Many excited real estate investors think they can get rich by using a bank loan to purchase and upgrade local fixer-uppers. While investment opportunities in real estate may be better than alternatives like the more homogeneous stock market because the existence of small, local real estate markets that create inefficiencies investors can exploit, you'll need to understand more than this to make money in residential real estate. To go from handyman to real estate tycoon, you must understand the market and the three key ingredients to strong real estate gains.

Look for a Healthy National Market
While experienced and astute real estate investors may be able to make some money in a weak national real estate environment, the odds are against them, and the odds of success for newer investors in such a market are even worse. Rising interest rates can throw a lot of cold water on an otherwise hot real estate market because those who have purchased real estate with adjustable rate mortgages have to pay more to keep it and those who don't have real estate often can't afford it. This leads to reduced demand for real estate, and prices fall accordingly.

Thus, when starting to build your real estate portfolio, the ideal time is in a declining interest rate environment. Generally speaking, not only will your loan be less expensive, but demand is likely to be higher, barring a momentary credit crunch, which can be withstood by good capital management.

Another desirable trait is a healthy gross domestic product (GDP), since this figure really speaks to the overall health of the economic system that supports the real estate market. In healthy GDP times, such as growth above 3% annually, it is rare to see significant real estate weaknesses.

Lastly, unemployment-rate data is often the best leading indicator of market softness. If people see few prospects for income around where they live, they move. In turn, this greatly reduces home price appreciation (HPA).

Choose a Specific Location
If you find flat to falling interest rates, decent GDP growth and respectable unemployment rates in the national market, you can start looking for a desirable local market. Seek out an area with relatively strong appreciation potential relative to other markets. Well-publicized data like the Case-Shiller Home Price Index and Bureau of Labor Statistics unemployment rates are excellent indicators into the future health of the top real estate markets.

Local unemployment data is often a leading indicator to the housing data. The smart investor looks to invest in a city that is exhibiting healthy unemployment trends and relatively strong HPA data. Hopefully, this is a city where you live and therefore have a strong grasp of the vagaries of the local marketplace and can easily manage the property. However, with sound management controls, it can be possible to invest successfully in other locations where quality management partners are available.

Find the Urban Sprawl Inflection Point
Once you have found the ideal city for your desired investment, look for the urban sprawl hotspot. If you see the city expanding and can tolerate some risk, invest in real estate in the outer perimeter. However, if the market looks ominous or vague, stick to the inner rings so that you have a buffer against reverse urban sprawl.

Warning signs to stay away from the perimeter include: material unemployment changes and/or slowing economic growth in the local area. Or simply look at the underlying business health of the major employers in the area. If it is weak, layoffs are likely coming, which could start to suppress real estate values due to marginal labor supply attrition. If the business health of the area's major employers is strong, the opposite is true.

Real estate values can vary widely within a metropolitan area. For example, if the average HPA in a city is 5%, it may be 2% downtown, 6% in the first suburban ring and 10% in the second suburban ring. The third ring would likely be farmland with modest HPA potential. Note the phenomenon here. Your most volatile real estate appreciation will happen in the outer ring adjacent to the farmland because this is the outer cusp of the city. This location leverage is exploitable by owning the edge in growth markets. Logically, in a down market, you would want to be in the core. This is where the least depreciation is likely to occur since full housing markets make this the least likely place for supply and demand balance disruption.

Understanding investing risk in different areas of the city is very similar to understanding how financial instruments generally behave. Think of the urban area of a city as investment-grade bonds, the first suburban ring as equities, and the outer ring as derivatives. Understanding where the urban sprawl inflection is occurring in a city can bolster returns on the upside, or protect investment on the downside.

For fun, let us peel the onion one more layer to find the hottest areas. Suppose that you decide to invest in the perimeter since you see economic growth and growing labor demand in the area. You could try to anticipate stoplight location. That is where future commercial properties like suburban strip malls will be built, and as residential real estate development fills in around these future strip malls, property values will likely jump significantly relative to average real estate returns.

