Real estate investing is a great way for investors to build a powerful portfolio of passive income. After years of successfully investing in stocks and equities, I took the leap and added real estate rental properties to my portfolio.
My wife and I contemplated the best way to grow our portfolio and diversify away from the stock market. We decided real estate investing would help us meet our goals. We expected doing so would increase the amount of flexibility in our lives and allow us to spend more time with our son, visit family and travel.
There are several schools of thought on stocks vs. real estate. I personally don’t believe there is a right or wrong choice; it depends on your overall investment goals and risk tolerance (just like any other investment).
I won’t get into the pros and cons of stocks versus real estate in this article since we’ve talked about starting in real estate investing and out-of-state investing before. However, I do want to walk through how I found attractive U.S. cities for real estate investing. Note that my focus for real estate is on cash flow (e.g., properties that pay out monthly after deducting expenses).
In comparison, some investors prefer to focus on appreciation (e.g., the rise in property value compared to the purchase price) and are willing to forego the influx of passive income. I prefer the former, but to each their own in the real estate investing world.
I’ve learned a few things looking for my first few properties and deciding to add real estate to my portfolio.
First, live where you want and invest where the numbers make sense. My wife and I live in Seattle, and the rent is too damn high. In all seriousness, if I had unlimited capital and didn’t care about cash flow (which I do), then Seattle would be a great place to invest because Seattle has positive macroeconomic factors in its favor.
Instead, I choose to focus on cities that make more sense financially for me right now. Some people want coastal cities with lots of demand and are willing to pay higher prices for that, but I am not in that bucket (yet).
Second, remember that real estate is a slow burn. There is no “get rich quick” scheme in real estate (even though HGTV may give you this impression). It takes time, effort and patience to do the research that is essential to being a successful real estate investor.
I started my journey after having a baby, so I searched for properties when I wasn’t changing diapers. For those with children, you understand how your time gets sucked away quickly (and those that don’t have kids, enjoy your time!) However, I made it a priority to carve out time to research and perform due diligence since financial freedom is important for me and my family.
4 Real Estate Factors To Consider When Deciding Where to Invest
There are countless factors to consider when going into real estate investing, but these are the four that I focus on when searching for a new city. This is not a comprehensive list of every single thing you should look into. However, these are the factors I start with.
With my search, I start by considering these four macroeconomic factors. Macroeconomic factors refer to large scale trends and characteristics of the area, as opposed to microeconomic factors.
Several publications list macro trends they believe will shape the real estate market in a particular year. The Urban Land Institute is a good source that typically puts out solid research on an annual basis. The four macro factors I start with when considering a metropolitan statistical area (the city and surrounding suburbs) are:
1. Population Trends
Population trends give a sense of what the overall future housing demand may look like for a city. I try to find cities that have shown growth over several years. People move for various reasons, but better job prospects is a primary driver for migration trends.
I look for regions with an increasing population because this tends to mean higher demand and a limited supply for housing, which can translate to higher rents and greater appreciation compared to areas with excess housing and shrinking populations. Look at population growth of both the metropolitan statistical area (MSA) and specific areas within the city. A couple of questions that I ask myself are:
Is the population growing or shrinking?
I look at three to five years trends for population growth to understand the overall picture for a city. There are probably investors who look at a longer period of time, but three to five years makes sense for me. Historically, population growth in the U.S. as a whole has been just under 1% annually, so areas that grow at or above that rate are attractive.
What are the age demographics of population growth?
Are these younger people who are heading into their peak earnings potential? Are they older people who may be closer to retirement and/or living on a fixed income?
2. Economy & Employment
While there are economic indicators that showcase how the country is doing at large (e.g., Gross Domestic Product), different states and cities each have their own smaller economies.
A good place to start your research is Housing and Urban Development, where they have fairly comprehensive overviews of select metro areas. Their reports give great insight into the stability of the region and where it is trending.
Depending on state and city local politics, there may be different growth trajectories you can reference. Some cities like Atlanta and Charlotte have several large employers (e.g., Coca Cola and Home Depot in Atlanta; Bank of America in Charlotte) while others have large city governments or big hospitals. Understanding these companies and their impact on a city can inform you about whether an area is a good place to invest. A few questions I always ask are:
- Who are the major employers and are they from diverse industries or in one sector?
- Are major employers expanding or contracting?
- What is the rate of new business growth in the city?
- How does job growth compare to the national average?
- What is the GDP of a particular city (Gross Metropolitan Product) and is it growing?
3. Salary & Income Trends
Income trends are important because this is where your rent comes from!
If income is growing rapidly, this could mean increasing rents and increased home values as everyone has more to spend. A higher average income can also lead to lower vacancy rates.
Are incomes increasing or shrinking?
What percentage of the population is living below the poverty level?
I use income to gauge a renter’s potential to pay rent at a city level. You won’t know how tenants will fare until you have some, but you can gut check where their salary may fall. However, some articles on this topic suggest a tenant’s monthly salary should be three times the rent so they have adequate cushion to pay the rent.
4. Price-to-Rent Ratios
The price-to-rent ratio measures the relative affordability of renting vs. buying in a given housing market. It is calculated as the ratio of home prices to annual rental rates (e.g., a home worth $200,000 could rent for $2,000 a month; the price-to-rent ratio is1%). The formula to calculate the price-to-rent ratio is:
Average Monthly Rental Price / Average Home Price = Price-to-Rent Ratio
The ratio is a proxy for how much cash flow you can expect from a property. The higher the ratio, the more you will have left over after paying for expenses and the mortgage. For example, the average rent in Seattle is $2,100 and the average price of an equivalent sized unit is ~$550,000. That means the ratio in Seattle is .38%. This may not sound bad at first, but let’s go through the math for a deal like this.
Down Payment (25%)
Repairs, Property Manager, Other Expenses
Do you see why I am not buying a rental property in Seattle!
I can stop there without deducting insurance, taxes and other expenses to see that the numbers just don’t make sense.
Some experts say investors should look for a 2% price-to-rent ratio (i.e. if a house costs$100,000, you should command $2,000 in rent monthly). However, I have found these opportunities extremely hard to find. I’m looking for passive income, so I look for properties I can easily afford and manage. You may be able to find them using active strategies, but that’s not for me.
Instead, I focus on markets with ratios of 1% or higher. I’ve found that 1% makes sense, especially if the purchase price on a property is below $200K (a 1% ratio would be $2K in rent; with a 5% APR mortgage, your payments are $805. You, the investor is left with $1,200 for other expenses).
You can find average rental and home purchase prices in a market by doing a simple Google search. Sites like Zillow, Redfin and Realtor are the ones that will likely have good information. RentCafe is another good resource for rental information.
And After My Research…
There are plenty of cities that fit my criteria outlined above, but I ended up honing in a few to start – Cleveland and Greater Columbus, Ohio, and Boise, Idaho.
I picked Ohio primarily because of the macro factors above AND I also had great luck in setting up a great team on the ground fairly quickly (agent, contractor, lender, property manager). Boise also has favorable macroeconomic factors and is close to Seattle in case I need to get there quickly.
After finding the areas that worked for me and my family, the next steps were putting together a team and buying the properties. Don’t worry, I’ll cover this in my next article.
Have you been thinking about investing outside of your city and trying to figure out the perfect place? Leave us a comment with your questions and connect with the Wealth Noir Community to learn more.
Derrick Deese got started investing when he was 18, buying Starbucks stock. He is still kicking himself for not holding it, but has learned a lot since then. He’s passionate about investing, financial freedom, and photography. He works in marketing and lives with his wife Natalie in Seattle.