Coast to coast, the real estate market is booming. Anecdotally, it’s easy to point to places like San Francisco or New York City and talk about how strong the market is because of how high rents are. But what does this mean for a real estate investor? For instance, does NYC really present a better investment opportunity than somewhere like, for example, Louisville, KY?
At the outset, it seems like a silly comparison. NYC and Louisville are so different, and in so many different ways! Yet we’re able to compare the strength of each city’s rental market by looking at a number of key indicators, including: vacancy rate, property appreciation average, capitalization rate, rent variance, and average days on market.
In fact, that’s the approach All Property Management took for its 2015 Rental Ranking Report. The report used those measures (and others) to evaluate the attractiveness of the real estate investment in 75 major U.S. metropolitan areas, over all four quarters of 2015 and with a preview of market trends in Q1 of 2016.
This is the beginning of a four part series in which we take a deeper dive into the report’s findings and try to understand what’s causing the trends we’re seeing. More importantly, we’ll look at what these trends mean for property owners and managers, and how they could impact your multifamily portfolio.
Part 1: West Coast is the best coast (for investor ROI)
Having been born and raised on the East Coast, it pains me to say this—but the West Coast is blowing the rest of the country out of the water in terms of the strength of its rental markets. A staggering 7 out of 10 of the top performing metros (based on ROI) are those located on the West Coast: San Francisco (#1), San Jose (#2), Seattle (#3), San Diego (#5), Los Angeles (#6), Denver (#7) and Portland (#8).
The report’s authors note that the results are, by and large, consistent with the findings in the 2014 Rental Ranking Report whereby large West Coast cities also dominated the top 10.
So, what gives?
It would be easy to credit the California sunshine for why so many West Coast markets perform so well, but that wouldn’t explain why Seattle and Portland make the cut. Instead, we have to look at three key factors: property appreciation, vacancy rates and job growth.
Homeowners and experienced real estate investors alike often make the mistake of focusing too narrowly on the functionality and style of a proposed purchase, expecting that if the home is modern and functions well it will automatically translate into higher value. But as the old adage goes, “location, location, location” is the number one thing that will influence a property’s value.
Case-and-point: in 2015, the average San Francisco residential property appreciated by 7.34%—a rate higher than any of the other top 10 metros. During Q1 2015, the city’s property appreciation average was a staggering 11.15% before tapering in Q4.
The rapid appreciation can be attributed to the fact that the Bay Area population continues to grow. Demand is high but supply is low in this land-constrained city. Finding space for new construction is challenging, and the process is even more complicated by the city’s notoriously slow permitting process. We’ve heard countless stories of investors shelling out millions of dollars for a fixer-upper home, only to tear it down and start from scratch. In San Francisco, like many West Coast markets, the value of the land can sometimes outweigh the value of the home itself!
Although San Francisco proved to be 2015’s leader for property appreciation, the other leading West Coast cities weren’t far behind.
In a “healthy” rental market, one in which renters in all income brackets are able to find housing at a reasonable price, vacancy rates tend to hover somewhere between 6% and 7%. Rents will continue to rise with these market conditions, but typically no faster than normal inflation.
The vacancy rate is the critical index of what will happen to rent and prices.
Not surprisingly, the vacancy rates in all but one of the top West Coast cities had an average vacancy rate of less than 4% in 2015. Denver fared slightly better, coming in at 4.83%. San Diego (3.43%), Los Angeles (3.28%) and Portland (3.43%) had the lowest vacancy rates. This puts a heavy burden on renters and prospective homeowners, but it’s a boon for landlords and investors looking to maximize their ROI.
“The vacancy rate is the critical index of what will happen to rent and prices,” explains Barry Bluestone, a professor of political economy at Northeastern University. “Landlords can raise their rents in a market where you have extremely low vacancy rates, and that’s what we’ve seen happen.”
Low vacancy rates have made Portland a particularly attractive market for investors: the city experienced the largest rent variance of any top 10 metro, with rents increasing 10% on average between 2014 and 2015. San Jose and Seattle were close behind, with rents increasing and average of 9% during the same period.
The overall health of the economy (as measured by BDP, employment data, manufacturing activity, the prices of goods, etc.) can have a major influence on the real estate market. Generally speaking, the U.S. economy is doing remarkably well compared to the downturn that lasted from 2008 to 2012, or so. But in certain markets, the economy is going gangbusters. And those markets tend to be concentrated on the West Coast.
All seven of West Coast cities to make the Rental Ranking Report’s top 10 list experienced double-digit job growth in 2015: San Francisco (14.11%), San Jose (19.11%), Seattle (13.41%), San Diego (12.20%), Los Angeles (10.16%), Denver (12.98%) and Portland (12.68%).
San Jose is the clear standout, with job growth fueled by the strength of Silicon Valley’s tech sector. The economic benefits are spilling over into nearby markets, most notably Seattle and Portland, which have begun cultivating their own bustling tech hubs. Meanwhile, Los Angeles and San Diego continue to attract well-educated entrepreneurs who are willing to pay a premium in these multi-cultural gateway cities given their access to Pacific and Latin American trade areas.
Now, before investors hop on the next flight to California to scoop up property, there are two other things to consider:
First, not all West Coast cities are performing well. Indeed, some of California’s metro suburbs are showing real volatility, particularly in Oxnard, Riverside and Sacramento. The dip in these markets dragged down the performance of the West Coast as a whole in Q3 2015, but the strength of the top performing cities slowed the downward slide by Q4 2015.
Second, the capitalization rates for West Coast properties (even those in the hottest markets) are among the lowest in the country. Both Los Angeles (#74) and San Jose (#73) landed in the bottom of the rankings, with average cap rates of just 3.72% and 4.06%, respectively. In Q1 2016, San Francisco joined the “Worst 5” list with the average cap rate a meager 3.60%.
The primary takeaway: investors who already own property in West Coast cities are likely doing very, very well given current market conditions. But those who are looking to enter these metros may face an uphill battle given the low inventory and steep prices, and returns may initially be low. That said, the economic indicators suggest that the West Coast provides a safe, long-term investment opportunity for those who are willing to take what are perhaps smaller but more stable returns over time.
Stay tuned for Part II of this Rental Ranking Report blog series, in which we’ll make a case for investing in Louisville, KY real estate. Louisville?! Yep. Louisville. You won’t want to miss this one!Read more on Real Estate Markets