Investing in a rental property offers an opportunity to diversify your portfolio while creating a passive income stream. According to a report from the Joint Center for Housing Studies at Harvard University, the number of renter households in the U.S. increased by nine million between 2005 and 2015, making it the largest increase over a 10-year period since 1965. With demand for rental housing expected to remain strong in the new year, it may be a good time to think about where real estate fits into your investment strategy.

Rental Property Rates Will Continue Their Upward Climb

Zillow estimates that, on average, rates for rental properties will increase by 1.7% through August of 2017. Of the 35 largest metro markets covered by Zillow, rent prices are expected to see the fastest growth in San Francisco, Seattle, Denver, Cincinnati and Portland, Ore. (For more, see Top 10 Features of a Profitable Rental Property.) 

San Francisco may not be much of a surprise, but the other four reflect a growing real estate trend – the rise of the 18-hour city. These are places that are seeing a steady influx of new residents who are looking for somewhere to settle down that offers the amenities of a city such as New York or Los Angeles without the same cost of living. Think Denver, Cincinnati, Indianapolis or Austin, Texas.

To put it in perspective, the national median rent price for a one-bedroom apartment was $1,100 as of November 2016, according to Apartment List. A two-bedroom unit came with a median price tag of $1,260 per month. In Seattle the median rent for a two-bedroom was $2,210, putting it in Apartment List’s rankings of the top 10 cities with the highest rent. Although rents in the Bay City have stabilized somewhat over the last year, San Francisco took the number one spot, with a median monthly rent of $4,570. (For more, see Top 10 Most Expensive Cities in the U.S.

Higher Rents Produce Stronger Yields in Certain Cities

Rising rent prices may be less than welcome news for renters, but the opposite is true for investors who are buying rental properties in selected markets. RentRange recently identified the top 25 cities where rental rates saw the biggest jump between the third quarter of 2015 and the third quarter of 2016. Perhaps not surprisingly, Seattle was the top contender. 

Seattle rental prices increased by 16% year over year. That sounds like a major payday for investors, but it’s important to consider the gross yield, once operating costs are deducted. Seattle’s average gross yield for the third quarter was just 5.9%, which is roughly a third of the 15.3% yield investors in the Cleveland rental market netted. 

The takeaway here? When it comes to choosing a rental property to invest in, it’s all about location, location, location. According to the data from RentRange, many of the hot-spot cities that are set to be profitable moving into 2017 are located in the Rust Belt. For example, the top five performing cities in the study in terms of yield were Cincinnati; Cleveland; Canton, Ohio; Pittsburgh and St. Louis. 

Part of the resurgence of these cities can be attributed to Millennial transplants who are coming in search of job opportunities and affordable housing. For example, the Harvard data shows that nearly 40% of renters are under 35 and make less than $25,000 a year. As demand for rental homes heats up in these cities, rental prices will continue to climb correspondingly. If operating costs remain low, the end result for property investors may be a larger payoff. 

The Bottom Line

Owning a rental property isn’t a cakewalk. First you have to locate a suitable property and find a way to finance it. Then there’s the pressure to get reliable tenants and keep the property occupied, so your rental income remains consistent. In addition there are the day-to-day demands of keeping up with maintenance and repairs.

Despite those wrinkles, however, real estate can be an effective way to hedge against market volatility and generate an additional income stream. Looking ahead to 2017, the rental market certainly appears inviting from an investor’s perspective. Before you dive in, however, be sure to calculate the risks involved and research the market carefully, so you understand how much you stand to gain (or lose) from becoming a landlord.