When I evaluate real estate, be it a market, a deal, or the economy in general, I try to pick a few key variables to research. These variables can be almost anything: job growth, population growth, the school system, proximity to a major deli, building permits, and so on.
The problem is, if you choose too many variables, you get stuck in analysis paralysis. Choose too few, and your analysis is too simplistic. It is important to use variables that are easy to measure, understand and answer your questions.
For me, I have a few favorites: interest rates, housing affordability, and population growth, just to name a few.
But today we’re going to talk about another variable: income growth. It may seem like an obvious statistic, but we’re going to take a deep dive and learn exactly what this statistic can tell us and what not.
And best of all, this concept is super easy to apply to your own real estate investments. Yes, there will be charts! There will be math! There will be a lot of good old common sense! But all of that is just to show you why income growth is a useful variable. From there it is easy to use it in your own investments.
What is income growth?
Income can be measured in a number of ways, but for the purposes of this study, we are going to use census data (more specifically for those who will ask me later, the American Communities Survey [ACS] from 2010 and 2019).
What the ACS shows is median household income, which I’m just going to call “ income ” for the rest of this article because it’s shorter and I’m not paid by word.
What we’ll look at here is the compound annual growth rate (CAGR) for the period 2010-2019 (data from last year). This gives us a simple growth rate based on percentages. For example, the median income in Oakland, CA, grew from $ 49,000 to $ 82,000 from 2010-2019, representing a CAGR of 5.84%.
Easy! So this meets my first two criteria for a good statistic: easy to measure and easy to understand.
What does income growth tell us?
There are many ways to measure whether a variable helps us answer the question. One of the simplest and most reliable ways is to graph the variables.
The questions I asked when I started this project were:
- Does income growth predict rental growth?
- Does it predict appreciation?
So I turned it off. On the vertical axis, we have rental growth (I used BPInsights data and calculated the 2010-2019 CAGR). On the horizontal axis we have income growth.
What we see here speaks for itself: when income growth goes up (to the right), rent usually goes up too! Hoera!
To further measure the interplay between these two metrics, I added a trendline to the graph and even displayed the R2 number (coefficient of determination). The math behind all of this can get complicated, but here’s what’s important to know: The R2 essentially indicates what percentage of the change in rent CAGR is explained by the change in income CAGR. For this, the answer is about 28%.
Think about that – we can explain about 28% of the change in rental growth between 2010-2019 by looking at a single variable! If you’re new to this kind of analysis, you’re probably thinking, “28% is for assholes, give me more!” but trust me this is great. Think about how many possible variables contribute to how rent grows over time, and in this one metric, we can explain 28%.
I’ve also plotted something similar for house prices:
As you will see, the dots in this chart are much more spread out, which we don’t like because it usually means we will learn less. The numbers confirm that, with our R2 at around 9%. That’s not as good as rent, but it’s still pretty good. Again, consider how many crazy factors contribute to whether a home values or not, and with this one factor, we can explain 9% of the valuation.
So this meets my last criterion: do the statistics actually answer the current question? In this case, yes!
No more graphs or mathematical statements, I promise. As I mentioned before, applying this concept to your own investments is really easy: places that are likely to see income growth, and that are likely to see rent grow too. While income growth is generally less of an indicator of valuation, it does contribute, and it certainly does not detract from the valuation outlook to see income growth.
Since all the data we’ve looked at so far is historical, the question is, how can we predict where income growth is likely to occur? Here are a few things I like to watch:
- Historical data. Historical trends don’t necessarily predict future performance, but historical data is still very important (as we saw above). Try the census, or just Google around for this data in your local market.
- Employment figures. When labor participation is high, there is competition between employers for good employees. To win that competition, employers often increase salaries, simultaneously increasing the median household income. Depending on where you live, the government can provide employment data or just try Googling.
- Growth of jobs. See which companies are investing and moving to a particular market. Has a technology company just opened an office in the city? Or just left? Whichever companies choose to invest in a particular market have a big impact on income anyway. Again, just go with Google.
Another thing about income growth is to look at the rent-to-income (RTI) ratio. I’ve written about this in the past so you can read that article here, but here are the basics.
RTI measures what percentage of a tenant’s income goes to the home. In general, anything below 30% is considered ‘affordable’ and anything above that is considered ‘unaffordable’. Personally, I think when the RTI gets above 30%, the prospect of rent hike diminishes significantly – as it should be, people shouldn’t spend more than that on rent.
Remember, income growth has shown it can help us understand rental growth, and to a lesser extent, appreciation. But nothing we’ve shown here indicates that income growth will actually help us understand cash flow or returns for a particular market or deal.
Main rental growth markets
I hope I have now convinced you to use income growth as one of the tools in your toolkit when evaluating where and when to invest in real estate. If you want to get a head start on some markets, here are the top 20 markets for income growth between 2010-2019. There are some obvious ones here (San Francisco, Seattle), but there are some other lesser known markets with strong cash flow potential.
In addition to the metrics we discussed above (income, rent, CAGR valuation), I also threw in the rent-to-price (RTP) ratios for these markets. I did this because my initial bias was that these cities were all going to be super expensive and therefore not have strong cash flow prospects. However, that is not the case.
Remember, RTP is a good proxy for cash flow, and anything above 0.5% is considered good. So while cities like Seattle, San Francisco, Denver, and Washington DC don’t offer the best cash flow prospects, there are some gems on this list. For example, take a look at Cape Coral, Florida and Reading, Pennsylvania!
And don’t get discouraged if you live in or near some of those larger cities. Often times, income growth extends beyond city limits and helps raise rents and housing prices in neighboring suburbs and cities, so check that out!