Identifying Undervalued Neighborhoods

I remember having a conversation about nine years ago with a very wealthy individual about what neighborhoods would have the best future appreciation in the local real estate market. She replied, “That’s easy, the same neighborhoods that have always had the best appreciation.” I nodded my head in agreement. It seemed like the perfect answer. But there was something in me that didn’t totally buy in. If neighborhoods appreciate at the same rate they always do, then how are gentrifying neighborhoods with rapid increases of home values explained? What causes the exceptional upward momentum of rising prices?

By the time I had that conversation, I had witnessed several neighborhoods in Nashville, TN experience rising property values that did not line up with their historic appreciation rates. They were beating their previous track record. Those neighborhoods had been undervalued, but began over-performing to compensate. Renovations were being completed by homeowners and investors alike. As more dollars poured into the improving neighborhoods, others took note and wanted to buy in as well. Activity furthered more activity, and successful flips led to more investment projects. I watched with a desire to understand what market forces were at work. And I began to anticipate what neighborhoods might be next. I knew that being able to identify undervalued parts of town would be key to future investment success.

In the book titled Zillow Talk: The New Rules of Real Estate, the authors write that, “Conventional wisdom says you should pay attention to ‘location, location, location.’ But, it’s much more important to focus on ‘future location, future location, future location.’ In other words, the best real estate strategy isn’t necessarily to buy a home in the most desirable part of town. Sometimes, the best strategy is to buy a home in the neighborhood that’s going to become the most desirable part of town.”

One approach to finding the next hot neighborhood is simply to look in the surrounding geographical area of the premier area. When prices in that most desired area reach a high enough point, buyers will begin targeting properties near the premier one, raising demand and thus values. Many neighborhoods have boundaries such rivers, interstates, or commercial thoroughfares that restrict growth in one or more directions. When that is the case, a popular neighborhood may only have one or two directions to grow toward. I frequently examine maps, looking for clues that will reveal which area the growth is heading.

Another indicator of a neighborhood poised for takeoff is the age of the housing stock. The older the dwellings, the more room there is for improvement. Renovations and improvements to houses built in the 1990’s do not have the same monetary impact as renovations of 1920’s houses. Neighborhoods built in the 1940’s or earlier offer the most potential. If a neighborhood has consistent historic housing stock that is priced well below nearby neighborhoods, wise investors will take note. It doesn’t matter if the condition of the houses are poor. If the city is growing in population, these are target areas that will eventually lead to dramatic profits.

Neighborhoods that have a below average rate of home ownership can also be ready for a breakout. Similar to the principle of the older houses, rental properties have typically not maximized their potential and therefore have room for great price gains. Landlords often defer maintenance and only do what is absolutely necessary to keep their properties rentable. These houses can be easier to acquire from long-time landlords rather than owner-occupants. Checking the number of building permit applications can reveal that an area is experiencing more improvement projects. I like to drive through different neighborhoods, keeping an eye out for new roofs, additions, paint, or landscaping. Wherever there are signs of money being invested, values will rise. As the visual appearance of these neighborhoods improves, they become popular. Sales and renovations can catch like wildfire, and when that happens, price gains are sure to follow.

When buyers are shopping for a house, they often can’t find a home that is the right size, in the right condition, in the right neighborhood, that also fits within their budget. Something has to give, and the compromise can go in any direction. But if there is a house that is the optimal size, condition, and price only a couple of miles from the most-desired neighborhood, it is easy to see how the buyer chooses the nearby, cheaper area. When this scenario gets played out multiple times, the price difference between the premier neighborhood and the cheaper one begins to lessen as more buyers select it.

Wise investors will ask the question, “Why pay top dollar for property A in a great area, when I can pay half of that amount for property B, and the difference between them in ten years may only be 10-15%?” The monthly cash flow from a rental house is a large component of the profit picture. But the long-term appreciation can be just as significant, and sometimes even more so. Investors who have experienced their property values doubling in a few years know the appeal of appreciation. In especially hot markets, it can dwarf the gains of annual cash flow. However, finding undervalued neighborhoods in growing cities can be a challenging game as more areas undergo price increases.

My primary investment strategy is built on buying properties at a discount in neighborhoods that I believe are undervalued as well. This allows me to have a two-fold opportunity to profit from above average future appreciation and built-in equity at the point of purchase. While I continue to look in highly-desired, premier neighborhoods to find possible investment properties, I realize I am much more likely to find good deals in the neighborhoods that aren’t quite there yet. Fortunately, my market, Nashville, TN is rapidly growing and there is no shortage of areas rising in value. The downside is that there seem to be less areas that are truly undervalued. It can be hard to stay ahead of the curve, but also not take greater risks of buying into neighborhoods that never experience the transformations and corresponding profits. It is a delicate balance that is all part of the game.