Selecting An Investment Location Part I - Appreciation Barometer

4 min read

There are thousands of places where you could choose to buy real estate. So, which one should you choose? It is not practical to do a detailed evaluation of each possible location because there simply is not enough time. Fortunately, there are a few filters you can use to quickly narrow the field. In this article I will focus on appreciation. I will talk about other filters in follow on articles.

I always start a search by determining a gross metric that is a good indicator of the overall condition of the market or system. For example, the first things doctors do to evaluate a patient is to check temperature and blood pressure. If both of these metrics are acceptable, chances are that the person is not seriously ill.

Appreciation is such a barometer for investment locations.

Why Is Appreciation a Good Barometer?

Property prices are a direct reflection of the demand and supply in an area. When there is an imbalance in supply vs demand, prices will either increase or decrease until supply matches demand. For example, if more people are willing and able to buy than there are available properties, prices will rise until the number of willing and able buyers equals the inventory. This is a reason why a 1,500SF property in Palo Alto, CA is worth $2,000,000 but if you moved that home to another market it might not even fetch $100,000. When demand increases, prices rise. If inventory equals demand, prices remain flat. If there is more inventory than buyers, prices fall. The same is true with rents.

Consistent property price appreciation indicates consistent demand growth for that location, a critical element to sustained profitability.

There are good studies showing a correlation between property prices and rents. Depending on the location, rents lag property prices by 2 to 10 years. What this means is that the trend you are seeing in property prices today is likely what will happen to rent in the future.

How Much Appreciation?

Appreciation is primary driven by two factors, increasing demand and inflation. I already talked briefly about demand so I will talk about inflation. Inflation is a term we all experience but may not fully understand. There are many technical articles on monetary supply and such but that is hard for me to really grasp. So, I offer you my non-technical explanation based on the impact of inflation, not the cause.

You have no doubt noticed that prices keep rising. Another way of viewing this is that the buying power of dollars continues to decline. For example, suppose you could buy a basket of goods for $100 and a year from now that same basket of goods costs $105. The goods have not risen in price, the buying power of $100 has fallen by 5%. This continuous erosion in buying power is what we call inflation.

To measure inflation, our government has a "basket" of goods by which they measure inflation. Basically, how much does it cost to buy the same set of goods. But the "official" rate of inflation is misleading because it does not include food or energy. So, while the official rate of inflation might be 3%, actual inflation that you and I experience each time we buy groceries is much higher. I will use a 5% rate of inflation for the following example.

So, if you rented a property for $1,000/Mo., and rent stayed constant for 5 years, what is happening to your buying power? See the table below.

End of Year Buying Power
1 950
2 903
3 857
4 815
5 774

So, after 5 years, the buying power has fallen by approximately 23%! Said another way, in order to buy the same basket of goods the rent needs to have increased to $1,276/Mo. If the rent increased to $1,276/Mo., rent only kept even with inflation. You would only be able to buy the same set of goods as you did in the past with $1,000/Mo.

So flat rent is not flat, the buying power of the rent you receive is actually declining at the rate of inflation. If you doubt this, think back how much you spent each week on groceries 5 years ago. Now, take that same amount of money and try to buy the same basket of goods today. Therefore, if the rate of appreciation in a location is below the rate of inflation, you need to look somewhere else.

Summary

If the property prices have been increasing over the past 10 years at or above inflation rates, the location is worth looking further into. If the property prices have been flat or even decreasing over the past 10 years, you probably should look elsewhere.

Where can you get appreciation data? There are many websites that provide such information by zip code, metro area and other methods. Spend a little time searching and you will find the data you need.

One last comment, do not be fooled by ROI, ROI is a snapshot of how a property is likely to perform on the first day of a 30 year hold. I will talk about ROI and ways to measure it in a future article.