Zillow’s Chief Economist Stan Humphries was recently on CNBC discussing the best places to invest in 2011. So what type of investor was the focus of his remarks? 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:
1. 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.
2. 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.
3. Foreclosure flipper: Seeks out distressed properties and plans to profit from a quick re-sale 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 in 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 so during more normal market conditions.
Looking at the list of investor types, we 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 top places to invest in 2011.
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:
1. Price-to-Income Ratio
3. Price-to-Rent Ratio
4. 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 which are more desirable to live or have 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).
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 re-sales (the monthly number of foreclosure re-sales 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 re-sales 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.
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 (versus 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 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 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.