Rental Investing

By Cassandre Juste & Brian Davis

Location, location, location - everyone already knows the three most important factors in real estate investing.  But how do you determine what makes a profitable location?  Maybe the upcoming stadium to be built in a gentrifying neighborhood?  Or speculation on the influx of jobs in a given city?  People choose their real estate investments for all kinds of reasons, but here are three tangible ways to measure the best cities for rental investing.

Capitalization Rates

Cap rates are a quick and easy way to compare potential investments by determining the ratio of rental income to expenses.  For the uninitiated: higher cap rates mean higher income and lower costs, which equals profit.

According to CoreLogic, the top five cities with the highest average cap rates are:

1. West Palm Beach, FL -  12.4 percent
2. Cleveland, OH – 12.3 percent
3. Fort Lauderdale, FL – 12 percent
4. Chicago, IL – 11.6 percent
5. Las Vegas, NV – 11.4 percent

Vacancy Rates

Another factor that can determine an ideal location for a rental investment is the city’s vacancy rate.  There are two types of vacancy rates: one is the percentage of time, in a given year, the specific property is likely to be vacant (this is what is calculated into the cap rate), and the other is the geographic vacancy rate.  The geographic or local vacancy rate is the percentage of vacant units in a specified area (e.g. a sub-division, or within a city's limits), so the lower the vacancy rate, the better for investing.  That means more monthly income and less time finding tenants to fill empty units.

According to Forbes.com, the cities with the lowest vacancy rates are:

1. New York, NY - 2.4% vacancy
2. Minneapolis, MN - 3.3% vacancy
3. San Diego, CA - 3.4% vacancy

Landlord-Friendly Laws

Lastly, an oft-overlooked aspect of evaluating rental property locations is the local landlord-tenant law.  Certain states have dramatically more tenant-friendly legislation than others, so it is critical to be aware of the landlord-tenant laws where you are considering investing.

One of the more landlord-friendly states is Arkansas where failure to pay rent on time, for any reason, is grounds for eviction.  Further, when tenants lease property in Arkansas, the renters are accepting it "as is." The only required maintenance is that which would violate health and safety housing codes.  In the more renter-friendly states, including California, New York, Illinois and New Jersey, if a renter is without, say, hot water, they can legally withhold rent until it is fixed (or pay to fix it and deduct that from the rent).  Another example of a city that is more renter-friendly is Baltimore, Maryland.  In Baltimore City, the eviction process takes at least three months, often longer, while the landlord must carry the mortgage and the tenant simply lives for free.  And when a judge does agree to allow an eviction to move forward, the landlord is not automatically granted a money judgment - they have to apply through another court process to recover past due rent.  For many Baltimore landlords it is not worth the trouble.

Often large cities such as New York, Philadelphia, San Francisco, and Seattle have more strict laws and regulations at the city level.  The state of New Jersey has strict landlord registration requirements and specific step-by-step regulations to follow for eviction.  In some instances, even though a city may be tough on landlords regarding laws and regulations; the state itself may not be.  While Philadelphia levels harsh regulations including registration, long eviction turn-arounds and a Fair Housing Commission that can interfere in tenant eviction cases, Pennslyvania's state laws are far more landlord-friendly.  In cities like this, if landlords slip up on the minutiae and details they could extend the already lengthy timeframe in which to remove a problem tenant.

While local employment rates and upcoming improvements are worth bearing in mind, remember that capitalization rate and vacancy rate are impacted by all of the other economic factors, and are more direct measurements of potential profitability.  And after all of the economics have been evaluated, remember that even good economics can be hindered by arduous landlord-tenant laws.