Investing In A Rental Property

What if someone told you the market for investing in single family homes was red hot? You might just think they’re crazy. In major markets, single family homes are red hot. BusinessWeek reports several “name brand” locales like Phoenix, Boston, and Washington D.C. are red hot with new buyers. Some owners report having multiple offers for their newly listed properties.

So what’s so hot about single family homes in 2012? Low costs of borrowing, excellent spreads between rental prices and mortgage payments, and a minute uptick in job growth. Elsewhere, investors are padding the real estate market with fresh cash to make their foray into the rental business.

Single Family Homes as Investment Property

The market for single family homes isn’t propelled solely by live-in buyers. In fact, even hedge funds have stepped up their interest in tangible property, purchasing homes to rent as perennially falling rates allow for higher returns on invested capital.

Single Family vs. Mutli-Family Property

Single family homes are usually off-limits for investors seeking cash flow. Multi-family homes offer much larger returns relative to the sales price, partially due to the limited interest for multi-family property. The real kicker is in the details – a collection of events favors single family homes over multi-family property as an asset class.

The single family home advantage can be broken down into a few key components:

  1. Appreciation – Single family homes tend to appreciate faster than multi-unit properties because of a changing demand curve. Investors tend to have much greater access to capital more reliably, whereas live-in demand ebbs and flows with employment. Investors using leverage to purchase a single family property have significant cash-on-cash upside on any uptick in property values.

 

  1. Liquidity – At any given time there are far more buyers interested in a single family home to live in rather than a multi-unit property. For one, higher prices for multi-family units leaves out much of the market interested in owning a home. Secondly, few people interested in a single family home are interested in the rental business – even at a discount, few people would agree to make the switch to live in a multi-family home. Besides, it’s likely much of the market for live-in homes is already seeking to escape a shared wall with another person.

 

  1. Potential tenants – This is purely anecdotal, but the experiences of other landlords suggests that the rental pool for single family homes is better than the rental market for duplexes or apartments. Single family renters are more likely to be established families – people interested in living in the same place for a considerable period of time due to job proximity, school districts, or neighborhood choice. Lower turnover boosts rental profits, as the home experiences fewer vacancies and less tenant-to-tenant maintenance like painting and landscaping.

From Catalyst to Exit Plan

Hedge funds are notorious for higher portfolio turnover. Institutional interest in single family homes suggests that funds see a catalyst for a smooth exit, with large cash on cash returns. So what do hedge funds see that other investors might not? Why would hedge funds (an investor class typically disinterested in collecting rental checks from individual families) favor single family homes over multi-family homes?

It might have everything to do with the macro.

The 2010 census reveals just how rapidly home ownership changed in the last three decades. In 1980, 22.1% of people aged 15-24 owned their own home. In 2010, only 16.1% of the same age group owned a home. The same decline in homeownership is also found in the 25-34 age group, with 51.6% of people 25-34 owning their own home in 1980 compared to 42% in 2010.

This shift is not as noticeable when one studies all age groups. Some 64.4% of Americans owned their home in 1980 compared to 65.1% in 2010. The aggregate reveals an opposite trend; homeownership has increased despite lower homeownership rates among younger Americans.

Starter Home Appreciation

Individuals aged 15-34 (more importantly, those aged 25-34) were the make-up of the housing boom – the people who purchased starter homes in cramped suburban neighborhoods for the opportunity at the American dream.

Is the American dream really dead? Did those 15-34 give up on home ownership forever? Not exactly. A more likely cause and effect sequence can be found in employment. At the end of 2011, 23.7% of Americans 16-19 were unemployed by official measure. Those aged 20-24 faced an unemployment rate of 14.2%. Meanwhile, unemployment for all ages was 8.6%.

Suffice it to say that the best new source of demand might just come from this age group – the age group most likely to experience the fastest employment growth. This is also the age group that would be most interested in inexpensive single family homes so popular with investors. Given the available financing (FHA requires only 3.5% down), any increase in employment can quickly change the dynamics of the buyer pool for single family property.

So there’s the exit. The alignment of trends looks far too perfect – a single source of demand is temporarily forced out of the market, rates are at record lows, and unemployment among a core demographic is testing new highs.

Continued job growth will only fuel the capacity for would-be buyers to snatch up inexpensive homes favored by landlords, and continued stagnation only fuels the necessity for others to rent. If unemployment stays near its highs, the rental market enjoys continued strength. If unemployment falls, new buyers come in to push up prices for single family homes.

