My Out-of-State Search: Step 2, Why Out-of-State?

Why buy out-of-state?

The only reason that you should ever make any investment is because it fits with your long-term goals and strategy.  If ever a short-term opportunity doesn't fit with your long term plan, you should either tweak your long-term goals, or pass.

For us, the three benefits of an out of state investment are all central to our long-term goals.  These include:

1.       Greater Immediate Cash Flow

2.       Greater Long-Term Appreciation

3.       Diversity of Real Estate Portfolio

Cash Flow

It’s 18 years until we flip the switch from acquire to retire, so to help with future purchases and offset the negative cash flow our current rentals, the new purchase must cash flow, and it must do so at a good rate.

 

I would say that there are a few cash flow metrics out there, these include:

*Operating Income (NOI)

*Cap Rate

*Dollars per door per month

1. *Cash-on-Cash return
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3. While I want to avoid getting lost in these definitions (for a great resource, check out: http://www.biggerpockets.com/renewsblog/2013/01/19/real-estate-math/), my long-term goals make it clear that my key metric in this search must be cash-on-cash; the quicker we can get our capital back, the quicker we can purchase another rental.  Compounding at work.
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5. We hope to find cash on cash return of at least 10%, after operating expenses and capital expenses.  The catch is that purchasing an out-of-state property will have higher capital expenses than an in-state equivalent.  These may include:

a)      Travel expenses (capital).  I expect to see the property and meet the PM before signing, and that has both a time and dollar expense.

b)      Hiring an adviser (capital)?  I haven’t ruled out hiring someone who does out-of-state investing to advise me on the process, help provide another layer of protection, help me get a deal, do due diligence, etc.  This may be a real estate agent if we purchase a “turnkey” property, or an adviser/consultant if we purchase from the MLS.  I’m still wrapping my head around this notion, but for now – highlight that it may be an additional capital expense.

c)       Higher operating expenses?  With local properties – I’m able to be just involved enough to keep tenants placed, properties clean and PM’s on-track.  Insofar that any of these slip for an out-of-state property, operating expenses will increase.

I typically find the 50% rule conservative for a SFR rental, but barring additional information, it seems like a reasonable starting point for an out-of-state investment.

So for now, generally speaking, this works out to around $250/month positive cash flow on a $100,000 house with 25% down (at 4%) and 5k in capital, renting for around $1200 month.  Using some very rough numbers, this means that a property renting for 1.2%/month is likely to get my 10% cash-on-cash return target.

A final note on cash flow:  The 50% rule is a good starting point, but any purchase must go through a more complete pro forma – with challenged and understood taxes, maintenance, PM, insurance and vacancy expenses plugged in!

Appreciation

Appreciation is a dangerous beast.  Still, 18 years is also a lot of time for appreciation, and frankly, is a part of our long-term plan.  At a high level, I believe that real estate will appreciate faster than inflation over the next 50 years, though I also believe that:

1.      Not everything will appreciate. 

2.       Appreciation should not be a necessary component of a retirement plan.  For a counter-argument to this, from a man much more experience and intelligent than myself, checkout Leon Yang’s BP podcast (episode 13).

3.       Buying a place that is robust against depreciation is often times more important buying for appreciation.

4.       Appreciation is the result of increased demand (from those with adequate resources).

To predict appreciation, the most obviously and popular method of determining this is simply looking at job growth – and that’s not a bad plan.  My concern is that job growth is temporary and volatile; at one point over the last 20 years, Detroit, Las Vegas and Phoenix were all job growth markets.   So, while job growth is a good data point, it is not the only indicator of future appreciation.

To me – the world is shrinking.  With fewer manufacturing jobs and more jobs that can be, and will be done remotely, I expect to see big shifts in how the US population is distributed.

In fact, I would argue that we are already seeing that.  While Detroit is probably the most popular example, the entire rust-belt seems to be feeling these effects – and many of their local economies (and in turn, demand and subsequently, their real estate markets) are feeling these effects.

Looking ahead is difficult because past performance is not always a good indicator of future performance.  Still, where moves are made will be determined by a few key factors:

1.      Cost of living. Keeping in mind that as the world shrinks, people will opt to move where their 90k income will let them live like a king.  As this happens, the cost of living for most places will rescind towards the mean.

2.       Economics and jobs.  There are several ways to look at this, including:

a.       Previous job growth.  This tends to be a good predictor of short-term job growth, and short-term demand (though demand is often already worked into the price).

b.      Unemployment.
c.      The physical characteristics of a city, such as natural resources or geographic location. 
d.     Fortune 500 companies are a good indicator of this, as I believe the future will see larger companies playing a larger role in the economy.
e.     Business-friendly politics are another indicator, but are volatile can easily shift with a single governor.
f.        Diversity of industry. 

3.       Value of living/city culture.  This one is tricky, but people want to live where it’s cool.  Or trendy.  Or popular.  Or Weird.  Or liberal.  Or into music. Or movies.  Or sex.  Or religion. Etc.  This one is difficult because virtually all of these are fads.  Additionally, this is very much affected be negative factors such as crime.

4.       Weather/Climate (no joke).  Sooner or later, people will realize that blazing heat and bitter cold weather is to be avoided. 

5.       Limited Population contraction.  City growth is good, but frankly – a city staying a stable size is probably just fine.  However, I would avoid cities that are showing negative growth for a prolonged period.

At this point, I would not and do not advocate buying for appreciation alone.  Still, net worth is a wonderful tool for retirement, and any market must present upside, with limited downside before I’ll invest in it.

Diversification

The importance of diversification is largely undervalued in REI.  This is unfortunate as real estate is one of the few investments that if not properly managed, can cost considerably more than your capital.  Indeed, the list of former REI millionaires who have since gone bankrupt is concerning.  Even more concerning is the list of current REI millionaires who are bound to repeat history.

I would say that the three biggest defenses against this happening are:

1.       Never being cash-poor.

2.       Never being over-leveraged.

3.       Diversification.

Diversifying the markets that you invest in lets you hedge yourself against virtually all real-estate specific risks.  And given my long-term goals, security is vital, making the long-term diversification of my REI portfolio a must.

With that said, diversification only becomes relevant when assets reach a certain level.  The point at which economy of scale makes more sense than diversification is more art than science.  To say it another way, 3 of our next 4 purchases should be out-of-state, but it doesn’t really matter where our next single purchase is.

What’s Next

So far, I've outlined my long term strategy (http://www.biggerpockets.com/blogs/4117/blog_posts/28373-my-out-of-state-search-step-1-know-thyself) and just described how an out-of-state investment fits into that strategy.  Next, I plan to start looking at specifics, such as what type of place I’m looking for, and what my game-plan to finding that place is.

Other Resources

There are not a ton of resources out there for out-of-state investing, but I thought that including relevant resources in these articles might be worth-while:

Out of State Investing 101 by Ali Boone: http://www.biggerpockets.com/renewsblog/2012/12/22/out-of-state-real-estate-investing/
An interesting podcast by Jason Hartman with Jed Kolko (Trulia’s Chief Economist) that talks about appreciation indirectly – exploring real estate and population migrations.  http://www.jasonhartman.com/cw-316-trulias-jed-kolko-explores-real-estate-markets/