Many excited real estate investors think they can get rich by using a bank loan to purchase and upgrade local fixer-uppers. While investing in real estate may be better than investing in the stock market – because the existence of small, local real estate markets creates inefficiencies investors can exploit – you'll need a more advanced level of understanding to make money in residential real estate. To go from handyman to real estate tycoon, you must understand the market, as well as the three key ingredients of 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 countrywide real estate environment, the odds are against them; 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 not everyone can 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, barring a momentary credit crunch, demand is likely to be higher, which can be withstood with 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 of over 3% annually, it is rare to see significant real estate weaknesses.

Lastly, unemployment-rate data is often the leading indicator of market softness. If people see few prospects for income 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 unemployment data from Case-Shiller Home Price IndexBureau of Labor Statistics, or other sources are excellent indicators of the top real estate markets' future health.

Local unemployment data are often highly indicative of the housing data. The smart investor seeks to invest in a city showing 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 thus 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, then invest in real estate on the perimeter. However, if the market looks ominous or vague, stick to the inner rings, so as to have a buffer against reverse urban sprawl.

Warning signs telling you to stay away from the perimeter include material unemployment changes and/or slowing economic growth in the local area. You could also 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 attrition of labor supply. 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 at the core. This is where the least depreciation is likely to occur, since full housing markets make this the least likely place for the disruption of balance in supply and demand.

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 layer further, 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 the location of stoplights. That is where future commercial properties, such as suburban strip malls, will be built; as residential real estate development fills in around these future strip malls, property values will likely jump significantly relative to average real estate returns.

The Bottom Line

The opportunity for above-average rates of return seems greater in the real estate realm than the financial instrument realm, since there are fewer eyes looking at nonhomogenous units. Knowing the local market also produces an 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 limited capital and tremendous insight into the sweet spots. Regardless of your time frame, you should first look for a strong national market, then a region where publicized data shows decent HPA opportunity. Finally, play the urban sprawl perimeter if you believe the area is growing, or stay away from it if you see it as shrinking. Understanding these key points can help maximize the value of any real estate portfolio.

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