Market-evaluation tutorial?

Question

Hi everyone,

In this post ...

http://www.biggerpockets.com/forums/12/topics/51498-question-on-market-evaluation

... I asked for some resources for the purpose of analyzing various markets, and respondents provided a few helpful links. Now I have a related question.

Can anyone point me to a Web resource or book that provides a step-by-step explanation of how to evaluate and compare real-estate markets? In the limited reading I've done thus far, the authors touch on this subject in only the most general terms -- i.e. to evaluate a market, one should consider population growth, economic conditions, infrastructure, average cap rates, housing supply and demand, etc.

While such guidelines are a good starting point, they fall far short of walking an inexperienced investor through the process of conducting such an analysis. I'm sure opinions differ widely on what factors one should consider (and the relative importance of each) -- and I realize that a high-level analysis of a city's real-estate market has limited utility (i.e. 'all real estate is local,' opportunity exists in most every city, etc.) -- but a 'market-evaluation tutorial' would be exceedingly helpful for someone in the process of determining where he or she wants to invest.

Thanks in advance for any suggestions. In the short time I've been on BP, I've learned a lot, and I look forward to one day being able to return the favor to other investors.

Cheers,

Scott...

Vikram C. · Answer

Scott, what you are asking for can be broken down into two distinct  components (a) an analytical methodology for evaluating markets and (b) the data that you will apply to the methodology to arrive at your conclusions.

The data is the easy part.  Most macro-economic data are published by the U.S. and the various state and city governments and are free to obtain.  I particularly like the U.S. census bureau data because it covers most of the things that I like to look at when evaluating markets, such as population growth, median household income, total market size, etc.

The methodology is trickier.  This is because there is, in reality, no one methodology.  The evaluation of markets, like the evaluation of stocks, involves judgment and each person will exercise judgment differently.  Some people may like to give greater weight to the growth rate of a city while others may give greater weight to the median household income, for example.

I would recommend that you use your own common sense and judgment to come up with a methodology that suits your beliefs and instincts.  I say this because I know many stock investors who learnt a particular methodology and then failed.  One of the reasons they failed is because the methodology did not fit well with their personalities and they ended up following it partially instead of fully.  There is also the issue of evaluating the methodology itself - how do you know if a methodology is a good one or a lousy one?  You will need to exercise your own judgment for this and you may as well use that same judgment to develop your own methodology.

J Scott · Answer

Marcus & Millichap also publishes a lot of research on market conditions, and a couple times per year publishes a report that overviews and ranks the best markets for apartment investing and the trends that contribute to the rankings...
          
          http://www.marcusmillichap.com/Default.aspx
          
If you're looking for someone to tell you "invest here, don't invest there," there are plenty of people who will do that.  Unfortunately, most of them have no idea what they're talking about, and those that do, are probably talking about a specific aspect of investing that may or may correlate to what you are planning to do.

My best suggestion is to find someone who is successfully doing what you want to be doing in your area, and try to learn as much as you can from them...

Scott Sutton · Answer

>>> I think you'll find that -- unlike in the stock market or other truly passive investment areas -- have a fully diversified RE portfolio will be nearly impossible unless you invest in REITs or own one.

Didn't mean to imply that I'm seeking a diversified RE portfolio. I'm not. Rather, I'm trying to identify a market in which to focus my initial efforts. I do understand that RE investing is a different kind of animal, and specialization in geography and approach seems wise for a beginner -- or, perhaps, anyone for that matter.

>>> People who are willing to spend the time researching and analyzing these trends can do a reasonable job of forecasting for the short- and mid-term, which is often a long enough time to make a lot of money in real estate.

Point taken.

>>> Remember, Warren Buffett would be the first to tell you that diversification is the *wrong* strategy -- instead, get really good at something, and then repeat it over and over and over again. He's proof that it can work.

Interesting comments about fund managers, but you're speaking of a business-oriented approach as opposed to the hands-off approach suitable for most investors based on their limited knowledge. Even Buffett's on record as advising most investors to adopt a passive, indexed approach.