For hedge funds and for individual real estate investors, this appears to be the perfect storm. Limited cash outlays for leveraged property plus high rental rates and a culmination of factors supporting future appreciation makes single family homes a fantastic wager for the long haul. As with any investment, we will have to wait and see how this plays out, but whether or not housing appreciates in value, rental checks will roll in as investors ride out the dip.

Comments

  1. Kurt @ Money Counselor says:

    You make a compelling case. I wonder: Would your argument extend to condominiums? I’m guessing not in at least one respect. The younger cohort you identify as the source of future single family home demand would likely not, in general, be looking to buy a condo. What do you think?

    • Larry Ludwig says:

      It depends. Condos have a different dynamic than single family homes. Condos are usually for singles, couples without children or empty nesters. I own a single bedroom condo, but it’s in an area that has a lot of singles and a great nightlife. When I sell it I should have no problem finding a buyer. In another community it might be a different story.

    • JT says:

      I think the biggest downfall to condos as an investment is the HOA risk – it’s a cost that can easily rise well in excess of increasing rents. Also, not all condos are pre-approved for FHA financing, which I really do believe will be the single driver of home purchases if and when the market improves.

      • Larry Ludwig says:

        HOA – this brings up a great discussion.

        It depends upon how well the condo association is managed. Before purchasing ask for the past 10 years of HOA fees. It should match the rate of inflation. If not then either they were charging too little, or some major improvements needed to occur. If a new condo or less than 5 years old, watch out. Many times the builder does not properly price HOA fees and can dramatically increase once real costs become known.

        Also ask for the prospectus. Find out what you are responsible for or not. For example: In some communities, you are responsible for the windows, while with others you are not. In some you are responsible for your patio, in others you are not. What are the common areas, and what can or cannot do to improve your unit.

        Also if an investor, it helps if you are on the board. You have much more input into the management, and aware of costs.

  2. David says:

    I don’t particularly want to be a landlord… But as you say, the spread is very large. A 4 unit apartment building just sold near me for $80k. Nice looking building too, just needed a little fixing. Rents would be at least $500/month each. Seems like the building could pay off pretty quick. I’ll have to look into some local houses as well.

    • Larry Ludwig says:

      $80k? I need to move to your area of the country! I just looked at a duplex (6 bed/4 bath total) that’s for $600k. Granted the rental rate is $2200/mo for a 3 bed/2 bath each and next to the beach. But that’s a much lower risk ($60k invested) to generate almost the same amount of cash flow per month in the $600k property I looked at.

      I would figure the positive cash flow for that property is approximately $1,400/month.

      That seems like a no brainer. Very little capital, and could pay for itself in no time. If you don’t want to be a landlord, you could hire a management company who would take typically 10% off the monthly cash flow.

      • JT says:

        You can buy duplexes in the midwest for $40-50k that spew $1,200 in monthly rents. No repairs needed. Granted, these are older units, so the 50% rule would probably apply – half your rents will eventually go to repairs or capital expenditures.

        Either way, the midwest absolutely kills in terms of cash flow. Appreciation – not so much. That’s really the wager…will there be any upside from appreciation, or is it all cash flow? With or without appreciation, the numbers are incredible!

        • Larry Ludwig says:

          Rentals IMHO should always be for the cash flow. Appreciation is a bonus. I’m not expecting huge appreciation in the next 10 years unless we have massive inflation.

          • JGC says:

            The Fed has $4.4 trillion on their balance sheet because of monthly bond buying over the last few years. They will unwind it over the course of the next few years. Will there be high inflation?…you bet. Will the stock market take a hit?…you bet.

            What’s our only hope to moderate both?.. the US remaining dominant in the world economy and hope that the emerging market countries need us to grow their middle classes.

  3. Krantcents says:

    Buying homes to rent out is a good move right now. You have a perfect storm of low prices and low interest rates. The numbers alone make renting out a home very viable.

  4. Evan says:

    My problem with single family rentals are the vacancy risk but I guess hedge funds would have that mitigated if they owned a TON of them.

    I wonder if they would be allowed to create their own Non-traded REIT that they would almost 100% and then run it that way for the tax benefits?

    • JT McGee says:

      No one can own more than 10% of a REIT. I heard that forever ago but never really thought about why that rule would be in place. It all makes sense now!

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