How do you evaluate a real estate investment?
For most of us -- and readers of
The Millionaire Zone
-- it's about long-term gains. Buy low, sell high.
But that might take a while, especially in today's environment of oversupply and soft prices. So what now?
I believe it's back-to-basics time -- time to bring the whole return-on-investment equation back into play. That means a closer look at current cash flow, or rental income, against the cost of your investment. That income keeps you in the game for the long term. In some markets, it may allow you to go positive right off the bat.
That's a smarter way to play today.
Really, we're talking about judging real estate investments more like a stock or any business investment -- through short-term earnings and cash flow, not just long-term growth.
Many real estate professionals look at something called rent to value, that is, the ratio of rental income to the price of the property. Suppose the annual rent is $7,200 ($600 a month) on a $144,000 property. The RTV is 5% -- not a bad return compared to other investments, and certainly enough to keep you in the appreciation game.
Maybe because I invest in stocks, I actually prefer the inverse of the RTV ratio -- the VTR ratio, if you will. It works like a P/E ratio for stocks. In the above example, the VTR ratio is 20, comparable to a stock with a P/E of 20.
OK, enough explanation. How do we use these ratios to make an investing decision? And do different U.S. markets really vary that much?
You bet. With the help of 2006 median rent and home price data from
Sperling's Best Places for 375 U.S. metropolitan areas, I was stunned at how much markets vary.
In fact, the VTR ratio (P/E equivalent) runs from a low of 10 in depressed markets like Danville, Ill., and Flint and Saginaw, Mich., to a screaming 56 in the Salinas-Monterey Bay area of California. In fact, most California locations are over 40, confirming the inflated home values you've read about. To say the least, that's a challenging market for new investments.
So what about the good market opportunities? Here's how I found them.
I'm looking for VTR ratios under 20. Fifteen to 17 is the sweet spot. Reversing the ratio implies a 6% annual return on your total investment. And since you're probably using a mortgage, your real ROI could be much higher.
Click here for the video version of this story from Jennifer Openshaw.
Now according to my analysis, some 180 of the 375 U.S. markets have a VTR below 20. But many of these are in small markets or depressed areas. It hardly matters what the VTR is if you can't find a renter, right?
So I also considered projected future job growth, selecting markets anticipating more than 10% growth between now and 2010. And I also considered intangible factors like quality of life and employment stability.
Finally, I wanted to spread my choices across as many regions of the country as possible.
Here's what I came up with:
Austin, Texas (VTR 17.6, future job growth 28.1%). For that matter, you could qualify most of Texas -- Fort Worth, Houston, San Antonio and Dallas all work. Austin has the strongest growth picture, and the rental market is strengthened by the presence of the University of Texas.
Rochester, Minn. (VTR 17.7, FJG 12.0%). Solid, stable Rochester is home to the Mayo Clinic, bringing (unfortunately) a need for temporary housing for patients receiving treatments -- and a fair number of medical personnel on short stints.
Rockingham County/Stafford County, N.H. (VTR 19.6, FJG 13.8). Where? Rockingham County sits on the narrow New Hampshire Atlantic Coast, just north of Massachusetts and Boston suburbs. The city of Portsmouth is a favorite for the tech industry, small businesses and telecommuters.
Lexington, Ky. (VTR 19.3, FJG 13.3%). Home to Toyota's largest North American plant and Lexmark , Lexington is a right-sized city, and boasts a strong college element -- the University of Kentucky.
Atlanta, Ga. (VTR 18.7, FJG 20.5%). The vibrant strength of this market is no surprise, and there's plenty of housing available at reasonable prices. There are lots of renters too, including corporate folks there for short-term steps up the career ladder.
Now, these ratios don't guarantee success. For one thing, they're based on averages. Individual investments all vary -- some may attract better rents than others. Not to mention that out-of-town investing requires special skills, patience and property management services.
But if you're really playing the return-on-investment game, these markets may produce a first-inning win. And that will help you get to The Millionaire Zone.
Jennifer Openshaw, a passionate advocate for helping Americans improve their finances and build their personal fortunes, is CEO of
The Millionaire Zone and America Online's personal finance editor. In addition to appearing regularly on TV shows such as "Oprah" and "Good Morning America" and on CNN, Openshaw is host of ABC Radio's "Winning Advice" and serves as an adviser to some of America's top corporations. Her new book,
"The Millionaire Zone," hit bookstores in April 2007.