In any event, I didn't mean to get us off track in a discussion of non-RE investing. Just wanted to share some connections and realizations I'd drawn in my own mind.  :D

Tnx,

S...

Derek Decoste · Answer

"Diversification is a protection against ignorance." - Warren Buffett

Of course from what i've read, most investors would be considered 'ignorant' compared to the amount due diligence Buffett himself does, but that just proves all the more that it's not only useful but also neccesary.

Derek

J Scott · Answer

I think you'll find that -- unlike in the stock market or other truly passive investment areas -- have a fully diversified RE portfolio will be nearly impossible unless you invest in REITs or own one.

It's just too expensive and time consuming to own a representative number of units in a representative number of cities having a representative socio-economic status and outlook.

If you had to use your own money and your personal leverage (assuming you're not ultra-wealthy), you'd likely spend your whole life buying units before you were anywhere near diversified.

Unlike the stock market, where you can be fully diversified with $1000 and a couple hours of open accounts and buying mutual funds.

So, in my opinion at least, focusing on diversification should not be your goal...for that -- and other -- reasons.

I'm not saying there are no ways to diversify your risk (there are!), but it's not equivalent to diversification in other asset classes.

I disagree with the part about it being unpredictable.  City populations expand and contract/collapse, and there are reasons for it -- government incentives for business, major transportation hubs, natural resources, climate, etc.

People who are willing to spend the time researching and analyzing these trends can do a reasonable job of forecasting for the short- and mid-term, which is often a long enough time to make a lot of money in real estate.

Read the Vollucci book...I think it will provide some interesting insight in this area...

Keep in mind that mutual fund managers aren't necessarily your best barometer of whether actively managed investments can be long-term diversification.  Remember that those that are REALLY good at this can make a lot more money buying and selling businesses than they can being fund managers, and therefore the fund managers tend to be those who haven't succeeded at the "big game."

Warren Buffett is a great example.  Essentially, he's just a fund manager.  But, instead of buying a few shares (or a few millions shares) here and there, he buys the whole company.  Sure, he also actively manages the investments (unlike the fund manager), but that's the easy part compared to the analysis of the business prior to purchase.

So, while fund managers can't beat the market, that's more because fund managers aren't good enough at the business, not because it can't be done.

Remember, Warren Buffett would be the first to tell you that diversification is the *wrong* strategy -- instead, get really good at something, and then repeat it over and over and over again.  He's proof that it can work...

Scott Sutton · Answer

Folks, thanks for the thoughtful responses. Good stuff. I'll check out Vollucci's book. 
          
          >>> Scott, what you are asking for can be broken down into two distinct components ...
          
          Exactly. There's no shortage of data, but without some type of methodology to sort and prioritize it, a comparative assessment of multiple markets would be little more than a futile exercise in guesswork. (And, yes, a methodology could simply be one that an experienced investor has developed over time, and one that's difficult to explain in explicit terms to others.)  
          
          >>> This is because there is, in reality, no one methodology. The evaluation of markets, like the evaluation of stocks, involves judgment and each person will exercise judgment differently.
          
          Yes, indeed -- understood. (See my first post and below.)
          
          >>> I would recommend that you use your own common sense and judgment to come up with a methodology that suits your beliefs and instincts. I say this because I know many stock investors who learnt a particular methodology and then failed... how do you know if a methodology is a good one or a lousy one?
          
          But, remember that these big companies get it wrong plenty of the time.
          
          No question, and the stock analogy got me thinking. A few years ago, I did a ton of reading on the subject of portfolio theory in the process of picking up a CMFC certification. In that literature, a prominent debate rages between advocates of 'active' and 'passive' investing. Active investors seek ways to 'beat the market,' while passive investors focus on the asset-allocation decision for their portfolios, and they simply use low-cost index funds to capture the full return of each asset class in which they invest. 
          
          I mention this for three reasons: 
          
          1. I'm a 'passive investor' when it comes to non-RE investments, so my mind first turns to the asset-allocation decision. In REI, this decision seems to consist of three parts: a) the market(s) in which one invests, b) the type(s) of properties, and c) the strategy employed (i.e. buy-and-hold, fix-and-flip, etc.). This is just the way my mind works, so I'm starting at the highest level by attempting to evaluate potential markets.  
          
