In college I once had an economics professor instruct us to “Buy low and sell high.” At the time I mumbled under my breath “thanks for the insight …”
Here I am more than a decade later still trying to figure out how to consistently buy low and sell high. Like many Americans I bought my home when prices were overinflated. With a bad taste in my mouth from my most recent experience in the housing market, I was not quite sure how to react when my firm concluded that now is the best time in 50 years to get into the residential rental market. Trying not to be biased, I began to evaluate this idea like any other investment looking at the supply, the demand and the risk to principal.
Walking through any suburban neighborhood makes it abundantly clear that housing prices have fallen and reasonably priced rental properties are available. Since 2008 there have been more than 5 million foreclosures with another 3 million on their way. With this abundant supply it is no surprise that the median home price has fallen more than 35% from its peak in 2008. For somebody wanting to enter the rental market this is a buyers’ market.
With home ownership falling in America the demand for rental property will continue to growing for at least the next few years. Banks now require most buyers to put down a 20% deposit on a new home, making home ownership harder to achieve. Additionally, former homeowners who underwent a foreclosure have been forced to become renters. As the demand for rental property has increased, rents have too.
Lower housing prices and higher rents make a perfect formula for increasing yields on rental investments. It is no surprise that a Goldman Sachs economist estimates that rental properties will yield 6.3% on average nationwide and more than 8% for investors who have bought distressed properties. I believe that well researched rental property acquisitions should average a yield near 10% annually.
Rental property has always been attractive to people looking for monthly income, because tax sheltered distributions come every month the rent is paid. In today’s market a 10% return looks great, but with a rental property it is even better because part of your income stream will be tax sheltered. The tax code allows an investor to depreciate the value of a rental home over 27.5 years. This means that if you bought a $100,000 dollar home with a lot that is worth $20,000 dollars, $80,000 can be depreciated over 27.5 years. In this case your first $2,900 of income would be sheltered from taxation until the property is sold.
Looking at the current supply and demand for rental properties it is clear there is a strong case for entering the rental market in 2012. The biggest concern for investors making this decision is; what is the risk to my principal? My theory is that pendulums often swing too far and housing prices are currently undervalued. Although I don’t know if anybody is qualified to call a bottom quite yet, with 25% of homes worth less than the mortgage balance, a number of industry experts are starting to suggest that we are near the bottom.
Even if an investment property could make as much as a 20% return on investment, I have no desire to receive a phone call in the middle of the night because of a plumbing issue at my rental property. I also want to avoid running the risk that home I bought was a lemon for one reason or another (mold, structural problems, etc.). To avoid excessive risk to principal, and become a repairman for my properties, it is best to invest in a diversified pool of homes managed and operated by a third party.
The old cliché “All real estate is local” holds as true today as ever. Markets like Las Vegas were grossly overbuilt in the boom years and have now been slaughtered with the price crash, while markets like Indianapolis took modest hits to property values. If you plan to become a landlord, and want to avoid the location risk find a way to diversify in different markets that were not grossly overbuilt.
Investing in the housing market today appears to be a great opportunity. In order to find the best opportunity for our firm we will be looking for programs with many houses in them spread across several markets. We will also look for the best and most experienced property managers. Great property managers can make a losing property win, while poor property managers can make a winning property lose.
Michael Roberts is a resident of the Chicago suburbs and has a degree in economics from the Miller School of Business at Ball State University. He is a Series 7, 22, and 63 Registered Representative with Alliance Affiliated Equities Corp. specializing in alternative investments. He invites questions or comments at (800) 453-5155 or by email at email@example.com.