Given the political developments in the past few months, a relevant question every real estate investor should be asking is, should I invest in blue states?
Let me begin by saying that this post is not intended as political commentary. That is not what this site is about. Every real estate investor should be analyzing each potential investment in terms of ROI and inherent risks. Once the ROI has been calculated, it has to be adjusted to compensate for the level of risk. Political risk in blue states has become a significant risk factor that must be considered.
Blue states are defined as those states where the majority of the people living in those states vote democrat or lean towards voting democrat. Blue states tend to have more regulations and more social programs, which result in higher taxes, and a higher cost of doing business. You can see which states are blue states here.
In many of these blue states, it is interesting to note that while the large urban centers are blue, the suburban and rural areas tend to be more red, or conservative. However, the populations of the urban centers far exceed the population of the non-urban areas, which results in the majority of the state voting for democrats.
Impact of Blue State Policies on the Real Estate Market
The environment of stricter regulations and higher property taxes makes investing in blue states more challenging. This has largely resulted in higher home prices and higher rents.
For example, in California, there are strict environmental regulations that either prohibit or delay the construction of new housing. This leads to higher costs and lower supply, while demand for housing remains robust. The end result is higher home prices and higher rents.
Most investors, home buyers, and tenants just accept the higher cost of housing as the price they had to pay to live in California.
There have been 4 recent developments that make investing in blue states even more challenging, namely:
1) Underfunded Government Pension Plans
Many blue states granted generous pension plans to their police, firefighters, teachers, and other government workers. The pension payments to retirees are consuming an ever-increasing percentage of government tax revenues. Politicians seem loathe to cut spending so their go-to solution is to increase taxes which were already the highest in the nation.
Residents of these states began exploring more affordable options and the net migration out of these states began. You will note from the chart below, that the 10 states in the USA with the highest net migration out of the state, are all blue states.
This net migration consists mostly of middle-class people who pay the majority of the taxes. As the exodus continues, the tax base will shrink, pushing the politicians to raise taxes even more.
2) Coronavirus Lockdown Policies
I discussed in a previous post what the impact of the coronavirus lockdown would be on the real estate market in general. As the coronavirus pandemic unfolded, the blue states enacted far more restrictive measures than the red states.
At the time of this writing, many of the red states have lifted their restrictions while the blue states continue with their lockdown policies. The longer it continues, the greater the damage to the economy; more business closures, and higher unemployment.
Landlords were particularly hard hit. In addition to the anti-eviction measures enacted under the federal CARES Act, blue states enacted even more restrictive eviction regulations, costing landlords millions in lost rental revenue.
Recently landlord organizations are filing class-action suits against the government seeking compensation for their loss of income. It remains to be seen if the landlords will prevail. However should they win in court, the government could be forced to pay out millions in compensation, putting further stress on their budgetary problems.
3) BLM Protests
Of even greater concern is the Black Lives Matter protests across the nation. The protests in blue states seem to be larger and more violent. Government officials have restricted the actions of the police resulting in more property damage and destruction.
4) Defund the Police Movement
As an extension of the BLM protests, there are now calls from the left to defund and/or disband the police departments. Many politicians in blue states are actually entertaining the idea. Should they follow through with such a policy, crime rates are likely to increase, resulting in higher insurance rates.
How Will These Developments Impact Real Estate Markets?
Some may argue that these developments are just temporary and all will return to normal in the next few months. I hope they are right but I fear that may not be the case. Let’s look at the worst-case scenario and what the net effect will be.
1) Migration out of blue states
The net migration out of blue states will likely continue, if not accelerate. This will be particularly true in urban centers in blue states. Demand for housing will fall resulting in lower home prices and lower rents. The IRS’s recent migration report shows that the nation’s seventeen flat and no income tax states won a net 1.9 million residents and $120 billion in Adjusted Gross Income (AGI) from blue tax states during the 2000-2018 period. This trend shows no signs of reversing.
2) Higher Insurance Costs
If government officials fail to regain control of their communities and the police are disbanded, home insurance costs are likely to increase significantly. In some communities, it may become impossible to insure against vandalism and fire from unnatural causes. Homeownership will become more expensive and riskier.
3) Higher Taxes
As the migration out of blue states continues, the tax base will shrink further and taxes will be increased. The obvious targets are sales taxes and property taxes. As housing becomes more unaffordable, the migration will only accelerate. At some point, the supply will exceed the demand, and home prices will drop.
4) Social Unrest
As state and municipal budgets become more stressed, services are likely to be reduced or even eliminated. More protests and social unrest are likely outcomes.
These factors in their totality create a giant feedback loop that does not end well.
The Bottom Line
Looking at the bigger picture, investing in blue-state real estate, particularly urban centers in blue states seems like a highly risky proposition. It would be more prudent to invest in smaller municipalities or get out of blue states altogether.
For the home flippers, there is still opportunity in the short term. Investors should pay close attention to the political developments in their investment areas and be prepared to act quickly to avoid losses.
The good news is that once this trend has run its course, there will be ample investment opportunities. The city of Detroit is a good example. It has worked through most of its financial mismanagement issues. You can read the history of Detroit’s problems here.
As you can see from the chart below, average home prices, although extremely low when compared to other US cities, have been increasing since the bottom in 2012. Unfortunately, many other cities in the USA, particularly those in blue states are about to go through the same process.