Conclusion
The opportunity for above-average rates of return seems greater in the real estate realm than the financial instrument realm since because are fewer eyes looking at nonhomogenous units. In addition, knowing the local market produces investment advantage. A long-term or buy-and-hold strategy is better if you have ample capital and limited opportunities, while a short-term or flipping strategy would make more sense if you have tremendous insight into the sweet spots and limited capital. Regardless of your time frame, you should first look for a strong national market, then a region where publicized data shows decent HPA opportunity, and finally, play the urban sprawl perimeter if you believe the area is growing, or stay away from it if you think it is shrinking. Understanding these key points can help maximize value of any real estate portfolio.

Related Articles
  1. Home & Auto

    Simple Ways To Invest In Real Estate

    Owning property isn't always easy, but there are plenty of perks. Find out how to buy in.
  2. Home & Auto

    Tips For The Prospective Landlord

    Investing in rental property can generate serious income, but there's more to it than collecting rent.
  3. Home & Auto

    Uncover The Next Real Estate Hot Spot

    Real estate land speculation is a way to get in on a hot investment before a boom hits.
  4. Home & Auto

    5 Things Every Real Estate Pro Knows

    Find out how to stop chasing the market and start leading it.
  5. Home & Auto

    Exploring Real Estate Investments

    Discover how owning properties can give you a roof over your head or a check in your pocket.
  6. Investing Basics

    10 Habits Of Successful Real Estate Investors

    Enjoying long-term success in real estate investing requires certain habits. Here are 10 that effective real estate investors share.
  7. Investing Basics

    5 Types of REITs And How To Invest In Them

    Real estate investment trusts are historically one of the best-performing asset classes around. There are many types of REITs available.
  8. Investing Basics

    5 Simple Ways To Invest In Real Estate

    There are many ways to invest in real estate. Here are five of the most popular.
  9. Investing

    Why We’re Bearish On U.S. Housing

    Hedgeye analyst Josh Steiner discusses the reasons behind our decision to go from bullish to bearish on the U.S. housing market.
  10. Investing Basics

    How to Get More Yield From Your Investments

    Yield seeking investors can boost the amount of income their investments generate through tweaking their portfolio of stocks and bonds.
RELATED FAQS
  1. Where do you get real estate leads?

    Real estate leads come from real world networking in addition to online sources. Tried and tested avenues of following up ... Read Full Answer >>
  2. What is a derivative?

    A derivative is a contract between two or more parties whose value is based on an agreed-upon underlying financial asset, ... Read Full Answer >>
  3. What is securitization?

    Securitization is the process of taking an illiquid asset, or group of assets, and through financial engineering, transforming ... Read Full Answer >>
  4. Can hedge funds trade penny stocks?

    Hedge funds can trade penny stocks. In fact, hedge funds can trade in just about any type of security, including medium- ... Read Full Answer >>
  5. Can hedge funds outperform the market?

    Generating returns that exceed those provided by the broader market is the goal of nearly every investor. However, the methods ... Read Full Answer >>
  6. Where do penny stocks trade?

    Generally, penny stocks are traded through the use of the Over the Counter Bulletin Board (OTCBB) and through pink sheets. ... Read Full Answer >>
Hot Definitions
  1. Flight To Quality

    The action of investors moving their capital away from riskier investments to the safest possible investment vehicles. This ...
  2. Discouraged Worker

    A person who is eligible for employment and is able to work, but is currently unemployed and has not attempted to find employment ...
  3. Ponzimonium

    After Bernard Madoff's $65 billion Ponzi scheme was revealed, many new (smaller-scale) Ponzi schemers became exposed. Ponzimonium ...
  4. Quarterly Earnings Report

    A quarterly filing made by public companies to report their performance. Included in earnings reports are items such as net ...
  5. Dark Pool Liquidity

    The trading volume created by institutional orders that are unavailable to the public. The bulk of dark pool liquidity is ...
Trading Center