Investment Location Considerations
In the last few blog entries we've been discussing some of the more common questions we hear. In this article I will talk about how I would select an investment location.
Before you start considering a location it is important to define what you are looking for. I believe that every property/location must meet three criteria:
- Sustained profitability - The property must generate a positive cash flow today and into the foreseeable future.
- Likely to appreciate over time - You would never buy a property just for appreciation but appreciation is very desirable. Especially when using a 1031 to reinvest equity or adapting to market changes.
- Located in an area where you can make money and risks are low. Key factors include state income tax, property tax, insurance cost and landlord favorable regulations. Regulations include property related laws like the time and cost of evictions, rent control, code compliance requirements, etc. For example, evictions almost always take less than 30 days and cost less than $500 in Las Vegas. In other locations, it can take up to one year. I view eviction problems like I view cancer. If it happens to someone else, it's a statistic. If it happens to you, it is a disaster.
Basic Location Requirements
Here are three basic location requirements.
- Locations with a population of at least 1 million. Wikipedia - List of Metropolitan Statistical Areas You want a stable economic environment; small towns may be too dependent on a single company or commodity.
- Choose a location you would like to visit because (check with your accountant) trips to check on your properties may be tax deductible. For example, my clients trips to Las Vegas to check on their investment properties are (partially) tax deductible.
- Locations with property prices you can reasonably afford. For example, if your maximum is $150,000, it would be a waste of time to consider properties in San Francisco. Trulia - National Home Prices
Three factors that directly impact profitability:
- State income taxes - Bankrate
- Property taxes - Tax Foundation
- Insurance Insurance by State - Note: I was unable to find a single site that compared landlord insurance cost by state so I used homeowner's insurance with is reasonable for comparison purposes. Landlord insurance is typically 10% to 20% more than home owner's insurance.
To see the effect of just property tax and insurance on ROI for an identical property in three different locations, see the article titled "Comparing Properties in Different Locations". Below is a summary from the referenced article showing the impact of property tax and insurance on profitability.
Longer Term Profitability Factors
Too often new investors only consider the location as it is today. If you only look at the current return, you could be purchasing a future financial nightmare. For more information on buying properties in locations that are transitioning down, see the article titled, "Investing in Declining Markets".
Investing, like everything else, involves risk. Some risks can be avoided and others can be minimized by careful research before you buy. The only way to avoid some risks is to not buy in that location. The most common business risk is eviction. For example, in California an eviction can take one year and cost thousands. In Las Vegas, evictions require 28 days and usually cost less than $500. If you own a property in California and the tenant stops paying you could be out thousands of dollars in eviction costs, lose a years rent and still have to pay the mortgage and other related costs. I could not afford this risk and I doubt that many can. However, just because you own investment real estate in California does not necessarily mean it will happen to you. You might own 50 properties in California and never have to evict anyone. It is sort of like cancer. The odds of you getting cancer are relatively small. But if you do get cancer it is devastating and "odds" mean nothing.
Population stability is critical. Only buy properties in a location where the population is stable or is growing at a sustainable rate. (Do not buy in boom towns, they tend to go down as fast as they go up.) Why is population stability so important? If people are moving out of an area, housing prices and rental rates are likely to fall due to decreasing demand. If people are moving into an area, housing prices and rental rates are likely to rise due to increasing demand.
However, you cannot simply look at metro area numbers and feel you have the entire picture. In every large city there are good locations, bad locations and most that are in-between. There may be good deals in any of these locations but you need to know the type of area in which you are buying and the return must be consistent with the location risk. Below are data sources for population trends:
- US Census Data - The most information but not the easiest to access.
- City Data - My favorite source of city data
- Governing.com - Population changes by county
- zipWho.com - Zip code level data
Job Quantity and Quality
In many parts of the US, manufacturing and similar jobs are going away and what remains are service sector jobs. Service sector jobs tend to pay less than manufacturing jobs so the families of these workers have less disposable income. Less disposable income means that they cannot afford to pay the level of rent they did in the past. A key indicator is inflation adjusted per capita income for the location over the past few years. If you see a declining per capita income adjusted for inflation, you need to carefully consider the long term value of the property. If you buy a property in such an area you will likely have increasing time-to-rent, declining rental rates and declining asset value over time.
The best source of inflation adjusted income I could find is melissadata.com. Look at the second data row titled: "Inflation Adjusted AGI".
In every major city there are areas which were once the best and over time become distressed areas. The major cause of such a change is urban sprawl. People want newer floor plans, newer homes, less crime, better schools, etc. If they have the income, they will move to such areas. As people with money move out of an area those left behind will, on average, have lower incomes. Property prices will then start to fall because the remaining residents have less disposable income. As property prices fall, property tax revenues will fall. City services are largely dependent on property tax and sales tax revenues. As revenues fall, cities have no choice but to cut services. This starts a downward trend from which few locations have ever recovered. There are exceptions but not many.
Below is a diagram showing what can happen to rental income over time due to urban sprawl. The colors represent monthly rent. Green represents a high rent and red represents a low rent. The diagram is overly simplistic but I hope it conveys the risk urban sprawl represents.
Not every city is subject to urban sprawl. For example, San Francisco is almost completely surrounded by water and what land there is has already been completely developed. (In 1912 San Francisco even passed an ordinance evicting all existing cemeteries from city limits due to the shortage of land). Another example is Las Vegas, which is completely surrounded by federal land and has very limited ability to expand. Landlocked cities have little urban sprawl risk. For more information on landlocked Las Vegas, see my profile page and click the link titled, "Is Las Vegas for You?"
I've read several articles on urban sprawl but none offered a concise way to detect it. Below are some of the better articles:
- An Economic Perspective On Urban Sprawl
- Wikipedia - Urban sprawl
- Urban Sprawl, Land Values and the Density of Development
- Smart Growth America
Unfortunately, the best way I know to assess urban sprawl potential is to look at a map and see if there are physical, political or other barriers to metro expansion. If there is no such limitation, there will be urban sprawl. Be very careful buying properties were urban sprawl potential is high.
Maintenance costs have a major impact on profitability. Here are some generalizations about locations and ongoing maintenance costs:
- Older properties require more maintenance than newer properties.
- Properties in climates with hard freezes require more maintenance than properties in milder climates.
- Properties in locations with a lot of moisture require more maintenance than properties in dryer climates.
Stable or increasing property values and rents rarely occur in areas with high or increasing crime rates. When crime increases, people with sufficient income move to areas with lower crime. The people who cannot afford to move tend to have lower incomes thus resulting in falling rents and property values. What you need to consider is the types and frequency of crimes in the area and how it is changing over time. There are multiple online crime databases you can check.
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