On June 8th, I wrote about Why I Like Single-Family Rental Properties. It creates passive cash flow. There are multiple ways to profit. There are strong demand drivers. There is a shortage of supply. Cap rates are generally higher when compared to multi-family rental properties. And, finally, I can move faster between different marketplaces as supply and demand drivers change.
On June 29th, I wrote about the Economics and Investment Potential of Single-Family Rental Properties. I described the recurring cash flow. I described the tax benefits of depreciation. I described the equity amortization created by the mortgage being paid down by your renter. I described the potential for long-term appreciation. And, I described how using leverage enables you to compound the return and real estate is the only asset where you can leverage up to 80% of the acquisition price.
In this blog post, I want to try to answer the following questions:
- What Determines the Demand for Housing?
- What Factors have a Positive or Negative Impact on the Local Demand for Housing?
- How Can We Use this Information to Determine Where Best to Invest?
My Criteria and Determining Factors for Selecting Local Markets:
- Legal Environment
- Demographic Factors
- Job Growth
- Population Growth
- Income Growth
- Crime Statistics
- Affordability
- Home Value Growth
- Top Industry Employers
- COVID-19 Factors
Introduction
On May 27th, I wrote about the factors that drive demand for real estate. In that post I talk about demographic shifts in populations and generations that lead to increased demand for new housing units. As people move into their late 20s and 30s, they start to form more permanent households, have children, obtain more steady employment and create more demand for housing units.
The Millenials, generally born between 1981 & 1996, are a very large generation. They are certainly larger that Generation X (nearly twice as big) and even a larger group than their parents generation, the Baby Boomers. As of 2020, the Millenials are aged roughly 24-39. Therefore they are in prime household formation ages and moving into their prime years for spending money on their homes.
You might notice that I am referring to household formation rather than home purchasing. The Millenials have shown more of a tendency to rent housing in order to maintain more flexibility in their lifestyle. However, regardless of whether they buy a home or rent a home or apartment, they are forming new households.
The Millenials have certainly delayed forming households compared to previous generations. But statistically, this is really only a few years later than the previous generations. There are some other factors that can start to drive this generation to move toward suburbs, good school districts, etc. as they form households and have children.
So, generally this generation is driving up demand in the U.S. for new housing units.
With that said, below I will describe why I have selected the following factors to determine what local marketplaces I am investing in single-family rental houses.
Categories
The first thing I do is segregate and group cities by population size. I have three categories.
- Large – populations greater than 1,000,000
- Mid-size – populations between 250,000 and 1,000,000
- Small – populations under 250,000, but generally above 100,000
This helps with my comparisons. I can’t expect a large city to grow at the same rate as a small city. So, I compare cities against each other within each group.
Legal Environment
The first factor I look at is the legal environment in each state. I want to only invest in states where the legal environment is more favorable to the landlord. I do not want restrictions on how much deposit I can request, ability to evict tenants that don’t pay their rent or have other serious violations of the rental agreement, or my ability to charge late fees, as examples. So landlord friendly states include states like Texas, Arizona, Florida and Alabama, plus some others. States that I will avoid include states like California, Nevada, Kansas, Oregon and others.
I also have a middle ground for states that are neutral in whether they are friendly to landlords or renters. I don’t eliminate the neutral states, but I could use that as a deciding factor when comparing cities.
So, this is my first screen. I don’t worry about pulling much data on cities that are in the states with the worst legal environments for landlords.
Demographic Factors
There are three demographic factors that I look at. They are job growth, population growth and household income growth. Let’s look at each of these factors.
Job Growth
Job growth really drives everything. If people don’t have jobs, they will struggle to afford to pay rent or continue to make mortgage payments if they own their house. When companies create new jobs in an area or move to a new area, it creates an environment where people can afford to live. This also increases demand for people to move from areas where there is no job growth or the number of jobs are shrinking to areas where the number of jobs are growing.
I look for cities where the job growth is in the 1st or 2nd quartile of cities. The reason is that the cities with higher job growth than the pack are going to attract more people to move there.
Population Growth
This is the ultimate driver of increasing demand for housing. If the population is growing, either families need larger houses or there needs to be additional housing for the increased number of people.
While I say this is the ultimate driver, I include job growth first, above, because job growth is generally a leading indicator of population growth.
Similar to job growth, I look for cities where population growth is in the 1st or 2nd quartile of cities. Again, the cities that are growing faster than the pack reduces our risk decreasing demand for housing.
Household Income Growth
In addition to job growth and population growth, I also screen for household income growth by quartile. Rather than looking at income per person or other measures of income, I like income by household because that’s what will really support paying the rent on a housing unit. When this indicator is growing faster than other cities, that is going to support rental increases and ultimately reducing our risk that rents could go down over time.
Crime
The third type of data point that I look at is crime statistics. When I look at the crime statistics, I am looking for decreasing rates of crime over time and below a certain level. Lower rates of crime are an indication of desirability and, generally, higher education levels and higher income levels within the area. We only want to invest in areas that job-seeking people are going to view as desirable areas to live.
Affordability
The fourth data point I look at is what I call an affordability index. The affordability ratio that I look at is the ratio of median rental rates to median mortgage payments. The larger the difference between the median mortgage payments over median rental rates, the harder it is for the average household to afford to buy a house. This leads to more people likely to rent rather than buy a house. I want to invest in markets where households are more likely to rent than other markets.
Home Value Growth
A fifth factor I look for is markets where the market values of houses are increasing faster than other markets. However, this factor requires some judgment. Markets where market values have continually increased faster than the the rest of the country for several years might be over-valued. So, home value growth is not an absolute. It’s more of a judgmental factor.
Top Industry Employers
I also look at the top 5-6 industries providing jobs in the marketplace and look for the drivers behind those industries. Are they industries expected to grow or are they at risk of decreasing? Again, this is where judgment has to be applied.
Putting them all Together
How do I use all these factors? Here is a quick summary in order of priority.
- Segregate cities into my three size categories by population.
- Screen out all cities in states that I view as unfavorable to landlords.
- Use all three demographic factors to rank the cities on each list. I don’t use this as a hard rule about one city ranking one point higher than another. I use this ranking to eliminate cities in lower half and focus more on cities in the top half and especially in the top quarter.
- Use the crime statistics to determine if any cities should be lowered in ranking or eliminated.
- Use my affordability index to further adjust the rankings.
- Use the list of top industry employers to determine if I need to eliminate any more cities.
From this I will end up with a list of cities that I will focus on. In a future post, I will describe specifically what I think the impact of COVID-19 will be on the housing market. In another future post, I will show you my location rankings based on these factors above.
Let’s Talk
If you’d like to have a conversation about this type of investment, feel free to email me or set up a call with me or just call me if you already have my phone number. I’d love to hear what you think.
For now, be safe and take care of your family.
Mark