The best perk about being comfortable with investing in rental properties at a distance is that you can easily analyze new markets without ever leaving your seat. Or beach chair if that's more your thing. On top of that, you can connect with agents, place offers, and go under contract before you even see the property. Today's technology allows us to vet a new market's fundamentals relatively easily.
Last year, I wrote an article for BiggerPockets for investors on how to analyze a real estate market in cities they consider targeting for real estate investing. It was met with praise and plenty of questions. Today, I'm going to rehash key points and expand upon my thoughts as I'm now a year older and ten years wiser. Many of my clients are participating in syndications in markets that they may not know like their own back yard, so this article will help them, and you, better understand how to analyze a real estate market and more importantly where you're placing your hard-earned money.
Analyze the Fundamentals Prior to Searching for Property
At The Real Estate CPA™ we aim for efficiency. It makes no sense to waste time browsing for rental properties if you don't have a clue as to how the underlying market performs. That's like choosing a car simply because of how it looks and completely ignoring any issues that may be waiting under the hood. You're wasting time, and time is money.
So first, pick a market that interests you. You don’t have to have any rhyme or reason as to why you chose the market(s) for investing in rental property that you have. You can tack a map to the wall and throw darts for all I care. But once you choose a market, resist the urge to jump on Realtor.com or Zillow and research the fundamentals first.
Since the premise of this article is how to analyze new real estate markets from your beach chair, we’ll naturally look at one of my favorite markets: Wilmington, NC. I love Wilmington because it's a fun beach city, has an international airport, and has several large industries supporting economic growth. That's the macro level understanding that you need to have with the market you choose. You’ll then need to dive into the micro level information, specifically demographics, employment rates, income information, etc. before you start investing in rental properties.
To review all of this information presented in a aggregated format, we'll look at the market's Comprehensive Annual Financial Report (CAFR).
The Comprehensive Annual Financial Report
A CAFR is a set of U.S. government financial statements comprising the financial report of a city (also other government entities) that adhere to the Governmental Accounting Standards Board (GASB). GASB provides standards for the content of a CAFR in its annually updated publications. A CAFR is “compiled” by the city and audited by an external accounting firm. Basically, you can count on the accuracy of information contained in the CAFR.
The Wilmington, NC CAFR can be found here http://www.wilmingtonnc.gov/departments/finance-department/financial-reports.
If you'd like to follow along while using your own market, simply Google "City, State CAFR" and it should appear within the first few links. If the CAFR does not appear, you'll have to drill down into the city's financial reports to find it. Some cities make it harder than others.
A CAFR is composed of three sections: Introductory, Financial, and Statistical. Each section will give you an immense amount of detail regarding the city’s operations, management, plans for improvement, demographics, and more.
Related: The Ultimate Guide to IRS Schedule E
If you want to take the analysis to the next level by tracing account balances year over year and learning how to comprehend fund accounting, then go for it. However I’m going to show you how you can quickly get a feel for the city as a whole.
The Introductory Section
The introductory section will provide you with high-level details (which is what we are looking for) so it’s important to give it attention. This section alone will tell us whether or not the market is decent enough to warrant investing in rental properties per our criteria.
The first thing I look for is population trends. I want to know if people are coming to the city or leaving the city. How old are the city residents? A younger city could indicate that rentals are in demand as younger, relatively speaking, have less spending power for home purchases than elders. An elderly city may indicate a retirement-type city. Will retirees rent or want to buy? Some of this information is in the Statistical Section, but on page xiii of the 2015 Wilmington NC CAFR, we can see a population growth of right around 2%. We can also see that the population will grow at the same rate as NC and faster than the Nation in the coming year.
When reading on the same page, two sentences stand out to me:
Wilmington’s unemployment rate has consistently been less than state levels and very close to or below the federal levels.
No single taxpayer comprises more than 1.8% of the total tax base providing further confirmation of the City’s diversity and non-reliance on any one employer or employment sector for economic stability.
The first sentence is great, but the second is awesome. I don't want to invest in cities that are subject to what I call "employer flight risk." If one employer leaves the area, we don't want that to put our investment at risk. The city should have a good portfolio of employers and it's clear that Wilmington does.
On the following pages, we see that Wilmington is home to a diverse number of industries which is important as “one industry towns” expose investors to unneeded risks as noted above. Think back to when manufacturing jobs started leaving our country. What happened to the towns dependent on the manufacturing industry?
We also see that Wilmington is home to two schools – UNC Wilmington and Cape Fear Community College. This means that student rentals may be a viable strategy to pursue. It also means that, upon graduation, these young people may stick around and need a place to rent as they enter the workforce. So if you aren't a fan of student rentals, you can potentially position yourself to market to young professionals new to the work force who are more likely to take care of your property than students.
The remainder of the introductory section will go into details about the top employers and various industries, talk about the city’s R&D and commercial projects, and tourism and attractions. We can also see long term financial planning and the city’s major initiatives which you will certainly want to read through.
The Financial Section
Unless you are a CPA and have experience with government financial statements, the financial section won't be very useful to you. However there are specific parts of this section that you should pay close attention to.
