How To Select A Good Investment Location

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The goal of most real estate investors is a passive income stream that will enable them to step off the treadmill of working to pay bills and have a chance to do things they want, not just what is necessary to pay bills. However, getting off the treadmill requires a dependable passive income. So we are on the same page, a dependable passive income must meet three requirements.

• Reliable - You must continuously receive income with minimal interruptions in good and bad economic times.
• Inflation Adapting - Your rental income increases faster than inflation, so you have the additional dollars you need to maintain the same lifestyle.
• Persistent – The income continues for a long time; you and your spouse will not outlive the income.

A dependable income stream is dependent on getting three components right:

• Location
• Tenant pool
• Property

Below are the process steps in order of importance. Each step in the process is dependent upon getting the prior step correct. For example, you must select a tenant pool segment before knowing what properties to buy.

In the remainder of this post, I will only discuss location selection.

Below are the criteria by which I would evaluate potential locations based on dependable passive income characteristics.

• Inflation Protection - Inflation continuously erodes the buying power of dollars. Your buying power will decline if your rental income increases below inflation. The best indicator for inflation protection is pre-Covid appreciation rates. Why pre-Covid? Covid distorted many markets. Locations that have not seen rent or price growth in years started performing. Such increases were transitory, and prices in many locations are reverting to pre-COVID conditions.
• Jobs - Rental properties are no better than the jobs around it. There are two components of jobs. One is the quantity, and the other is the quality. Quantity is the number of jobs, and quality includes how much these jobs pay. Also, it is not just the jobs your tenants have today. Companies have an average life of about ten years. Even S&P 500 corporations only have an average life of 18 years. So every job your tenant pool currently has will disappear in the next 10 to 20 years. Unless the location has new employers setting up operations and creating new replacement jobs that pay similar wages and require similar skills, the area will decline, and so will rents. One metric for determining the economic health of a metro area is inflation-adjusted median household income.
• Population - Prices and rents are driven by demand. Where there is little demand, real estate prices are low. Insufficient demand will not increase prices and rents at or above the current inflation rate. A good indicator of rising demand is population growth. Only invest in locations where both the state and location population are increasing.
• Operating Costs - It does not matter how much rental income you gross. What matters is how much you net after deducting all operating expenses. There are two types of operating costs; direct costs and indirect costs. Direct costs include insurance and taxes. Do not buy in any location with high insurance and property taxes. Your cash flow must be much higher in these locations to offset the high insurance and property taxes. Check this site to compare state property tax rates), and this site for state homeowners insurance comparison. Indirect costs can be even more expensive than direct costs. These include rental restrictions, the cost and time to remove non-performing tenants, and many others.
• Natural Disaster Risk - I am always surprised that people ignore natural disaster risks. At least once a month, a tornado, flood, or hurricane destroy a community. People seem not to be concerned because they have insurance. The problem is not rebuilding your property. The problem is that the tornado (or other natural disasters) destroys the entire community, including employers, city services, retail, and everything. Your tenant will not wait for 1 to 2 years for your property to be rebuilt. People and jobs will relocate to areas where they can work or make money today. It could be many years or never before the location recovers. And, during all these years, your mortgage, taxes, and insurance costs continue, even though your property is vacant. No one can afford this. I view the probability of a natural disaster like I view cancer. If you read about cancer in the newspaper, that's a statistic. If you have cancer, it's life-changing at best, and statistics do not matter. Do not take this risk.
• Crime - Crime is far more prevalent in some locations than others. Employers considering locations for expansion will not choose locations perceived as high crime. Neighborhood Scouts’ top 100 most dangerous US cities list is the best source of high crime cities to avoid.
• Economic Stability - I recommend only considering locations with a metro population greater than 1 million. Smaller cities tend to be less able to weather economic turbulence. Also, when employers consider new operation locations, they want easy access, which means a good airport. Large airports only occur in larger cities.

A couple of additional thoughts:

• ROI and similar metrics are only a snapshot in time. They predict how the property will likely perform under ideal conditions on day one. Such metrics do not indicate how the property and location will likely perform over the long term. What is likely to happen over the next 10 years is far more important than what is likely to happen on day one.
• Low-cost locations are very tempting. However, prices are driven by demand, and prices and rents only increase in high-demand locations, with higher prices than in low-demand locations. You cannot afford to buy in a location where pre-COVID price and rent growth were less than the current inflation rate.

Summary

As long as you buy in a location where rents and prices increase faster than the inflation rate, appreciation and rent increases will correct all but the worst mistakes. However, if you buy in a location where prices and rents increase below the inflation rate, you can do nothing to reverse the situation.

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