How To Invest In Real Estate When The Bubble Deflates
Amid mounting evidence that the rapid rise in home prices is over, investors in rental property will have more options over the next few years as sellers outnumber buyers and prices deflate – slowly in most markets but very rapidly in others.
As has ALWAYS happened in the past, home prices and rents will eventually re-align with local income. This readjustment may take years but investors don’t need to wait that long to spot good opportunities.
In all real estate markets some local areas do better than others, on the downside as well as in boom times. Investors can spot the differences using solid local data.
Local data can tell you if there will be strong or weak demand for housing, in what rent range you find the heart of the rental market, and what type of investment will fare best in the local housing mix. Then investors can decide if an available property is a good fit for the local conditions.
For example, Charleston, South Carolina has been a strong real estate market for years, only a few places like Austin and Boise have grown faster. But some areas within the Charleston market will do better than others in the next few years.
Let’s look first at the growth of local income, by which I mean total income, not just the average. This tells you how strong demand will be for housing: whether people and money are flowing into an area or not.
In the table, look at Ladson (zip code 29456). Over the last three years total income grew 45 percent. In Summerville (zip code 29485, right next door), income grew just 14 percent; and in Hollywood (zip code 29449, west of the city) total income actually decreased 4 percent.
It sure looks like Ladson is the better bet for rents and home prices in the future. As prices soften, Ladson will provide better opportunities than the other two. That doesn’t mean you shouldn’t invest in Summerville or Hollywood, just that in those places you have to drive a harder bargain because you can’t count on strong future demand.
The next step in evaluating a property is to identify the heart of the local rental market – the range of monthly rents where you currently find the most renters. This is very important because if the property rent is much higher than this range, you’ll have difficulty finding a tenant, maybe not right now but in two years when the average tenant moves out. That’s when you might sit with an empty property or need to cut the rent.
Let’s look at Ladson again in our table. In 2021, the bulk of renters paid between $1,007 and $1,524 monthly rent; add about five percent to bring that up to 2022 dollars. A property with rents in this range will easily attract tenants, but if you plan to charge $2,000 there will be far fewer people who can afford it.
The last step is to find what type of investment is easiest. The ratio of the average home price to the average annual rent can tell you because it’s a measure of how expensive homes are compared to rents. Typically it’s around 18. A straight single-family rental is easiest when the ratio is between 15 and 22. Above 22 most homes are too expensive to rent out, so apartments or subdividing a house into renter units is easier. Below 15 homes are cheap relative to rents, so buying one and upgrading to a higher rent is a good opportunity.
In Ladson, the average home price in 2021 was $216,000, while the average monthly rent was $1,271. The average annual rent therefore was $15,252 and the ratio of home price to annual rent is 14. This low ratio means that pretty much any type of investment is fairly easy here, straight single-family rental, apartments, or upgrading.
In Hollywood, on the other hand, where there are far fewer renters, the ratio is a high 28. Here you’ll have a difficult time with a single-family rental, apartments are an easier investment.
None of these are hard and fast rules, they are guidelines. They let you see the forces that drive the local market. They rely on hard data, not wishful thinking. A good investment opportunity could go completely counter to what they suggest, but if it does, you probably should find out why.
How to Get the Data
It’s a bit tricky the first time but worth your patience.
Local income data is available through the Census.
There are filters on the left side of the page. For Geography, pick Zip Code Tabulation Area and choose the zip code you want. For Topics, pick Income and Poverty, then Income and Earnings, then Income. For Years, pick 2020. Then click the Search button lower right.
You’ll see a list of tables. Click on S1902 Mean Income in the past 12 Months. The table shows how many households there are and the ‘mean’ (average) income per household. Multiply one by the other to get the Total Income.
Repeat this for 2017, then calculate the increase. That’s step one of the strategic analysis, and the most important one.
For the rent range, again go to the Census site and and choose the zip code. For Topics now pick Housing, then Financial Characteristics, then Renter Costs. Choose 2020 for the Year, then Search as before.
You want table B25063 Gross Rent. It shows how many current renters pay how much monthly rent. For zip code 29456 the heart of the renter market is probably from $900 to $1500 (note that the reporting intervals aren’t all the same size). Update this range to 2022 for inflation.
To calculate the price-to rent ratio, go to the Census site and choose the zip code. For Topics pick Housing, Financial Characteristics and check both Housing Value and Renter Costs. Choose 2020 for the Year, then Search.
You get table DP04 Selected Housing Characteristics. Scroll down to get the median value of owner-occupied units ($182,600), then the median gross rent ($1,199, monthly). In this case the ratio of home value to annual gross rent is 13. Updating the values to 2022 gives a ratio of 14, not much different.
Alternatively, Local Market Monitor provided the data in this article for Charleston, SC and publishes over 200 reports with these calculations already done for you.
Softening markets are a time of opportunity. You’re looking for an investment that will retain its value and produce a good income year after year, well into the future. If you take the time to analyze the desirability of a local area, the most appropriate rent, and the most suitable type of rental for the local housing structure, you’ve got the best chance for a solid long-term investment.