You’re thinking about investing in rental properties out-of-state, you find some deals that look amazing, and you can’t see any reason why they may not be a good deal. Have you looked at the market they are in? The market itself may be the reason you should be leery about buying a particular rental property.
Why Does the Market Matter for a Rental Property?
Let me tell you something to get your brain juices flowing when it comes to markets. Let’s say you find two properties in two different markets that are offered as potential investment properties you can buy. In Market #1, you are offered a nice property priced at $50,000 with a cap rate of 14%. In Market #2, you are offered a very similar property in terms of quality and size for $80,000 with a cap rate of 9%.
What should jump out at you right away when you see these two offerings?
The very first thought that would run through my head at seeing these two offerings would be, “The offering in Market #1 is riskier.” Why? Because most often there is a trade-off between numbers/returns and risk factor. A whole other article could be written detailing this trade-off (just came up with next week’s article!), but what you need to know now is that you should never just go off of projected numbers on a rental property.
In fact, you should know that numbers can tell you a lot. In this case, the more appealing numbers in Market #1 should automatically suggest to you that there is some kind of risk tied in there somewhere. It could be with the property condition and specific neighborhood or other things, but since I said the two properties in each offering are comparable, the risk isn’t tied to those things. The risk is most likely with the market.
Before I list out the things that can be impacted by a market, let me explain very briefly the three types of markets out there.
- Growth Markets: These markets are growing. The population is trending steadily upwards.
- Stable Markets: These markets aren’t necessarily growing at a rapid rate, but they are steady enough where they aren’t likely to experience much decline either.
- Declining Markets: These markets are heading downhill. The population trend is trending steadily downwards.
What causes the differences between these three types of markets? Jobs, industry, general desirability. I’d say those three things just about cover it all. A market can obviously change between any of these three categories, but it typically doesn’t happen in a quick timeframe. “Gentrification” is a popular word to describe an area (more often a neighborhood rather than an entire market) that changes over from declining to growth. You’ve all heard of these and how much money can be made in them if you get into them at the beginning of the growth cycle.
But look too at how long those gentrification periods take, and those are just for neighborhoods. So you can imagine the time associated with an entire market switching from a declining to a growth market. Unfortunately it can be much easier and faster for a growth market to become a declining market; all it takes is one major industry crash to completely switch the direction of the market. There is more to it, but you get the gist of the basic differences in market directions.
Now, what can the direction of the market affect in terms of owning rental properties there?
- Exit Strategy. What is your ultimate plan with your rental property? Do you want to sell it down the road? Are you looking for appreciation on it? Do you want to continue to rent it? The direction the market is going will drastically impact all of these things. For example, if you buy a rental property in a declining market, what do you think is likely to happen down the road? It will doubtfully go up in value, that’s for sure! What does that affect? A decrease in value affects how much you can sell the property for later, and it certainly won’t give you any appreciation. In more severe cases, it can send you underwater on your property with no chance of recovery. How will a declining market affect your property if you just want to rent it for the rest of your life?
- Rentability. What happens to the rentability of a rental property in relation to the direction the market is going? Basically, it will impact your tenant pool down the road. If your property is in a growth market, you can expect a continuous pool of tenants, and the quality of those tenants should typically remain higher quality (depending on the specific neighborhood, of course), and if anything should only get better. In a declining market, you should be concerned that your tenant pool will shrink, and of those left in the pool, it would be a fair assumption to say that the likelihood of the quality of those leftover tenants declining is pretty high.
- Profit. The point of owning a rental property is financial gain, right? Well what do exit strategy and rentability have in common? They both are key factors in determining whether or not you end up profiting off of a rental property!
Well, that all sounds great, but how do you know if a market is growing, declining, or stable? No worries — I got you!
How to Determine a Market’s Trending Direction
How about instead of listing out various things to look at, I give you two examples? One market I like for investing and one I don’t. Then at the end, I’ll kind of summarize what factors I pointed out in each, so you can look for similar factors in markets you are evaluating. Cool? Good. Here we go.
Example Market #1: Cleveland, OH
I don’t like this market for rental properties. Why? (Note: I haven’t actively investigated this market this year to know if anything has changed since these stats, but these are the reasons I bypassed Cleveland last year while shopping for rental property markets.)
- Leading into August 2013, Cleveland led the nation in job loss over all of the 37 metro areas in the U.S.
- It has shown historic loss of industry.
- The population has gone down to about 400,000 people, with a housing stock built for more than one million. Of that aging stock, about 15,000 houses are vacant, with more than half of those being condemned and waiting demolition.
- Rumored gentrification of the market exists, but that same rumor has been talked about for roughly 20 years, and there are no sign of the turnaround yet.
That may not seem like a lot of detailed stats to go off of to make such a definite determination, but in fact that small pile of stats is all I need to decide I don’t want to invest in a market. At the point the population is at a steady decline, the industry and job stats solidly suggest a continued decline, and there are so many vacant houses — I want nothing to do with any of it.
Need me to explicate a little more? With stats like these, I would expect the following issues if I were to buy a rental property there, due to the job loss and population declining:
- There will likely be less demand for buying and renting properties.
- There will likely be an increasingly smaller and less stable tenant/renter pool.
- There is a possibility of higher tenant default rates (as people lose their jobs, they suddenly can’t pay rent).
- There will likely be longer vacancy periods due to the market having way more properties than the number of qualified renters (vacancy = extremely expensive).
All of that ties right back around to property values as well. It’s a supply and demand thing. Do you think with those kinds of market fundamentals that the value of a property will be going up anytime soon? I certainly wouldn’t assume so. A declining value on my rental property? No thanks, I’ll choose another.
I would personally deem this a declining market.
Example Market #2: Kansas City, MO
I’ll skip the schmooze-talk and get right to the stats. I think you’ll quickly see why I’m in favor of investing in Kansas City right now.
- The population in downtown KC has quadrupled over the last 10 years.
- New residential high-rises have massive waiting lists.
- 16,000 jobs are expected to be created with the $4.5 billion campus for Center Corporation alone; construction has already begun.
- A $1.45 billion project is already underway for BNSF Railway, a company supported by a $44 billion investment by Berkshire Hathaway (Warren Buffet’s company).
- It’s seen a steady 8.5% increase in the median rent over the past year (top 5 in the country).
- It has a lower than average unemployment rate compared to the nation (5.2% vs. 5.6%).
How are those looking? Pretty good to me. Quite encouraging, actually.
I would personally deem this a growth market.
So how do the two markets compare to you? How do you feel about each? I can pretty much promise that the prices will be lower and the projected returns will be higher in Cleveland than they will in Kansas City. But what it comes down to is not what the projected returns of either market are on paper, but what returns actually happen if you buy the property.
Now keep in mind, none of this is to say that if you buy a property in Cleveland that you won’t achieve the projected returns. Maybe you will, and some have. Some investors have gotten away with buying there, or in cities like it, and had great success. And this also isn’t to say that if you buy in Kansas City that you are guaranteed success. What should be your consideration instead, since none of us have a crystal ball and know what will happen for sure with any property we buy, is risk factor. In these two examples, the stats suggest that Cleveland is a much riskier market to invest in than Kansas City.