The Unassuming Economist

From First American:

“Over the past year, increasing investor activity in residential real estate, particularly in single-family homes, has drawn a lot of attention. News of large institutional investors snapping up single-family homes underscored this summer’s historically hot housing market. Investors now own an estimated 2 percent of single-family rental housing units in the U.S., but investor activity varies significantly across markets. Adapting a metric commonly used for measuring the return on investment for commercial real estate can help identify the most attractive markets for residential real estate investors.

Housing’s Investment Return

Investors in commercial real estate often use a concept called the capitalization rate (cap rate) to calculate their potential rate of return on a real estate investment. The cap rate measures the net operating income of a property – its rental income less any operating costs, such as property taxes, insurance, and maintenance and repair costs – compared to the value of the property. Similar to the yield on a bond or the rate of return on an investment, the higher the cap rate, the more profitable the investment. While commonly calculated for commercial real estate transactions, it can be applied to residential real estate as well.

To calculate the typical market-level residential cap rate, take the median residential market rent and assume that the property will be vacant for three of the 12 months of the year (the typical vacancy assumption mortgage lenders use when underwriting a residential investment property), leaving an investor with nine months of collected rent. After accounting for property costs – property taxes, maintenance costs and annual homeowner’s insurance premium – we are left with estimated total rental income. Dividing the estimated total rental income by the median home sale price in each market yields a residential cap rate.

Which Markets Offer the Highest Return?

Breaking down the cap rate for the median single-family home in each of the top 50 U.S. markets reveals the residential housing markets that are potentially the most profitable from a real estate investment perspective. Of the top 50 U.S. markets, the five markets with the highest cap rates in the third quarter of 2021 were Pittsburgh (3.4 percent), Birmingham, Ala. (3.3 percent), Memphis, Tenn. (3.3 percent), Detroit (3 percent), and Virginia Beach, Va. (3 percent). The five markets with the lowest cap rates were New York (0.1 percent), San Jose, Calif. (0.3 percent), San Francisco (0.4 percent), Los Angeles (0.7 percent), and Boston (0.9 percent).”

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