Investing in High-Cost vs Low-Cost Markets, Which Will Make You Rich?

Being in San Francisco bay area, one frequent investment question I get  is whether to invest in Bay Area or a low cost market remotely.  This is likely to be  question in lot of investors considering investing. Broader question is whether to invest in a high cost, high appreciation market, or a low cost high-rent market. I am analyzing historical data below to what can we expect in these different investment strategies based on historical data. 

Figure 1: The price growth in Cleveland and San Jose from year 2000 to year 2021.

I decided to make a comparison based on historical data for two typical markets in high cost market and a low cost area. So I selected Cleveland OH, and San Jose CA for comparing investment returns of two markets. San Jose is a high cost market and Cleveland is a low cost market. These are used as two representative examples, most of the markets in falls in between these  in terms of prices. Hence the analysis may be helpful to understand the differenced and to do your own analysis.  

Let us compare two markets.  San Jose, CA   has a population of little over a million. San Jose is one of  the costliest housing market in the country with median home prices at 1.48 million . On the other hand Cleveland OH, has a population of three hundred and eighty thousand. Median housing price in Cleveland is 178 thousand during the end of 2020 (The values are taken from home value index data published by Zillow research for mid-tier single family homes, I find it different from Zillow site data, possibly due to different methodology)

Let us see how a million in invested in each of these markets would have performed in six year of  2015 to 2020. I select this period as time with no rare events like post-recession recovery, pandemic etc. 

The Figure 1 and 2  below shows rent and price appreciation for these two markets. Let us assume we buy a median priced homes which can be rented at median rents in these two markets at 2015. To make both investments one million, let us assume we buy multiple houses in Cleveland and San Jose. The investment amount is not important as we compare percentage of appreciation in these two markets. 
Let us notice some basic facts in Figure 1. The prices points are much higher in San Jose, and appreciation are faster also. Cleveland has a lower point of entry with some steady appreciation. 

Figure 2: The rent growth in San Jose and Cleveland from year 2000 to year 2021.

In Figure 2 on comparing rents, again, rents are higher in San Jose Compared to Cleveland. The Cleveland has a steady increase in rents also. The rents are higher in San Jose Compared to Cleveland, but not as high as prices. Let us compare the numbers in these markets the Table 1 Below.  

Table 1: The comparison of prices, rets and change over the period for San Jose and Cleveland. Rent appreciation is more for Cleveland, price Appreciation is more for San Jose. Rent to price ratios are much better for Cleveland. Most importantly, rent to price ratios are much higher for Cleveland Vs San Jose. 

In Table 1, the market fits the reputation. Most notably, prices in San Jose are almost eight times than that of Cleveland. Rents are higher not but not the same scale as the prices.  Rent to price ratios  are almost three times for Cleveland Vs San Jose.  Rent appreciation is more for Cleveland, price Appreciation is more for San Jose.

Now that we have all facts and figures, let us answer the main question. How much money we will be making in each market with a one million investment. I am not considering any financing costs here. I assume that half the rents collected in each market goes towards expenses. For selling I am assuming a 7% selling cost. So the numbers looks like as in Figure 3. These are broad figures without going into details.

Figure 3: The total returns in in two markets. Appreciation is better in San Jose, Rent returns are better in Cleveland. Overall return, Cleveland is coming out be higher. 

Does this mean that Investing in low cost markets is better for all the time? Not really. Let me described some key differences without going into numbers. 

1. If you are investing a small amount, you would not have a choice, but to invest in a low cost market. 

2. If you are investing a large amount, you would have to buy a large number of houses in low coast markets. This essentially increase effort to buy and maintain. For example, to buy a million, you may have to buy eight houses in Cleveland vs one in San Jose. This is almost eight times of effort to buy, rent and maintain vs difference in returns is much smaller. 

3. Other market factors like stability of markets, type of tenants, and new constructions. For a market with lots on new construction, the market prices goes up as newer and bigger Houses are constructed but the price of the older house will remain the same.  Places like silicon valley and Manhattan new constructions are low due to price constraints. 

The above analysis is not an investment advice. I analyze the basic investment returns based on the historical numbers (future number may vary from historical numbers). What market is right for you is determined based you your careful analysis, and factors like where you live, what is your investment  goals etc. Please let me know your comments below, what do you think of different markets and what other factors determine where to invest.