Methodology:
When discussing "real estate investors," there are three main categories; each has a different time horizon and source of profiting off of his or her investment:
Traditional investor:
Interested in a long-term investment in property from which rental income can be generated. Typically expects modest value appreciation and instead is looking to generate regular positive cash flow.
Rapid appreciation flipper:
Plans to hold a property for a short period of time and to profit from rapid market movement. This class of investing became a cottage industry during the boom but is effectively dead today.
Foreclosure flipper:
Seeks out distressed properties and plans to profit from a quick resale after doing some generally cosmetic improvements to the property. In fact, investors buying foreclosures at a public auction might need to make only modest improvements (to) the property.
As such, investors are essentially serving as a conduit of a property in uncertain condition and with unknown liabilities to a more traditional buyer (and they extract profit from this service of converting a risky property into a more known quantity for the mass market).
These investors are quite numerous in the current housing recession but are much less numerous during more normal market conditions.
Looking at the list of investor types, Zillow approached this question from the perspective of a traditional investor, who is looking for opportunities in real estate and sees the depressed market as a good time to buy.
Our point of view shaped the parameters we chose to evaluate to make our list of "10 Hot Markets for Real Estate Investors."
We collected data on 95 cities, and ranked them in each category. Each category was then weighted to determine a composite score. We considered four categories to measure how attractive a market is to this type of investor:
- Price-to-income ratio;
- Foreclosures;
- Price-to-rent ratio;
- Price appreciation;
Each market's current price-to-income ratio was compared to its historic average. The period from 1985 to 2000 is used as the "historical average" -- this avoids the run-up in prices in the last decade and we assume that a 15-year sample gives a good picture of the local market. This is a rough measure of how much of their income homeowners spend to own a home in that city. Places that are more desirable to live or have a very limited supply of housing (such as Honolulu or San Francisco) have higher price-to-income ratios.
We're assuming mean reversion — that the historical average we observed from 1985-2000 is the equilibrium ratio for that city and that the price-to-income ratio for that city should return to that level. If a city's 2010 ratio is lower than its historic ratio, we consider real estate in that city to be currently priced at a discount, so it's an attractive time to buy. If a city's 2010 price-to-income ratio is higher than the historic average, then property there may be overpriced right now, assuming there were no shocks to the system (like, say, an explosion of oceanfront property in Oklahoma City).
Foreclosures:
Our foreclosure analysis was broken up into four subcategories:
1. Foreclosure frequency (current monthly number of foreclosure liquidations as a percentage of overall housing units).
2. Quarter-over-quarter change in foreclosure frequency.
3. Year-over-year change in foreclosure frequency.
4. Foreclosure resales (the monthly number of foreclosure resales as a percentage of total monthly sales).
While a high number of foreclosed properties might suggest that there are great deals to be had in a given city, it also means that real estate in that city might see more drops in price as those foreclosed properties make their way to the market. We balanced this by favoring cities that have low foreclosure rates and are improving, but also giving good marks to cities where foreclosure resales are a big part of the market.
Our idealized market for foreclosures would have an ample supply of foreclosed properties right now, but one that sees the pipeline drying up. This would suggest that there are investment opportunities right now, but that the overall market is picking up. Additionally, a city with a high foreclosure rate has a built-in population of new renters.
Price-to-rent ratio:
The price-to-rent ratio compares the rent for a property with the estimated purchase price of the same property. A lower ratio means that the difference between annualized rental and purchase costs is small and that buying a home (vs. renting) becomes a more attractive financial decision. Usually, this means that either purchase prices will rise or rents will fall in the near term.
This can be a double-edged sword for an investor, as a currently low price-to-rent ratio suggests that purchase prices are attractive right now but could also signal that rents might fall (but they could be high now relative to purchase prices so the property might generate income quickly).
A drop in rents could affect the rental income that an investor receives, but a jump in housing prices could lead to more appreciation.
