When evaluating real estate, be it a market, a business, or the general economy, I try to pick a few key variables that I want to study. These variables can be almost anything: employment growth, population growth, the school system, proximity to a large deli, building permits, and so on.
The problem is, if you choose too many variables, you can get stuck in analytical paralysis. Choose too few and your analysis will be too easy. It’s important to use variables that are easy to measure, easy to understand, and that can answer your questions.
For me, I have a few favorites: interest rates, housing affordability, and population growth, to name a few.
But today we’re going to talk about another variable: income growth. It might seem like an obvious metric, but we’re going to dig deep into it and see exactly what this metric can and cannot tell us.
Best of all, this concept is super easy to apply to your own real estate investment. Yes, there will be charts! There will be math! There will be a lot of good ol ‘common sense! But all of this is just to show you why income growth is a useful variable. From there, it’s easy to use for your own investments.
What is Income Growth?
Income can be measured in a number of ways, but for the purposes of this study we will be using 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’ll just call “income” for the rest of this article as it’s shorter and I’m not paid by the word.
What we are looking at here is the Average Annual Growth Rate (CAGR) for the period 2010-2019 (most recent data year). This gives us a simple percentage growth rate. For example, the median income in Oakland, California rose from $ 49,000 to $ 82,000 in 2010 through 2019, a CAGR of 5.84%.
Easy! So this meets my first two criteria for a good metric – easy to measure and easy to understand.
What does income growth tell us?
There are many ways to measure whether a variable is helping us answer the question at hand. One of the easiest and most reliable methods is to plot the variables on a chart.
The questions I asked myself on this project were:
- Does Income Growth Predict Rental Growth?
- Does it predict appreciation?
So I planned it. 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 is pretty self-explanatory: as income growth increases (to the right), rent tends to increase too! Hooray!
To further measure the interplay between these two metrics, I added a trend line to the chart and even displayed the R2 number (coefficient of determination). The math behind all of this can get tricky, but the following is important to know: The R2 is essentially what percentage of the change in rental CAGR is explained by the change in income CAGR. For that, the answer is around 28%.
Think about it – we can explain about 28% of the change in rental growth from 2010 to 2019 by looking at a single variable! If you are new to this type of analysis, you are probably thinking, “28% are for fools, give me more!” But believe me, this is great. Remember how many possible variables contribute to how rent grows over time, and with just that one metric we can explain 28%.
I also drew something similar for house prices:
As you will see, the dots on this graph are much more dispersed, which we don’t like as we generally learn less. The numbers back it up, with our R2 being around 9%. That’s not as good as rent, but it’s still pretty good. Think again about how many crazy factors go into whether a home appreciates or not, and that one factor can explain 9% of the appreciation.
This fulfills my last criterion: Does the metric actually answer the question at hand? In this case, yes!
No more diagrams or mathematical explanations, I promise. As I said earlier, it’s really easy to apply this concept to your own investments: places where incomes are likely to rise, and rents too. While income growth is generally less of an indicator of appreciation in value, it helps, and it certainly doesn’t hurt the prospect of appreciation to see income growth.
Since all of the data we’ve looked at so far is historical, how can we predict where income growth is likely to be? Here are a few things I like to check out:
- 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 this data in your local market.
- Employment rates. When employment rates are high, there is competition between employers for good workers. In order to win this competition, employers often raise salaries, thereby increasing the median household income. Depending on where you live, the government can provide employment data or just google it.
- Job growth. Take a look at which companies are investing and entering a particular market. Has a tech company just opened an office in the city? Or did someone just leave? In any case, the choice of companies to invest in a particular market has a huge impact on income. Again just go with Google.
Another aspect of income growth is the pension to income ratio (RTI). I’ve written about this in the past so you can read this article here, but here are the basics.
RTI measures the percentage of a tenant’s income that goes into their home. In general, anything below 30% is considered “affordable” and anything above is “unaffordable”. Personally, I think the prospect of rent increases drops significantly when the RTI rises above 30% – as it should be, people should stop spending on rent.
Remember, income growth has shown that it can help us understand rental growth and, to a lesser extent, appreciation. But nothing we’ve shown here suggests that income growth will actually help us understand cash flow or returns for any particular market or business.
Top rental growth markets
Hopefully I have now convinced you to use income growth as one of the tools in your toolkit in assessing where and when to invest in real estate. If you want to look at some markets, here are the top 20 markets for income growth between 2010-2019. There are some obvious (San Francisco, Seattle) but some other lesser-known markets that have strong cash flow potential.
In addition to the metrics discussed above (income, rent, appreciation CAGR), I also considered the rent-to-price (RTP) ratios for these markets. I did this because my initial bias was that these cities would all be very expensive and therefore not have good cash flow prospects. However, this is not the case.
Remember that RTP is a good proxy for cash flow and anything above 0.5% is considered good. Cities like Seattle, San Francisco, Denver, and Washington DC may not offer the best cash flow prospects, but there are some gems on this list. Take a look at Cape Coral, Florida, and Reading, Pennsylvania, for example!
And don’t be discouraged if you live in or near these larger cities. Often times, income growth extends beyond city limits and helps increase rents and house prices in the adjacent suburbs and cities – so check this out!