As the real estate market cools and potentially slides into a downturn (which is natural and not the same as a crash, mind you), investors must examine their risk exposure. New data from ATTOM shows that Southern and Midwestern markets are at the least risk for a serious downturn overall.

The markets with the most significant risk exposure to a downturn were (perhaps predictably) in and around Chicago, New York City, and inland California.

But what makes a real estate market risky? Should investors always avoid these areas? Make no mistake – where you invest matters. Equip yourself with the knowledge to see the warning signs.

5 Signs a Housing Market is Vulnerable to Decline

Sign #1 – Higher Foreclosure Numbers

High foreclosure rates signal homeowner financial difficulties, such as job loss, reduced income, and high debt levels. This economic distress can be a symptom of broader economic problems affecting the housing market. When foreclosures increase, those properties are also put back on the market at a reduced price. This, in turn, can pull prices down across the board. That leads us to our second vulnerability…

Sign #2 – Underwater Mortgages

Mortgages are considered underwater when the balance owed on the property is more than its valuation. This creates negative equity, so a seller would owe more than they earn from a home sale. Not a situation any property owner wants to be in! Unfortunately, we may see more of this in the future as home prices level out. If someone overpaid in a bidding war, they could end up underwater.

Sign #3 – The Affordability Gap

What share of the market’s median income goes to housing? It’s pretty safe to say that the 28% maximum is impossible for many. Both owning and renting homes are more expensive, and wages aren’t keeping up. According to The Joint Center for Housing Studies from Harvard University, the home price-to-income ratio is at an all-time high.

So why does this make a market risky? If households are increasingly overleveraged, an economic bump in the road may prevent them from meeting all their debt obligations. This can lead to eviction and foreclosures. We’ve already discussed how those can impact the housing market!

Additionally, when housing costs take up most of one’s income, economic participation (and thus, economic growth) becomes more challenging. This is all connected. If someone is living lean because housing is unaffordable, they’re less likely to (for example) patronize a local small business. The local economy and its diversity are instrumental in the housing market’s health, so you can see why there’s a domino effect!

Sign #4 – Economic Instability

Let’s expand. Markets in areas with weak or declining local economies, job losses, or major employers leaving often experience reduced housing demand and falling prices. Pay attention to the employment rates in any investment market under consideration. Look at trends. Investigate business openings and closures, the diversity of industries in the area, and the major employers present. Are local policies and lawmakers friendly to small businesses?

The stronger the economy, the higher the wages, the better the employee retention. This leads to population growth and increased housing demand.

Sign #5 – Speculation and Overvaluation

We’re rolling speculation and overvaluation into one, not because they’re the same, but because they’re often intertwined. A market primarily driven by speculative buying, where investors purchase properties expecting quick profits from price increases, can quickly backfire! Speculation creates overinflated values that won’t last once the hype dies down.

Overvaluation happens for other reasons, too, but speculation is undoubtedly one of the factors. The market may be overvalued when property prices are significantly higher than historical averages or are rising much faster than local incomes. The other shoe must fall eventually – resulting in a price correction.

We want to cap this off by offering a quote from Realtor.com Chief Economist Danielle Hale, “We’re at a point…where your experience in the real estate market depends on where you are. It’s more local now than it has been at other points of time.”

Further Reading: Why Remote Real Estate Frees Investors to Dream Big

As a real estate investor, you know that location matters. Be prudent about where you invest. Aim for markets with a history of stability, economic strength, and predictability. Watch for the red flags. Understand that how you experience the market and succeed in this industry depends on where you plant your flag.

Learn more about some of the best real estate markets for passive income. Talk to your REI Nation advisor today!