Location, Location, Location- But Why? Here are the Real Drivers of a Strong Market

Everyone knows the old saying in real estate: “The three most important aspects are location, location, location.” But what actually defines a good location? Two of the most powerful drivers are supply and household incomes.

This article outlines the initial due diligence investors should perform on a property before even scheduling a site visit.

Supply

Two types of supply that can impact pricing: Construction and existing vacancy.

Construction

Nothing ruins a year of expected rent growth like a new property entering lease-up across the street from an existing property.

The business model for a merchant developer is to build and sell as fast as possible. Developers will usually offer generous concessions to reach a stabilized occupancy rate (90%+) quickly. Depending on the size of the project and length of the lease-up period, this new supply will likely supersede any population growth to the area in the short term, causing effective rent growth to flatline or decrease while pushing aggregate vacancy higher.

There is little an existing property owner can do to combat the newly delivered supply, which usually offers the best amenities, and none of the wear and tear of an older product. The existing property often must cut rents and/or offer concessions for new leases and renewals.

Much like the effect of new supply at the micro level can be examined, looking at new supply in a submarket or metro has a similar effect. Prospective tenants who might have otherwise leased Class B units are often drawn to newly delivered Class A properties due to elevated amenities and competitive pricing strategies, such as rent concessions. As a result, Class B vacancies increase, which in turn attracts tenants from Class C properties. This tenant migration disrupts the balance of demand across the market, leading to elevated vacancy rates and downward pressure on rents for existing inventory.

When acquiring a new multifamily project, existing or development, survey the market to see how much product is:

1. In lease up
2. Under construction
3. Under renovation
4. In planning for development (by pulling permits)
5. Note any parcels of land or functionally obsolete buildings that are candidates for future development

Existing vacancy

Similar to new product delivery to the market, existing vacant units in the market can impede rent growth and negatively impact net operating income for an existing property. To illustrate this point, here is a simple example:

There are several assumptions in this table, such as no new supply in the market and no population growth in the submarket, but it illustrates the struggle of increasing occupancy and raising rents in markets where supply exceeds demand.

How to acquire a property in a market with strong growth potential, but high levels of existing vacancy:

1. 1. Model the worst.
      1. Assume slower lease-up, minimal or no rent growth until the property and submarket reach a stabilized occupancy, higher vacancy, increased use of concessions, and greater bad debt write-offs.
   2. Analyze What’s Missing in the market
      1. Identify the housing types needed in the market. Position yourself as either the low-cost provider of quality housing or the premium product commanding higher rents. Avoid properties that simply mirror the weakest aspects of the market.
   3. Find the best-in-class property manager who has a long tenure in the market and can point to case studies of success.

Buying in a market with high levels of construction and/or vacancy can be a massive headwind, which could take years for the market to correct. Conversely, markets with limited new supply and high occupancy rates tend to quickly deliver stronger organic rent growth and attract higher-quality tenants.

Household Incomes

Renters look for apartments based on what they can afford. People learn to spend what is in their pockets. If the asking rent of a property is too high, the renter looks elsewhere for a lower-priced property.

As a multifamily buyer, you need to work out this equation with the opposite approach. What is the income in the area, and how much rent does this income support?

For example, if the median household income in an area surrounding a property is $60,000/year, multiplying this figure by 30%, which is the recommended allocation for housing, yields $18,000 for housing for the year, or $1,500/month.

With a $1,500 allowance for housing per median income earner, a conservative property buyer will plan to proforma rents at a maximum of $1,500/unit. Yes, there could be cases of double incomes per household or a tenant could pay for the whole year upfront, but these assumptions can be dangerous as they are not typical.

Backing into proforma rents using median income, it puts a ceiling on expected gross rents in your model, protecting you from overpaying for a property or overestimating achievable rents.

Summary

Location matters, but not as a general statement. It matters because supply and household income levels are the real drivers of rent performance and long-term value creation.

Important Information 

This article is provided solely for educational and informational purposes. The views expressed reflect general observations regarding investment analysis, private markets, real estate investing, valuation methodologies, underwriting practices, due diligence considerations, and fund structures.

The information presented is not intended as investment advice or a recommendation regarding any specific investment, manager, property, fund, security, or strategy. Readers should conduct their own independent due diligence and consult their professional advisors before making investment decisions.

Investments in private funds and alternative investments involve substantial risks and are not suitable for all investors. Such investments are generally illiquid, may involve leverage, may have limited transparency, may be difficult to value, and may result in the partial or complete loss of invested capital.

Certain statements contained herein may constitute forward-looking statements. These statements reflect current assumptions and expectations regarding future events and market conditions.

Actual results may differ materially from those expressed or implied due to changes in economic conditions, capital markets, interest rates, tenant demand, property performance, financing availability, governmental actions, and other factors beyond the control of Valoran Capital Management.