Be sure to always read through the first couple of pages of the Management Discussion and Analysis (MD&A). The MD&A provides you with financial highlights and there are often gold nuggets of information that can help you understand the city's economic situation.
Within the "Finanical Highlights" section of the MD&A, we will normally see the Net Position and commentary about it. The Net Position of a city is important. Think of it like the city's net worth. Just as you don't want to have a negative net worth, the city doesn't want to have a negative net position.
If you scroll a few pages down, you'll likely find the Government-Wide Financial Analysis (page 7 of the 2015 Wilmington NC CAFR). In this section, the Net Position will be discussed and key factors affecting the net position will be pointed out. For instance, check out the following commentary on Wilmington's Net Position:
A significant portion of the City’s net position $238,268,560 (69.7%) reflects the City’s net investment in capital assets (e.g. land, buildings, machinery, and equipment). The City uses these capital assets to provide services to citizens; consequently, these assets are not available for future spending.
Is this good? Bad? Read on:
Although the City’s net investment in capital assets is reported net of the outstanding related debt, the resources needed to repay that debt must be provided by other sources, since the capital assets cannot be used to liquidate these liabilities.
So what we have is roughly 70% of the city's Net Position can be considered "equity" in capital assets. However, these capital assets cannot be liquidated to cover the debt associated with them. This likely stems from legal/contractual reasons, but from our perspective, it's concerning that 70% of a city's "net worth" is illiquid.
Because "other sources" must cover the debt on the city's capital assets, we want to know what those "other sources" are.
Scroll to page 131 “General Fund, Schedule of Revenues, Expenditures and Changes in Fund Balance - Budget and Actual.” The general fund is a government’s basic operating fund and accounts for everything not accounted for in another fund.
On page 131 we see the city's various revenue streams. On page 132, we see the city's various expenses. We want to know whether the city's revenues exceed their expenses and by how much. So scrolling down to page 133, we see actual "Excess of revenues over expenditures" for $20.9MM. On page 131, we see actual "Total revenues" of $97.8MM. This means the city is running on a profit margin of 21.4% which is pretty darn good from a city management perspective, relatively speaking.
Now let's find the city's Debt Service. On page 133 of the 2015 Wilmington NC CAFR, you will see "Operating transfers - out: Debt Service Fund" for 9.3MM. Calculating the debt-service coverage ratio (DSCR) we get 2.24. Who wouldn't take that bet?
The Statistical Section
This section is fairly easy to understand, and thus, is my favorite section to look through. It's also ripe with awesome information that can help you develop your investment strategy above and beyond what it may have been without this "inside information."
I first want to understand what the changes in property tax have been year-over-year. This will tell me how well the city manages its money as cities generally raise property taxes to get themselves out of a bind. We find this information on page 203 of the 2015 Wilmington NC CAFR and you can see they raised property tax from $0.40 in 2014 to $0.41 in 2015 which amounts to 2.5%. Because that's roughly the rate of inflation, the increase doesn't scare me.
I then want to know who the city's top taxpayers are. These are generally going to be employers unless you have a billionaire living in small town. Do you remember in the Introduction section the city claimed that they had a great portfolio of employers which I then said reduces your risk? While true, we still want to know who the top taxpayers are because, no matter how big or small, if they leave they can have an impact on the economic performance in the surrounding area.
We find the city's top taxpayers on page 204 for the last 10 years. If you're looking closely, you'll notice that there are companies who do not have a value listed in 2015. This means the company is no longer has a presence, or has an insignificant presence, in the Wilmington area. We want to know why this is the case. Did the company fold? Get bought out? Leave for more fertile grounds? That's for you to find out.
Related: Hiring a CPA is Key to Your Success
Pages 213 and 216 are my favorite pages of the entire CAFR. Page 213 shows us the demographic and economic statistics over the last ten years. We see that population has been growing steadily as well as per capita income. It’s unfortunate that we don’t have 2014 and 2015 income numbers, but with governments, there's a huge lag time in reporting. We also see the median age has stayed relatively stable, meaning there is a good amount of young people who are continually drawn to the city which is important for continued growth. We also see the unemployment rate has experienced fluctuations but is currently at low and stable levels.
Page 214 shows us the top ten employers. Similar to the top taxpayers, I always ask the question – if the number one employer left, would this cause undue hardship on the surrounding area? Since almost 6% of the city’s workers are employed by one employer, I might be inclined to say yes. However that employer is the county’s health network, so it’s unlikely that employer would ever “leave” which mitigates my concerns. Additionally, the top ten employer lists is made up of a diverse set of industries, so if one industry left the city, I wouldn’t be concerned in the short-run.
I hope you enjoyed learning how to analyze a real estate market and that quick analysis of Wilmington NC. Based on this analysis, and similar to my findings last year on my BP article, I still think Wilmington NC is a great area for investing in rental property due to its diverse industries and employer/taxpayer portfolios. The city has done a great job managing its financials, hence the 21%+ profit margin, which gives me plenty faith in the future economic stability of the city.
The city may not be poised to experience rapid growth, but it's clearly not going anywhere soon. Like cash flow property investing, you can count on it to produce year after year.