How to Identify Emerging Markets
I see a lot of posts on Szikov asking what market is the best to invest in and a lot of people talking about investing in high cash flow markets like Kansas City, St Louis, Cleveland and Memphis to name a few. Before you pick a market based soley on cash flow, look at city and what is going on in that city. Next dig into sub markets and decide if certain sub markets are going to have positives happening. Many people are all to quick to hear that a city is great to invest in, but then fail to understand that does not necessarily mean the city is good, it could be the suburbs or it could be a few neighborhoods within that city.
Want to be sure that you make money in real estate? There are several factors that will bring you success: Buying right, managing right, exiting right are among the top of the list. With buying right and exiting right, one of the critical factors is buying in a market/neighborhood that is not exhausted. Cash flow is king in Multi-family and if you get a good enough deal in any phase of the market you can weather the storm, but why weather the storm when you can ride it?
Study the above graph carefully, get to know it and understand it and it will help you buy right and exit right. When looking at the cycle chart you want to buy in mid-phase 1 and exit near the top of Phase II (but don't wait too long and get stuck). Below I will discuss how to look at and find those markets. Also, be aware that in most large cities you will have a neighborhood that is somewhere within this cycle that you can capitalize on. Please also be aware that some neighborhoods may never see the recovery stage – or at least no time soon, so look out for those areas.
Let’s get down to it! A few years ago I decided my local market was experiencing compressed cap rates and historically high prices(we are over $140,000/unit on average and seeing 7 cap and less in C class), so I started to study markets that had opportunity. What I was looking for was a market that had good cash flow and fundamentals to increase in value. Some markets may have good appreciation, but if you get in at the top of phase II, then when the rents go down, so will you. That took out a lot of major markets - after all I do not buy on appreciation, I buy on cash flow and so should you.
The first step I took was went on to loopnet.com and searched by capitalization rate. I used a 9 cap + to find markets that had multiple listings at or above that mark. The next was to research the most affordable cost of living markets, this further narrowed my list and then I looked at those markets in a quick search to find out population growth and job growth. Once I identified a few dozen potential markets with good cap rate potential, affordability and growth potential, it was time to dig deeper.
How to identify an emerging market: 1. Job creation, 2. Increase in population and future expected growth, 3. Building proposed (permits pulled), 4. Government planning 5. Affordability 6. Absorption rate and vacancy rate. 7. Courage. Let’s take a closer look
1. Job creation is probably the most important factor. If the city you are looking at is not creating jobs, then don’t invest there. Jump on to the internet and type in the cities you identified as potentials and type in keywords with “job growth,” “new companies,” “employment data, “future growth.” You can may also find a metropolitan council, chamber of commerce, etc report. Other good sources are your local real estate brokers or the national brokers such as Marcus and Millichap, CBRE, Colliers, etc. Go on to their web pages to find detailed reports of the market you are interested in. The Bureau of Labor Statistic will have great information as well as your local government branches. A few important factors when looking at job growth is where are those new jobs located (your property should be close) and what types of jobs are coming. If your target city is heavy on manufacturing or one industry, be careful.
2. Increase in population goes along with job growth, but the most important factor is to understand where the increase is happening. Every city has a path of progress and possibly a few paths, but they also have areas of decline. Just because your city has high job growth does not mean that people will want to live in your building. Take Chicago for instance, there is job growth in downtown and the northern suburbs and some south suburbs, but there are large parts of the city that hold limited low paying jobs and have little reason to attract good tenants. The result is declining neighborhoods with declining buildings and value. You can buy a building in those areas that show on paper a 10% cap, but in reality they will result in poor performance and will continue to get worse. Again talk with Real Estate brokers, look on loopnet or Costar demographics search, go to the crime maps, talk with local government to find out their economic plan and redevelopment zones. Lastly, look for areas labeled “Art’s districts." Check out the Census Bureau for statistics on population.
3. Buildings coming to market and permits pulled will need to be examined. Be sure that the city you are targeting can absorb the future supply. Too often late in phase II and early in Phase III we see more units built than people coming into the market. This happened in the early 90’s and again in 2005-2008, so pay close attention. Also pay attention to the trend of the market. Right now we are trending to a renter nation, but pay close attention to see if that shifts back to a home buyer nation. You will want to dig into historical trends on this to see where the city is at with building permits compared to other years.
4. Government planning. What is the city and non-profits doing to bring in business? What types are they targeting? You will want to look at the comprehensive plan and the path of progress. If the government is not trying to attract jobs, then you may want to stay away from that city. Look for cities that are easy to move to and have a good workforce. Also, cities that have economic development areas and are easy to deal with.
5. Affordability is a key factor in picking a market in my mind. This tells me that as a property owner you have room to raise rents. As the economy improves and incomes go up, people will be fine with paying more in rent. This is especially true in cities where rent is low and yet housing in comparison is expensive to buy. You can search online for housing affordability in your markets and also look at the median rent vs the median income. If the median income is more that 66% of the median yearly rent, then you have an affordable rental market. If renters are forced to pay more than 1/3 of their income for rent, then your high rents could be in trouble. Look at that and compare it to the price to buy a house as well and the inventory for houses available.
6. Absorption rate and vacancy rate. First you will want to look at how quickly the new units being brought to market take to become leased up. When a lot of units are sitting vacant that are newly built and large incentives are being offered that is a bad sign. The second part is looking at the vacancy rate in the market and sub market. Look for the historical vacancy rate and the current rate. I would analyze on whichever is worse. The important factor in this is looking for a vacancy rate that is decreasing, meaning people are moving into the buildings vs. moving out. Brokers are a great source for this information along with property managers.
7. Courage. Have the courage to buy in an area or city that fits the 6 criteria above. You may have plenty of naysayers, but that is a good sign. When you follow the herd, you will get hurt, but when you do the opposite that is when you can make a fortune. In 2008-2011 everyone was running from real estate and I was running to it. I was able to buy a lot of amazing deals. Take the right steps in the process and don’t wait. I personally identified several emerging markets 2-3 years ago and hesitated. These markets are still good today, but they have already climbed considerably. Had I taken the action 2 years ago I would have been miles ahead.
Look for my next blog, where I identify the top emerging markets in the US and why.
To your success!