Over the past few weeks, we've been publishing a series of market profiles about Heartland metros that might be attractive to real estate investors interested in capitalizing on the region’s compelling price, demand, and demographic trends.
So far, we've covered:
Before we serve up another profile, we thought it might be helpful to contextualize that discussion with some general principles about market analysis.
In particular, we want to answer the question:
What should investors look for in a market?
The first and most obvious way to figure out the answer is to ask: “what kinds of returns can I realistically expect?” There are a few metrics that help forecast return scenarios for a given market. In addition to returns at the outset — which are usually a function of buying stabilized properties with in-place cash flows — investors should think about the trends the market is likely to experience over time, how demographics and supply and demand could influence prices in the market, and what the market’s risk profile looks like.
While not exhaustive, here are a few ways to break it down:
Cap rates aren’t the be-all end-all of property valuations, but they are a helpful at-a-glance comparison tool for prospective investors. All else equal, a building trading at an 8% cap rate is generally higher-risk and higher-reward than a 6% cap alternative. But, because a cap rate is an unlevered metric and financing terms vary based on the strength of a market, the conversion from cap rate to cash-on-cash — a better indicator of investors’ true return experience — can look different in Milwaukee than Miami.
Occupancy rates, rent trends, new construction projects, and asset appreciation (or depreciation) all serve as important proxies for evaluating investor and tenant demand.
On the tenant demand side, the most important question is “what is your revenue growth going to look like over time?” Preserving a healthy occupancy rate while growing rents is critical for materializing returns. High rents don’t matter if tenants don’t want to live in your building, but steady occupancy without any upward mobility in rents is a recipe for mediocrity.
To preserve yields during economic downturns, it’s also critical to look at income composition in the metro: are jobs disproportionately contingent on a single industry, or a few stagnant industries, or is employment widely distributed across a diversity of industries with good growth prospects?
On the investor demand side, market depth — the extent to which investors are interested in transacting in a particular geography — is an important consideration. Low cap rates at acquisition could signal frothy investor demand and complicate entry into a given market. On the other side of the coin, the velocity of a market matters when it’s time to exit: unexpectedly bloated cap rates and lackluster investor demand could invite exit valuation risk — the unpleasant realization that you have entered a market you can’t easily get out of. As such, it’s critical to assess what anticipated investor demand will be at the target exit date.
Are property values eroding? Going up? Why?
Predicting market forces is a formidable task, but investors seeking out new markets can’t afford to skimp on research. Rental properties are an income stream — and buying usually implies a mid- to long-term commitment to the market. A tight investment thesis that accounts for value trends and incorporates a plan to capture that value is indispensable.
Understanding demand trends, and how regional demographics move in response to economic developments, invites a more specific set of questions.
We pointed out earlier that investors should ask whether local industries are well diversified in order to mitigate collection issues associated with market shocks. Ask, “is the metro in question heavily reliant on a bubble that might burst and tank property valuations?”
Property valuation trends over time can be good proxies for how bullish employers are on the metro — and, consequently, how you can expect your tenant base to change over time.
That’s important, because real estate investment value is a function of a property’s income stream, which is contingent on the depth and resilience of its tenant base, which is itself dependent on the regional economy.
But, region isn’t the only variable. Value erosion in a given market usually isn’t static across different multifamily asset classes — which means that a promising workforce housing market might look very different than a promising market for Class A apartments.
We’ve already mentioned value erosion, lending, and disposition risks, but due diligence for a new market involves estimations about a host of accessory risks. Is the city you’re looking at perched atop a fault line? Is the area vulnerable to hurricanes or tornadoes? Is local infrastructure robust? Is the government fiscally responsible? How resilient is the local economy in the face of recessionary environments?
Risk is a set of trade-offs, though. A market with built-in downside protection can protect investors against worst-case scenarios, but it can also limit returns. Knowing the risk profile of a given market is important, not in that investors should always select the least-risky available option, but that they should select the market whose characteristics best match their investment goals.
That’s why there’s no substitute for planning and due diligence. Market analysis involves some degree of subjectivity; an ideal market for one real estate investor probably isn’t an ideal market for another investor, which is why establishing a crystal clear definition of individualized investment value is a critical first step in market analysis - a subjective benchmark against which an investor can evaluate a given market’s unique characteristics.
These, of course, aren’t the only questions to consider in the search for new markets - regional territories are complicated entities subject to a variety of forces. Estimating impact on market trends — and, ultimately, your bottom line — is well worth the calories.
That said, returns in real estate aren’t exclusively a function of making the right picks. Selecting markets with strong financials today could come back to bite real estate investors tomorrow if they disregard the fact that real estate investing demands commitment, tolerance for illiquidity, and executional follow-through. Locating strong markets is one important part of the equation, but as the last year has made more clear than ever, there’s no substitute for a resilient business plan, strong partnerships, and a capable team.