The idea of “screening” in stock market investing is well-known, and has assisted many a diligent investor in finding a selection of equities that meet their strategic criteria and offer best chances for success.
For example, the investors might command the equity-screening algorithm to limit the search to all public companies with a price-earnings ratio under 10, a debt-to-equity ratio of less than 1, but five years of rising profits.
The search results are usually followed by more qualitative, deeper scrutiny. But the initial work has been accomplished by the screening process.
Applying this tactic to US real estate investing, screening metropolitan regions by certain criteria expedites city selection, allowing the investor to hone in on the hunt for profitable real estate investment opportunities.
Here at StarPoint, our major screening criteria for cities which offer the best real estate investment opportunities include:
- The size of a metro area
- Regional population growth and household formation rates
- Job growth / Expansion of the employment base
- Diversity of the regional economy and job base
- Which industries and sectors are growing
- Cost of living and rent levels
1. Metro Size
While investment opportunities abound in every city, towns below a certain size can present greater volatility, including an economic base not sufficiently diversified to protect investors against the departure of one or two local employers, much less an industry downturn.
In addition, in the modern age many smaller towns that are not satellites to major urban centers are suffering from population drift, as young adults continually migrate to the big city for cultural and employment opportunities.
Yet many of America’s largest cities are running into stiffer economic, geographic, regulatory and political barriers to robust growth—and population growth is another variable that needs to be carefully considered.
The “size sweet spot” for American cities is largely “secondary” cities, which are those with populations above 300K but which are the not the traditional gateway markets or fully mature metropolitan areas like Los Angeles, New York or Chicago.
Cities with more than 300K people have the critical mass to attract residents and expand, and indeed many are growing because they have favorable regulatory and tax policies to attract new businesses and residents.
Such growth regions do have to be monitored closely, as city expansion can often stall. As a metropolis becomes larger and more congested, the civic mood alters from growth to modulation. Taxes and regulations creep higher as the cost of city services are no longer covered by the virtue of growth.
In mature, very large or “gateway” cities, development times can become elongated and even uncertain, yet competition for property or development opportunities is intense, driving down the reward-to-risk ratio. Certain kinds of real estate development, such as re-purposing obsolete properties within the extant footprint, may be successful in a mature market.
2. Population growth and household formation
A city without population growth is a risky investment, as evidenced in many Rust Belt real estate markets from Cleveland to Pittsburgh to Detroit, to smaller towns across the Midwest that have been shrinking for generations.
Declining populations in general reveal an unhealthy economic base, or not enough urban amenities to retain residents, despite low housing costs—neither of which bode well for property investing.
Household formation rates are another vital signal when evaluating urban health. If household formation rates stagnate, that usually signals a sluggish economy or overly onerous housing costs. When housing costs get too far above national norms, the prospect of hitting an affordability ceiling becomes real, along with a population base that may seek fortunes elsewhere.
And when populations begin to migrate away from a city, the risk-to-reward ratio of successful property investing tends to steepen.
3. Job growth
Another vital signal of the health any particular urban economy is seen in job and wage growth, as shown in figures released by the Bureau of Labor Statistics.
Interestingly, in recent years medium-sized urban areas not on the coasts have been winning by this criteria, including such cities as Salt Lake City, Denver, Austin and Dallas. In contrast, America’s two mega-cities, Los Angeles and New York, are struggling to add to their job bases, perhaps a yellow flag for investors.
Tracking job growth in the most recent one, three and five-year periods gives investors a feel for the direction of this important indicator.
4. Diversity of Economy, Job Base
A growing job base is a requisite screening criteria, but in addition the diversity of the job base is a key variable. For example, two cities near Los Angeles have growing job bases, Phoenix and Las Vegas. In terms of job growth alone and perhaps housing costs, both look like interesting investment options.
But for all of its successful promotional skills, Las Vegas is something of a one-trick pony—driven largely by the tourism and convention sectors. A decline in either could put the damper on Las Vegas property values, certainly long enough to extend past the date envisioned in the investor’s exit strategy.
Phoenix, in contrast, has been building a diversified job base for generations, including the recent addition of tech-giants such as Taiwan Semiconductor and Lucid Motors setting up shop in the metropolis to access a ready labor force. While any particular company or industry in Phoenix could wobble, the economy of the whole city is likely to sustain growth.
5. Type of Sector Growth
While all job growth is good for an urban area, some industries have better prospects for the long run. A city growing as a healthcare center is well positioned; most likely, the aging U.S. population will require more health services in the future.
Today’s tech industries are also likely to have stamina.
Silicon Valley has been an engine of economic growth since the 1970s. In recent years Northern California has become so expensive that tech industries are seeking other lower-cost and less regulated locations, with certain cities, such as Phoenix and Austin, popping up again and again as emergent tech hubs.
While the future of any industry is not certain, businesses operating in the advanced technology sectors are more likely than mature industries to have many decades of expansion ahead.
6. Cost of Living and Rents
Several federal agencies (including the Census Bureau and Bureau of Labor Statistics) collect and publish information on wages and household incomes, while rents, housing costs and property-values are well-tracked by several private-sector enterprises, including CoStar or Zillow, and many others.
These urban data streams tell tales, most importantly including the cost of living, particularly housing and rents, for regional populations.
Cities that feature high housing costs in comparison to typical household incomes may run into market barriers regarding future rent increases, as well as additional civic initiatives to control rents, both of which could put a damper on property investing.
Cities with high rents relative to incomes present nuanced challenges to property investors. High income earners will usually outperform in wage growth, allowing select property owners to raise rents. However, this demographic is by definition a smaller component of renter households, which means the investor has little room to absorb project head winds.
The cities with the highest rents are fairly well-known, and include New York, Los Angeles, Boston, San Jose and San Diego.
Interestingly, the states of Florida and Louisiana feature some of the highest rents to average household incomes, due in part to relatively lower incomes. In some recent years, residents of New Orleans expended more of their income on rents than even dwellers of Boston or Los Angeles, a possible red flag for investors.
Cities in which residents are not stressed by rent and housing costs as a percentage of their incomes offer better prospects for higher rents, and thus property values, in the future.
Of course, even after finding the select metropolitan regions that score well under the various screens, the actual act of profitably investing in a particular city takes considerable skill, time, and money.
But since StarPoint chooses to invest in secondary cities that exhibit diverse economies, growing populations, and reasonable housing and living costs, we mitigate downside risk and increases the odds of a successful outcome.