition is the scapegoat for the prices being through the roof and investors, in desperation, become speculators. 

The true investor must adapt to the current market in order to succeed.  Admittedly, while it is still possible to get a good deal in my local market, the effort to find it makes it next to impossible to sustain oneself as an investor.  Effort may be much better spent finding a new market to invest in where your dollar will go much further and more importantly, where you can help more people get out of their real estate bind that need it. 

What are the criteria that define a good market for investors?

A good real estate investment market meets four critical criteria.  A good market will have little chance of depreciation, lots of available deals, low competition, and multiple employable exit strategies.

        1.        Little chance of depreciation

Mortgage insurance companies hedge their existence on analyses to determine market risk.  Fortunately for us, they make this information public.  The mortgage insurance industry determines their risk for default on a loan in a given area using the Mortgage Risk Index.  The Mortgage Risk Index is a measure of the risk of depreciation for a given market over the next two years.  Values are published at http://www.housingrisk.org.  At this site, you’ll find a long list of markets with their respective risk rating.  Where the market has been determined to have a high risk index, the analysis indicates that real estate in that area is overpriced and poised for a large decline in values if subjected to similar financial crises as experienced in 2007.  An MRI value of 10%, for example, indicates that 10% of the loans in a given group would be expected to default in a severe stress event like that experienced in 2007.  Markets with MRIs higher than the national average may indicate that prices are overinflated due to high incomes or an influx of newly employed buyers that are driving prices up.  High MRI’s may also mean that there are more first-time home buyers than secondary-home buyers, meaning that the quality of the loans are worse as a whole with low down payments and low starting equity positions.  Either way, that means a seller’s market, which makes for more competition and greater risk for loss than in a buyer’s market.  Perhaps in these markets it’s best to spend your energy finding a different market.  Where the market is shown to have a lower risk as compared to the national average, these properties are considered to be at a rather stable price point or even better, at a point where there is still plenty of room for growth.  It doesn’t necessarily mean that the market is a hot one though. 

Another important input to assessing the downside risk is the local market economy.  The investor should get to know some basic demographic information to learn the potential of the market.  The local economy can be assessed from household income, population growth, unemployment rate, job growth, housing inventory, rental rates, and median home price.  A plethora of demographic information including rental rates can be found using the US Census Quick Facts page at http://www.census.gov/quickfacts/table/PST045215/06001,06013.  Simply go to the page and select your city, county, or state and browse the table of information.  From the data published, the investor can get a feel for the area he’s looking at and whether it’s a demographic he’s looking to invest in.  Likewise, they can compare historical data to more recent data to see if the trend in up or down.  For instance, are jobs increasing year over year?  Is there an influx of residents?  What are the predominant age groups, retirees or families?  These data can help you identify if the market fits your niche or not. 

        2.       Lots of available deals

Once the investor has identified markets with good potential and low risk, the next step is to evaluate whether there are deals available in the market.  They might start by looking at other key criteria within a given market like housing affordability and high rental rates.  Housing affordability is publicized monthly by the National Association of Realtors at http://www.realtor.org/topics/housing-affordability-index.  One can search by metropolitan area or nationally.  The metropolitan area list is quite extensive fortunately.  Where the housing affordability index is 100 it means that a family earning exactly the median household income can afford a home priced at exactly the median home price (assuming a mortgage payment of no more than 25% of household income).  Where index ratings are higher, it means the family making the median income has more than enough to qualify for a home purchase at the median home price, conversely for the lower index ratings.  At the time of this article, the home affordability index for the San Francisco Bay area is 72.6, meaning that families that make the median income (or investors looking for deals) would find it quite difficult to buy a property. 

One can also get a feel for the housing market by comparing the median household income to the median home price.  Dividing the median home price by the median income enables one to produce a measure of affordability.  Where the result is less than 3, that market is likely to have plenty of affordable homes available.   One can find more recent housing price data on Zillow at www.zillow.com/research/data.

Rental rates are published from a number of sources.  The Department of Housing and Urban Development (HUD) publishes recent rental rate information.  Simply go to http://www.huduser.org/portal/datasets/fmr.html and search for the county or metro area of interest. 

