What is Submarket Risk in Real Estate?

What is Submarket Risk in Real Estate?

Posted by on Mar 5, 2022

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Real estate investing involves various types of risks. Categorizing and identifying those risks is one of the first steps to managing them. One risk you are likely to encounter is submarket risk. Virtually every real estate investor is susceptible to this risk since nearly all properties are in some submarket. Let’s look at what a submarket is and how to analyze its risk.

What Is A Submarket?

A real estate submarket is a defined sub-sector of a larger real estate market. Major cities usually have many different submarkets. 

Large cities are diversified across many aspects. This includes population, income, culture, geography, and industry, to name a few. An example of a submarket might be a suburb away from the city center and industrial areas. It is quiet, has well-educated, high-income residents, and great schools. Its boundaries are well-defined. Let’s call this submarket A.

The above area is quite different from another section of town near the railyards, has a low-income population and high crime. We’ll call this Submarket B. Both of those areas are also different from a low-income area experiencing gentrification (Submarket C).

While the city that contains all of these various submarkets or neighborhoods has its own economic factors at play, submarkets also have micro-economic factors that affect only those markets. This means property values can vary widely across submarkets.

The city may be an industrial town driven largely by the manufacturer of automobiles. With a lot of automation in recent years, the city has been in an overall decline due to the loss of jobs in the auto sector. However, some high-tech companies have moved into the city center.

Submarket A is experiencing growth due to its well-educated residents, who are mainly tech workers. While some of these workers commute to the city center, others are able to work remotely from their homes.

Submarket B is not able to take advantage of the shift from the automobile industry to tech. Many of its residents have had to move to a different city. This submarket is experiencing a population decline.

Submarket C is on the up and up. However, it is a bit of a gamble as the demographic is very diverse, making it difficult to get a read on potential. But the area seems to be heading in the right direction (i.e., overall improvement).

Submarkets aren’t restricted to just neighborhoods or areas of a city. It might also mean sectors such as industrial, office, residential, or mini storage.

Analyzing Submarkets Against Macro Environments

Analyzing a submarket is similar to analyzing a macro market (i.e., the encompassing city). Taking a top-down view helps focus on the broader picture vs. just the submarket. A top-down view means analyzing the macroeconomy then drilling into the submarket. Starting at the macro level allows you to see if larger forces are at play that might affect a submarket, even if it is strong.

For example, Submarket A in the previous section looks strong. However, the macroeconomy is declining due to automation in the auto industry. While some tech companies have moved to the city center and workers are able to work remotely, if tech companies stop moving in or even begin moving out, Submarket A might suffer. Additionally, Submarket A is vulnerable to a shift in remote working. As the pandemic gets further and further into the rearview mirror, more companies may begin requiring workers to come into the office.

So yes, Submarket A is very strong in isolation, and its future looks bright, but it is still dependent on the macroeconomy.

What Is Submarket Risk?

The previous section demonstrates submarket risks inherent in Submarket A due to the macroeconomy. But what risks does Submarket A have in isolation — meaning, idiosyncratic risk?

If Submarket A’s housing doesn’t grow fast enough to meet demand, housing prices will continue increasing. This may start pricing out new residents who want to move in but can’t afford to, even with a high income. Submarket A might also be geographically restricted and can’t grow anymore. This will be the case if the area is hemmed in by a lake and mountains. This can all put an upper bound on Submarket A’s growth.

Unearthing submarket risks can be difficult as these risks can be unfamiliar. One example is an area located in a 300-year floodplain but is marked by not being in a floodplain since it has never flooded there in living history. Finding this information requires lots of digging, understanding of how floodplains are rated, and any workarounds that may have bypassed floodplain restrictions. 

Just because an area is deemed not in a floodplain doesn’t mean it can’t flood if the conditions are just right. This was the case in Houston during Hurricane Harvey, when many homes thought to be safe from flooding were, in fact, flooded by several feet of water.

If you don’t know a particular local submarket, it’s certainly worth spending the time to appreciate its microeconomics and other characteristics fully. A local realtor should also be able to help in identifying various nuances of the local market.

 

This material is for general information and educational purposes only. Information is based on data gathered from what we believe are reliable sources. It is not guaranteed as to accuracy, does not purport to be complete and is not intended to be used as a primary basis for investment decisions. Realized does not provide tax or legal advice. This material is not a substitute for seeking the advice of a qualified professional for your individual situation. Examples shown are hypothetical and for illustrative purposes only.

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