Q: Where are the best places to invest in rental property?

Where can I get the most bang for my buck as rental property investor?

One of the best lessons about investing I ever learned was this: “Make your money when you buy, not when you sell.” That is, look for investment properties that seem to be priced at a discount from their intrinsic value – and a great way to define ‘intrinsic value,’ from a financial theorists’ point of view, is this: Priced cheaper than the discounted present value of expected future cash flows.

This methodology is a little difficult to apply to owner-occupied real estate, and to stocks that don’t pay a dividend.

It’s just tough to get a reliable handle on expected future cash flows for these types of investments. But residential rental property is ideal for this kind of analysis. Regardless of the asset class, though, any investment – including real estate, should have the following characteristics:

1. Definable expected future cash flows. For residential real estate, this primarily going to be your rental income, though some properties may have crop yields, livestock yields and mineral rights revenue that could generate cash income, too. 

Residential real estate is ideal in that rental income is generally in cash, and unlike mineral rights, is not exhaustible, as long as you keep up the property.

2. Potential for growth. This is where real estate is better than, say, bonds. While real estate and bonds both generate current income, the bond will eventually mature, and cease providing income. You may the principal back and then you have to go find another investment

3. Think in terms of ROI, or ‘return on investment.’ Ideally, the idea should work without leverage. Leverage makes good ideas better, but it makes bad ideas worse!

4. Don’t rely on selling a property to a ‘greater fool.’ That way lies disaster. The surest way to price appreciation is purchase at a reasonable price relative to cash flows. Anything else is just speculation.

The Best Markets 

So where can you find the best properties on an income yield basis? The prominent real estate data firm RealtyTrac did some number crunching. It turns out that the areas that are producing the most promising rental income properties from this perspective are, well, pretty unglamorous. They’ve identified the top markets as follows:

• Wayne County, Michigan (near Detroit)
• Clayton County, Georgia (Atlanta/Marietta)
• Washington County, Mississippi (near Greenville)
• Bibb County, Georgia (Near Macon)
• Baltimore County, Maryland
• Wyandotte County, Kansas (Near Kansas City)
• Putnam County, Florida (Near Palatka)
• Fayette County, Pennsylvania (Near Pittsburgh)
• Hernando County, Florida
• Pasco County, Florida

RealtyTrac simply divides the median sales prices in these markets by the annual average fair market rentals and generates an average annual gross percentage yield. Each of these markets are generating 20 percent or more to property investors per year, unleveraged. In Wayne County it’s 30 percent!

Is a property that can be rented out for 20 percent of its purchase price each year likely to fall much in value? No. If it does, well, by all means, buy more! You can hire a property manager to handle everything on the property, soup to nuts, for about half of the property’s rental yield.

This is the kind of phenomenon that’s attracted a lot of smart money – institutions and hedge funds – to residential real estate. The professional investors know a good deal when they see one. And for buyers who know how to value property and get a good price, there are some fine deals indeed if you’re willing to go off the beaten path and buy properties in more rural areas.

Is this a foolproof calculation? No. Rents can fall. Vacancy rates can rise. Detroit, for example, is facing a huge surplus of housing stock and many places are going unrented. But this method of evaluating investment properties as a built-in margin of safety.

With 20 percent un-leveraged ROI per year, you can afford a setback or two and still do just fine, in the long run. Keep some cash on hand to deal with vacancies, repairs, problem tenants, and you’ll be fine. A good property manager should be a valuable shock absorber, as well, marketing your property to reduce vacancy issues and screening tenants to keep that cash flow going.

What’s more, among these top markets, not a single one is posting average median sales prices of anywhere near six figures, The priciest of them, Baltimore County, is selling at $85,000, on average. Properties there rent for an average of $1,599 per year, generating an average annual gross percentage yield of 23 percent.

Most of the other counties listed above are posting median sales prices closer to the $50,000 and $60,000 range.

The Worst Markets

The worst markets for new investors, according to RealtyTrac, all seem to be in ritzy, high-status areas with steep home prices:

• New York County
• Eagle County, CO
• San Francisco County, California
• Kings County, New York
• Marin County, California
• Gallatin County, Montana
• San Mateo County, California

None of these areas are generating annual gross yields of more than 5 percent of the purchase price. All of them are selling for at least $308,400, and some for more than $800,000. Most of these areas are near San Francisco or New York City. Both areas have strong rent control laws that limit the prices landlords may charge tenants.

You can find RealtyTrac’s complete listing for the top and bottom 20 real estate markets in the country here.

Interestingly, but not surprisingly, their findings closely match our own research. While our methodology is different and focuses on some different metrics, we do find that the markets that rank well in our own Rental Health Index (now RPI Score) are also a little bit away from the glossy, high-status cities, and many in the Heartland or the South. Our methodology is a little more complex than a simple rental income/price calculation.

We look at vacancy rates, rent increase/decrease trends, cap rates, price appreciation and job growth to calculate our numbers. So pricing trends and momentum counts in our model, where it’s not relevant in RealtyTrac’s. In fact, the lower the prices fall, the better it is for your area’s ranking in RealtyTrac, where as the effect would be minimal in our own rankings: The “appreciation” column would go up but the “cap rate” would go down and the two effects would cancel each other out.

Which is better? It depends on your approach and your time horizon. However, at a minimum, even if you prefer the RealtyTrac pure yield-on-price methodology, you take a look at vacancy rates in those areas.

After all, even a great theoretical cap rate in your city on average won’t help you if in reality you don’t have a paying tenant in your property.