          2. You can learn a great deal about an investor simply by knowing what kind of activities and information they spend their time on. In REI, macro-socio-economic factors may be interesting but, ultimately, they're beyond the control of the individual investor and largely unpredictable. And since I suspect most people invest where they live, such cross-market comparisons may be of no concern. Consequently, it seems that most REI investors wisely choose to spend their time on things over which they can exercise some control. Makes sense. 
          
          3. Just as numerous scholarly studies have shown that the number of actively-managed mutual funds that outperform the market (i.e. the index for the relevant asset class) are no more than one would expect from pure chance, I'm sure there are plenty of ill-conceived techniques for REI market evaluation -- but I also suspect there are a couple of 'tried-and-true' principles that are worth consideration. To some degree, an investor can learn from others in the 'marketplace of ideas.' If a methodology has some value and has produced worthwhile results, we'll hear about it from credible sources who have earned our trust. (That's not to say that identifying 'credible sources' is a simple matter, or that a single methodology is appropriate in every context.)
          
          Anyway, in light of the points and caveats raised by everyone above, I think I'm really just interested in seeing a few examples of how small investors have gone about evaluating and comparing a handful of markets. In particular: 
          
          1. Which specific factors/data did you consider?
          2. How did you prioritize this information? 
          3. Why did you adopt this particular approach? 
          
          Needless to say, my circumstances will differ, but I'd be quite interested in learning more about the thought processes employed by RE investors when assessing alternative markets for a buy-and-hold, cash-flow approach. 
          
          Cheers,
          
          S...

J Scott · Answer

Vikram -

Well said...

I wish I could have expressed it as concisely as you just did...  :-)

Scott - There's your answer...

J Scott · Answer

Part of the reason is that there are some things that can't be quantified very easily.  Gut instincts of seasoned investors certain are meaningful, but to determine exactly what quantifiable data is behind a gut instinct can be very hard, if not impossible (maybe one day).

Also, every investor has a different set of goals, so asking one investor where to invest (and how to evaluate it), may not get you the answer YOU are looking for.

If you look at the reports that Jon and I highlighted, this will give you an idea of some of the data and trends that the big companies use -- things like employment, market rent trends, number of new starts, population trends, etc.  But, remember that these big companies get it wrong plenty of the time.

In fact, here's a great exercise that will probably help you a lot -- take a look at the data these companies put out 2, 3, 4, even 5 years ago for various markets, and see how well it's played out.  In areas where they got it right, what were the common denominators?  In areas where they got it wrong, what were the common denominators?

One book that highly, highly recommend is "How to Buy and Sell Apartment Buildings" by Eugene Vollucci.  It's very specific to one type of investing (value plays) with one type of property (apartment buildings), but should give you an idea of how good investors think about things like market trends and analysis.

Scott Sutton · Answer

Jason (J Scott), thanks for your reply. 
          
          I'm not looking to be told where to invest. First and foremost, I'm seeking a resource or two that provides fairly explicit guidance in how to independently evaluate markets on my own. 
          
          For instance, you and Jon (thank you both) have shared links to two companies that regularly produce information-packed reports, and these reports provide some level of analysis for the company's purposes. While the reports contain heaps of data -- and I plan to dig in -- I'm looking for a book or other resource that attempts to explain what steps a small investor should follow in order to interpret available data to arrive at an overall market assessment for their own purposes -- in other words, a methodology that an economics layman could follow in order to assess the viability and potential of a market. 
          
          Of course, maybe such a thing doesn't exist. But without some kind of methodology, the process of choosing a market in which to invest would be something of a crapshoot (in part, for the reasons you point out).

Scott Sutton · Answer

Thanks very much, Jon. Those Red Capital Group reports look promising, and I'll have a look at Lindahl's book.

Good stuff, I'm still hoping to find something that's a little more prescriptive. :-)

Market-evaluation tutorial?

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