Double down in a market you know or diversify?

Question: “I recently got my first rental property and I plan to get another one soon. Is it better/smarter to buy another in the market I’ve done the most research in or try to identify a new market (such as another city or even state) to diversify my portfolio?”

Congratulations on your first rental property!

Short answer:

In most cases, you should stay in your own market, at least for a few more deals.

The one compelling reason to explore other markets is if you’re not able to find acceptable deals in your own market. If there aren’t any/many deals nearby—as is the case in certain areas of California and the Northeast—then you don’t have much choice. In that situation, if you want to do deals, you have to look elsewhere. Or try to identify a different strategy that might work in your area.

But that doesn’t appear to be the case here. The question says that you “got your first rental property” and implies that there are other acceptable deals nearby. Further, the question asks about the desirability of diversifying a portfolio, not of the necessity to look elsewhere.

Related: How To Prepare Properly Before Buying Your First Property

Note: I’ve referred several times to “acceptable” deals. The definition of “acceptable” will vary with the investor. Usually, it refers to your return on investment. It might also include the location of the property, the ability to find “good” tenants, the availability of property management if you’re not going to manage the properties yourself, and so on. What another investor might find acceptable might not meet your standards, or vice versa.

With that out of the way: Stay in your own market.

Markets vary. Even areas within markets vary. I looked at a property last weekend. It was a small 3 bed/1 bath house that needed serious updating. The house, about 60 miles from Washington, D.C., would sell to an investor for about $100,000. Fixed up, it’d be worth maybe $250,000. If it were 25 miles from Washington in one community, the numbers would be closer to $225,000/$400,000. But in another D.C. suburb, only 10 miles from the city, the numbers would be around $130,000/$300,000.

You need to know your markets. I’ve gotten “burned” twice on out-of-town properties that seemed to be good deals, but weren’t. And it’s not just that prices and rents will vary. It’s also more difficult to do your “due diligence” on out-of-town properties.

Point One:

If you’ve done the most research on your current market and are finding acceptable deals, then stay in that market for a while. Improve your knowledge of the market and your experience in finding and negotiating deals.

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The questioner’s objective is to diversity his/her portfolio. The concept of diversification involves spreading and thereby reducing the risk. If one investment turns bad, the others hopefully won’t. And it’s true that different markets, especially over time, will perform differently. Some will do better, some worse. But the question deals with rental properties. While the value of the property itself may fluctuate substantially, rents tend to be a lot more stable. Even in the real estate meltdown of 2007-2010, when some property values dropped by 50% or more, rents in most places stayed flat or nearly so. If it was a good investment pre-2007—and that’s measured largely by return on investment—it likely remained so during the rough years that followed.

Point Two:

If the property starts off as a good rental investment, it’s likely to remain so.

Related: Understanding The Yield Curve

A final comment: Diversification doesn’t just mean broadly geographically. As noted above, you can diversify geographically within a market. Or you can diversify based on type of renters: A property near a university probably will attract more students. A property near a military base probably will attract more military. (Incidentally, while both of those tend to have a lot of turnover, the demand for military and student housing is likely to remain strong.) Or diversify by type of structure (single-family home, townhouse, duplex, triplex, and so on).

Point Three:

You can diversify within a single geographic market.

Longer term, you may want to explore other geographic areas. But if your area—where you’ve done the research already—has good, investible properties, stay there for the time being.