AMA - Which Small Market?

Farhana asks, “Given the real estate prices in big cities are skyrocketing, which small city would consider investing?”

Farhana, this is a great question. But before I answer the question directly, let’s ask another question. “Why would prices be skyrocketing?”

The housing market is a free market. That is to say, prices are subject to the laws of supply and demand. Excess demand and prices rise. Excess supply and prices fall. 

Furthermore, Is it actually true that prices are skyrocketing?

First of all, Real estate is a business like any other business. That means that its about solving problems that real people have, that they’re willing to spend money to have solved. If housing is scarce and people have high paying jobs, then the price of housing gets bid up. You want to be able to solve those problems. 

When cities are generating new jobs, once the unemployment is absorbed, new housing is needed. The tightest market for housing in the nation is the SF bay area. In the past couple of years that area has generated 3.5 jobs for every unit of housing created. This has resulted in longer commute times and even greater demand for housing in San Francisco itself. So are these markets skyrocketing? Well, they were for a while. Today, the price growth in a lot of these hot markets has levelled off and in some cases we are starting to see prices dip a little. But the fact remains, these markets are expensive.

If your goal is to be a buy and hold investor, I would not recommend San Francisco, just to pick an example of an expensive market because the numbers don’t work. The underlying assumption in your question, is that expensive markets don’t work from a rate of return perspective. You have to spend too much money to acquire a property compared with the rent you can get in the market. It comes down to the ratio of net income to your total investment. In other words the capitalization rate. 

So the question then becomes which markets make sense?