Market and Submarket Selection

There are two major strategies when choosing a market to invest in:

1. Betting on the rising tide lifting all real estate values
2. Search for mispriced assets and discounted assets

Strategy #1: Betting on the Rising Tide

Strategy #1 is used by large investors and institutions who deploy substantial capital. This involves them acting as a macro-economist and betting on markets where they believe population growth and rent growth will increase significantly. They operate in a market where it's very difficult to pick up assets at a discount or find assets that are mispriced. So instead, they look for markets where competitors are underpricing growth.

Strategy #2: Search for Mispriced Assets

Strategy #2 is the approach used by smaller investors. Instead of being a macro economist you can play in less competitive markets and hunt smaller deals. Smaller investors should look for the market that is the least competitive and search for mispriced assets within that market.

Step 1: Identify Cities Under 300k Population

Identify the least competitive markets where you can find mis-priced assets. The least competitive markets are going to be lower in population. Using 300k population is just a benchmark and does not need to be followed religiously and is a good way to find a starting point for identifying less competitive markets.

Step 2 & 3: Analyze Supply and Demand

When you're analyzing markets you want to make sure the supply and demand dynamic are healthy and don't have any reason to get worse. The only way the supply and demand dynamic can get worse is if supply increases and/or demand decreases. When supply increases or demand decreases the supply and demand dynamic gets worse and rental and sale prices drop.

What causes supply to increase?

New developments. Developers start projects when it's profitable to do so. So if you can find a market where it's not profitable to develop you can be certain that supply most likely won't increase. An easy way to find these markets is to identify markets where the average market sale price per unit is substantially below replacement cost. This means that it's not profitable for developers to build.

Finding these markets neutralizes the supply risk. To neutralize the demand risk investors need to look at the unemployment rate, population growth, crime rate and number of active employers in an area. Ask yourself "is there anything that would cause the population to drastically decrease?" or "are there any structural issues with the market that'll eventually lower demand in the area?".

Step 4: Identify Mis-priced Assets

The last criteria is making sure there are mis-priced assets in a market area. A typical broker marketed return is around a 15% IRR. You want to find deals that're better than that. So we consider any deal where the stabilized yield is 200 basis points + above the market cap rate to be a mis-priced asset. Now, you want to find markets with the most mispricing's because that's where you make your money.

Track a market for 4-6 months and if you don't see a few deals in which the delta between your stabilized yield and the market cap rate is 200 basis points then the market is likely too competitive.