Market selection is a critical step in the investing process. Understanding the benefits and drawbacks of investing in growth and stable markets can help in identifying where you want to invest and why.
Growth Market Benefits
Investing in real estate in a growing market generally offers the wind of appreciation at your back, which can often provide a little more room to make mistakes without going under on a purchase.
Potential for Appreciation
In a growing market, property values rise faster than the rest of the country. As demand for real estate increases due to population growth, job opportunities, and other factors, property values often appreciate. Generally, cap rates compress in growth markets as more investors move into the market chasing appreciation.
Rental Income
A growing market usually means an increased demand for space — both residential and commercial. Demand can often rise faster than building supply, leading to higher rental rates and NOI (net operating income), and in turn, leading to a higher property value.
Development Opportunities
In growing markets, there might be opportunities for property development or redevelopment. Buying land or older properties and renovating them can lead to increased property value and potentially higher rental income. The highest and best use of an older property's buildings and lots often haven't yet been recognized. As the infrastructure gets built out in a growth market, it can push appreciation even further.
Growth Market Risks
While investing in real estate in a growing market can offer many benefits, there are also reasons why some investors might choose to avoid it. Here are some potential drawbacks and challenges associated with investing in real estate in a growing market.
Overvaluation
In rapidly growing markets, there's a risk that investors flooding into the market can cause property prices to become overinflated. This can lead to a situation where properties are priced beyond their intrinsic value, making it difficult to achieve reasonable returns on investment. With interest rates higher than cap rates for many commercial asset classes, properties will be cash flow negative if they are traded in many growth markets. Alternatively, development can catch up with demand and eventually surpass it, driving down prices.
Increased Competition
A growing market can attract a flood of investors looking to capitalize on the opportunities. This increased competition can drive up property prices and potentially lead to bidding wars, making it harder to find good deals. Most of the primary markets in the Southeast are competitive in all asset classes. Higher demand also allows sellers to be more choosy, requiring higher down payments and better-capitalized investors.
Unsustainable Growth
Sometimes, growth in a market can be driven by speculative investment rather than genuine demand. This can create a bubble that eventually bursts, leading to a significant drop in property values. Investors need to closely monitor population growth and development to look for signals of growth slowing down.
Stable Market Benefits
Comparing growth to stable markets is often viewed as an appreciation versus cash flow debate. Stable markets allow for more cash flow by offering better entry prices compared to net operating income. Stable markets are also generally associated with lower volatility and reduced risk compared to rapidly growing or declining markets. Potentially, there is less downside risk, but that is debatable.
Cash Flow/Predictable Returns
In a stable market, property values and rental income tend to experience gradual and more predictable growth. This can provide investors with a reliable source of income and potential appreciation over time. Generally, you are able to purchase a lower price to income (higher cap rate) leading to better cash-flowing properties from day one.
Less Competition
Stable markets might have less competition among investors compared to hot markets. Lower competition allows for more sellers to be open to negotiating terms. Seller financing options are now increasingly available in stable markets, which allow for a great return on initial down payments as sellers need to be more open to get a deal done.
Stable Market Risks
Without the push of appreciation, there is a potential for stagnation in a stable market.
Potential for Stagnation
Over time, a stable market might become stagnant or declining if it doesn't experience significant growth or there are demographic changes (e.g., population movement Southeast). This could lead to slow appreciation or even depreciation and increased vacancy as demand slows. This is why most investors avoid markets with declining population growth. If you are going to invest in a borderline or declining market, the deal should leave a lot of room for error (e.g., be highly cash-flowing) or be in a great location in the market.
It is important to remember that the decision to invest or avoid investing in real estate in a stable market depends on your investment goals, risk tolerance, and overall strategy. While stable markets might not offer the same level of excitement as rapidly growing markets, they can still provide a reliable source of income and long-term wealth building. Thorough research, financial planning, and alignment with your investment objectives are key factors in making informed decisions.
Bottom Line: Where Do You Invest?
Investing in growing markets generally means investing in the path of progress. You will eventually get the growth and appreciation of the market, but you can usually find an undervalued or reasonably priced property. The growth and demand slowly push out to your property, and you can often find outsized demand. It's often best to look for a stable submarket in a growth market.
Within a stable market, a growth submarket can usually be found. Follow the development if there are large infrastructure projects or a trendy neighborhood that is seeing outsized appreciation. Seeking out a growth submarket in a stable market is ideal.
Ultimately, the great risk mitigation factor and window to opportunity is market knowledge. Without sufficient knowledge, investors might make uninformed decisions that could lead to suboptimal outcomes. If you need to invest outside your geographic market, focus on one or two target markets as a starting point. In-depth knowledge of a market takes time and research. It is best to focus and develop your expertise.
It is important to recognize that every market is unique, and the decision to invest or avoid investing in a market should be based on a thorough analysis of the specific conditions and risks involved. Conducting due diligence, seeking expert advice, and carefully assessing your risk tolerance are essential steps when considering any real estate investment strategy.
About the Author:
Vijay Prabhakaran is a commercial real estate investor who has invested in small multifamily properties in Chicago over the past decade, which allowed him to replace his take-home pay and shift to non-residential commercial properties. As a Best Ever blog contributor, Vijay aims to share his experience achieving financial independence and his decision to focus on multi-tenant retail and industrial spaces in the Midwest.
Disclaimer:
The views and opinions expressed in this blog post are provided for informational purposes only and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.