Home-value appreciation:
Home-value appreciation measures the quarter-over-quarter and year-over-year change in the Zillow Home Value Index (ZHVI) for each city. If the median home value in a city is increasing, that suggests that the real estate market in that city is relatively strong.
It's more attractive for a prospective investor to buy in a city where the market feels stable and will continue to appreciate.
Quarter-over-quarter (data) was weighted twice as much as year-over-year to prioritize recent activity and momentum. Because so many markets are still declining, ones that have only modest declines in the past year are more attractive than ones with bigger drops because there's lower volatility.
More Notes:
The analysis also considered InvestorScores from investment analytics firm SmartZip. InvestorScores are risk-adjusted financial assessments generated for individual properties that are based on projected cash flow and annual investment yield over 10 years.
On a scale of 1 to 100, properties that score above 50 are expected to outperform the market while those that score below 50 are expected to underperform. The analysis considered only those markets with scores of 50 or above.
After the final 10 markets were chosen, they were ranked according to InvestorScore. Where InvestorScore was the same, the markets were ranked by projected return on investment, another metric created by SmartZip.
Projected ROI is the percentage of money expected to be gained or lost by owning a property in this market relative to the amount of money invested. In its ROI calculation, SmartZip considers total first-year investment (down payment and closing costs), annual net cash flow, 10-year estimated appreciated value of the property, and closing costs associated with the eventual sale of the property.
The 10 markets are (in this case, US Market), in order: Indianapolis-Carmel, Ind.; Winchester, Va.-W.Va.; Gainesville, Fla.; Tucson, Ariz.; Tallahassee, Fla.; Hagerstown-Martinsburg, Md.-W.Va.; Salt Lake City; Richmond, Va.; Gainesville, Ga.; and Winston-Salem, N.C.
Seven out of the 10 markets are in the South, two are in the West, and one is in the Midwest. None of the markets are in the Northeast.
The results of the analysis mirror two major economic trends: population growth and improving employment. In the past decade, the South has seen the biggest jump in population, up 14.3 percent to about 114 million people, according to the U.S. Census Bureau. The nation's second most populated region, the West, saw its population jump 13.8 percent to nearly 72 million.
The Midwest and the Northeast registered much smaller population increases — up 3.9 percent and 3.2 percent to about 67 million and 55 million, respectively. Those smaller growth rates eliminated many of the markets in those regions from consideration in this report.
Nationally, unemployment stood at 9.2 percent (not seasonally adjusted) in March. The Midwest and the Northeast had the lowest unemployment rates among the four regions: 8.7 and 8.3 percent, respectively. The South was not far behind, however, at a rate of 8.9 percent.
The West was the only region to see an unemployment rate higher than the national rate: 10.9 percent. The two markets on the list from this region — Tucson and Salt Lake City — had considerably lower unemployment rates compared to major metro areas nearby, such as Phoenix and Las Vegas.
Four of the chosen markets are state capitals (Indianapolis, Tallahassee, Richmond, and Salt Lake City) and at least three others benefit from proximity to either a state capital (Gainesville, Ga., to Atlanta) or the national capital (Winchester and Hagerstown-Martinsburg).
Riding the rental upswing
Despite recent job growth, unemployment is still high across the country and foreclosures continue to plague many markets, turning many former homeowners into renters. Affordability has hit a record high, with home prices continuing to fall in many markets, leaving some buyers skittish and waiting for the proverbial market bottom. Those who do attempt to buy a home may find their desires thwarted by higher credit standards and down payment requirements.
In such an environment, investors, especially those with ready cash, see a chance to put their money in an asset with income potential for years to come.
"Everyone has to have a place to live. Because people are not able to afford their mortgages and are selling — usually short sale — or just walking away, the rental market is strong," said Betty Armbrust, broker-owner at Southridge Realty Co. in Denver.
"As an investor in a lowering price market, I look for deals with either a fix-and-flip or rental (potential). I know that if a property won't sell, it will rent."
