Most first-time investors focus on areas with good demographics, high population growth, low crime and an abundance of amenities. While this is all good for deciding where to live it often times does not translate directly to making money on a real estate deal. To make money on real estate you have to focus on factors that directly correlate with the upside scenario of the transaction.
How do real estate investors make money?
Real estate investors make money on mis-pricings or if they have a unique and efficient business model that the market hasn't priced in. When you're first starting out you don't have a unique business strategy so you'll have to work to find mispriced assets.
If every deal was adequately marketed and sold for full price, the market would be fully efficient and no one would make outsized returns. Try to avoid market efficiency and hunt for the inefficient markets and submarkets where outsized returns are possible. Larger markets are usually more efficient. Smaller markets have less competition, less price discovery and more mispriced assets which make them prime for generating outsized returns. The main criteria for finding a market to invest in should be to find the markets with the least amount of competition.
In Depth Analysis
Most people think looking for markets with fancy amenities, population growth and low crime is the way to find the best opportunities. These areas typically have more competition because they are already seen as attractive. If 10+ investors are bidding on real estate in these markets, there's no window for mispricing and the only way to get outsized returns is if you're lucky or have an efficient business plan. Otherwise, the market characteristics that are seen as attractive have already been priced in.
The only market statistic that matters is finding a market that frequently misprices assets and has a strong upside case. Everything else doesn't matter.
The main difference in investing in expected high growth cities vs. expected lower growth cities is underwriting rent growth. The tradeoff is in higher growth cities/areas an investor will have more competition in exchange for higher future expected rent growth. This is not an asymmetric deal. You lose the ability to find mispriced assets in high growth areas in exchange for an educated guess of higher expected rent growth that has a chance of not even happening. If rents don't grow in the already high growth city you may lose a lot of money on the deal.
The process of finding a deal is the same in both cities/areas, the process of underwriting is mostly the same in both cities/areas and how you manage the asset after acquisition will most likely be the same as well. All that changes when investing in expected high growth vs lower growth cities/areas is the amount of competition the investor will have and the amount of assets that are considered mispriced available to the investor in that area.
If you go to smaller markets, exploit lower competition and find mispricing you're actually taking on less risk because you're not betting on things outside of your control in the future and most importantly you'll have a higher chance to find mispriced assets.
This is why starting in high growth cities/areas doesn't make much sense. Tier 2/3 cities/areas have:
- Less competition and lower quality competition
- Ability to rely on safer assumptions: You can rely on in-place market rent to model your returns
- Strategy: Your strategy will be more in your control. In an expected high growth city you're paying a premium for market growth which isn't guaranteed. In a low growth city without that assumption the investor has to focus on value add which is in their control.
- Higher Initial Cap Rates: Higher initial cap rates means there's more margin for error on the exit.
- An investor can develop better relationships with real estate brokers to find better deals in smaller markets than larger markets.
Finding Your Market and Submarket
Go onto loopnet/Bright/Zillow and set a radius of 50 miles (3 or 4 hours from where you live) and look for the market with the highest cap rate in that area that still has average sales volume. Higher cap rates aren't always a perfect indicator of lower competition but this should be a good start.
Find Your Submarket
Submarkets are well defined and recognized areas within your market and they have known borders. Submarkets usually have certain characteristics that differentiate them from other submarkets within the broader market.
After identifying your submarket call up the listing broker and discuss the listing. Tell the broker that you're running investments for a private wealthy family from your area and that you're searching for new markets. Using this method is vital to encouraging the broker to discuss the project and not to push you off even though this may be your first deal. This method also allows real estate brokers to take you seriously.
The main questions that you want to understand are:
- What are the areas investors absolutely shouldn't buy in
- What are the 3-5 best submarkets?
Repeat this process with at least 2 more brokers. The point of this process is to have a funnel and get your name out there while exploring your options. You're going to compare notes between the 3 brokers and pick out the 3-5 submarkets you want to target. For your first deal this is good enough and you'll easily be able to avoid the bad submarkets which is the most important thing. Once you start getting comfortable with the market you'll formulate your own opinions.
Demographic Check
The next step is to analyze demographics. This is where you can do the things that most investors do first. You're going to check population growth, check rental growth, check the crime rate and check the school systems. The purpose of this experiment is to avoid the bad submarkets. You want to make sure that demand won't fall off a cliff anytime soon. Ask the brokers about any planned developments in the submarkets as well.
Rinse & Repeat
Track one of the submarkets for 3-6 months and search for mispricing. If you can't find any mispriced assets the market may have too much competition. Move onto the next submarket on your list and do the same tracking method. Eventually you will find one where mis-pricings pop up and you'll have found the submarket to operate in.
Summary
You want to find submarkets where the mispricing of assets allows for consistent 150 bps+ spreads between the stabilized yield and the market cap rate. If you're able to do this repeatedly you'll be successful.
Notes
Cap Rate (Capitalization Rate)
Net Operating Income / Property Purchase Price. Cap rate is the expected annual return on a property based on the income it generates. Example: If a property costs $1,000,000 and generates $70,000 in net income annually the cap rate is 7%.
Interest Rate %
The cost of borrowing money (Mortgage rate)
Spread
Cap rate minus interest rate
- Scenario A: Property with 7% cap rate and 5% mortgage rate = Spread of 2%
- Scenario B: Property with 9% cap rate, 5% mortgage rate = Spread 4%
The larger spread in scenario B means better leverage potential. The property's income exceeds your financing costs by a greater margin which generally means more cash flow and a better return on your invested equity.
Stabilized Yield
The cap rate the property will achieve after improvements / renovations are complete and the property is fully leased at market rents. This is your expected return once you've executed your unique strategy or business plan.
Market Cap Rate
The cap rate at which similar stabilized properties are currently trading in the market. This is what buyers are willing to pay for stabilized properties.
150bps+ spread
1.5 percentage points or more difference. Buying a property at a higher cap rate (lower price) because it needs work then improving it so it performs like properties that trade at lower cap (higher prices).
Example
Buy a distressed apartment building at an 8% cap rate (based on current underperforming income). After renovations and lease up the stabilized yield is 8%. Comparable stabilized buildings in the market are trading at a 6.5% cap rate. The spread is 8% - 6.5% = 1.5%
This is important because the 150+ bps spread represents your profit opportunity. Once stabilized you can sell a property at the lower market cap rate which means a higher valuation and substantial profit. Or you can hold it and enjoy the higher ongoing returns.
The larger the spread the greater your potential value creation and return on investment.
For accurate property valuations in any market, our team provides expert appraisal services with deep local market knowledge.