To use the rental data meaningfully, one would divide the average annual rents into the median home price from any of the sources to come up with a median rental rate of return.  This is one element to the total overall return one can expect from their investment property (remember, total return includes rental income, equity appreciation, and principle pay down).  Using an example from Alameda County at the time of this publication, the median rental income is $1,325 per month, or $15,900 annually whereas the median home price is $509,300.  If one accounts for typical expenses at 40% per se, then the resultant net annual income (excluding debt service payments) would be $9,540.  The resultant net rental rate of return is 1.9%.  That’s a pretty horrible return by itself for most investors.  To be profitable in a market like this, one would likely have to put forth a great deal of effort to find or create a good investment deal or be willing to take a great deal of risk in hopes for huge near-term appreciation.  Remember though, investors don’t bank on appreciation, speculators do. 

Related Article: Investing or Speculating? Your Call.

        3.       Low competition

Competition drives prices up.  Getting back to basics, where supply is short and demand is high, prices will rise.  When an investor puts an offer on a property that is competing with several others, the investor is wise to simply hand over the property and find another one.  Let the hobbyists or the owner-occupants get it. 

In the current Bay Area market, homes with any potential are bombarded with offers, often 15% or more over the list price.  Where investors need to make a profit, hobbyists and owner-occupants don’t necessarily.  They may have a family member that they’ll be “renting” their house to who’ll do some of the rehab while they’re there or perhaps they plan to do a live-in-flip that’ll take a bit more time.  Or perhaps they’re a novice investor looking to break into the “hot market” and are willing to sacrifice some of the profit in exchange for the experience.  Unfortunately, real estate investing for me is a business and the numbers have to work in order for me to sustain my business and continue to help people with their real estate problems.  Not to mention, usually when a market is labeled as “hot”, it's often too late for the serious investor to get into it.  The serious investor has likely already tapped into it and moved onto the next. 

When the competition heats up and multiple offers are going onto properties, bidding wars ensue, and houses are selling for way over asking price, that’s a bad market to in.  Find another one.   

Investors are in the best position when they are the only offer on the table.  They have much more leverage in negotiations in that scenario.  Often times the most desirable areas to work or live are the ones with the most competition, for instance, those that were very hot during the boom such as areas of CA, Vegas, Florida, and TX.  Less dense areas typically have less speculation and competition which often results in lower purchase prices for distressed properties.  Smaller cities even amongst those surrounding the bustling hotbeds of activity may present much better opportunity for investment with far less competition.  So, perhaps try looking at the outskirts of the major metropolitan hotbeds as a start. 

        4.       Multiple Employable Exit Strategies

Having multiple exit strategies is critical to mitigating risks of losses and/or surprises after an acquisition.  Flipping older homes, for instance, one often encounters those hidden surprises lurking behind the walls or under the floors that can cost thousands of unplanned dollars to fix.  It may mean that the investor has to hold the property longer than expected.  In this scenario, the investor may look to refinance into a more affordable payment and rent the property either traditionally or with a lease option.   

Conversely, if the investor cannot locate a decent property management company or good tenants for a property they had planned to rent, they can flip or wholesale the property assuming they’ve purchased it at the proper discount (buying right with equity built in).

The savvy investor will consider multiple exit strategies in their acquisitions to mitigate the risk that the first exit is unsuccessful.  Simply put, multiple exit strategies will give you peace of mind throughout the improvement of the investment.  Returns in real estate require work, management, savvy, and problem solving.  Many of the high priced “hotbeds” are difficult to cash flow across several modes of exit.  It may come as a surprise, but many deals with tremendous equity, tremendous cash flow and multiple exit strategies are often found in the places most people aren’t looking… the outskirts or even smaller local cities. 

Summary

The best markets for real estate investors are those with 1) little risk of depreciation, 2) lots of available deals, 3) little to no competition, and 4) multiple employable exit strategies.  An investor that has found these four pillars of strength is well-positioned to experience incredible returns on their efforts and investments.  Of late, the Bay Area has been one of those hotbeds that was hot during the last few years but feels pretty tapped out to me.  The competition is plentiful and showing signs of foolishness engaging in bidding wars and inflating prices while banking on future appreciation.  The MRI is higher than the national average and the affordability is deeply stressed.  For this investor, the deals are somewhere else. 

This investor will be applying the learning here to find new markets to explore.  We’ll be looking for minimal chance of home values decreasing, tons of available deals, low competition and ability to find deals with tremendous equity and tremendous cash flow.  I’ll keep you posted as things progress. 

In the meantime, be mindful that the success of any deal is still specific to that property and not to the market as a whole.  So keep your ears and eyes open even in the worst of markets.  You may still find that diamond in the rough.  Just be careful about over expending your energy and capital in markets like this one.  If you're not careful, it could mean the end of your business. 

Thanks for reading and please share your own thoughts.  Until next time…

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