A recent report from property search site HotPads found that rental listing prices on the site climbed 7.4 percent between April 2010 and April 2011, while for-sale listing prices dropped 8.8 percent.
"We predict investors looking to ride the rental upswing will continue renting properties and will wait for home values to appreciate," the report said.
"Increasing demand for rental properties is an indicator of a growing preference for low-risk housing options, which is closely linked to the broader economic uncertainty."
A rise in rental interest among consumers has also manifested itself in real estate search traffic. Visits to sites that specialize in home and apartment rentals climbed 33 percent in February compared to February 2010, according to Web metrics firm Hitwise.
Investors accounted for an average of 21 percent of transactions in first-quarter 2011, about the same share as in first-quarter 2009, according to NAR survey data. Cash buyers made up an average 33 percent of transactions in first-quarter 2011 — the highest share of any quarter since NAR began keeping track in fourth-quarter 2008. NAR's data does not separate out investors from cash buyers, though the association does say that most cash buyers are investors.
By contrast, first-time homebuyers have accounted for an average 32 percent of purchases for the past two quarters, which is the lowest share since fourth-quarter 2008.
In March, total distressed property sales, including foreclosures and short sales, trended upward to 40 percent of total sales, NAR said. Investors snapped up 54 percent of those distressed sales, according to economic research firm Capital Economics.
"Investors, looking for diversification and an inflation hedge, are looking at deeply discounted homes to generate rental income. The median price of an investor-purchased home in 2010 was cheap — at $94,000," said Lawrence Yun, NAR's chief economist, in the survey report.
"One thing that was lacking for the second-home market in the past two years was mortgages to buy … non-primary-occupant homes — because government-backed mortgages are not there for these properties. An eye-popping 59 percent of investor home purchases were made with cash in 2010."
Only 39 percent of investors used a mortgage to finance their purchase in 2010, compared with 80 percent of primary-home buyers, according to NAR's 2011 Investment and Vacation Home Buyers Survey.
Buyers of investment properties had higher median household incomes than buyers of primary residences — $87,600 compared with $69,600, the survey said. Investors also tended to be older than buyers of primary residences — 45 compared with 37.
Like buyers of primary homes, investors favored purchases in suburbs or subdivisions — 33 percent bought in that type of location. A quarter of investors chose to buy in small towns, compared with 16 percent of primary-home buyers. Both types of buyers bought rural and urban properties at the same rates in 2010 — 17 and 18 percent, respectively.
Also similar to primary-home buyers, investors favored the South (32 percent) and the West (24 percent). Investors lived a median 19 miles from the home they purchased in 2010.
"Having chased 'markets,' the thing I now value most is proximity," said Sean O'Toole, a real estate investor and founder of ForeclosureRadar.
"I truly believe that a good investor should be able to find value in any market, so we believe investors are better off focusing on the market(s) they know, and properties they can easily and regularly visit." Most investors (63 percent) bought detached, single-family homes, followed by condos or duplexes, in buildings with two to four units (16 percent).
The biggest proportion of investors bought their property through a real estate agent (44 percent), while 20 percent bought directly from an owner they knew, and 17 percent bought through a foreclosure or trustee sale. "To rent to others" was the most popular reason to buy among investors, according to the survey. The second most popular reason cited was "to diversify investments/good investment opportunity."
The median length of time investors planned to own their purchase was 10 years. More than half of investor buyers (52 percent) said it was at least "somewhat likely" that they would buy another vacation or investment property in the next two years.
Investors tended to be more confident about the housing market than primary homebuyers: 77 percent of investors said "now is a good time to purchase real estate," compared with 68 percent of primary-home buyers. "Historically speaking, whenever economics favored buying rather than renting, or … were about even, people favored buying because of the perceived benefits of homeownership," said Rick Sharga, senior vice president of foreclosure data site RealtyTrac.
But now a "psychological hangover" is preventing potential buyers from entering the market, Sharga said. "Nobody wants to wind up on our foreclosure list."
Source: Zillow.
