Capital Perspectives: Rental homes – it can’t be that easy

Listen to this article

While there are substantial variations between markets, the price for a typical U.S. home has now eclipsed the pre-crisis level. Despite this, housing affordability is still quite high by historical standards per the National Association of Realtors Housing Affordability Composite Index, which tracks the affordability of housing based on a mix of median home prices, median incomes and mortgage rates. The index currently registers at 157.7, compared to the long-run (since 1986) average of 138.84. Since the turn of the century, the index has been as low as 102.7 in the heady days of the mid-2000s and as high as 207.3 in early 2012 as the implications of the financial crisis were still filtering into the real economy.

Despite higher levels of housing affordability, per the U.S. Census Bureau, the home ownership rate in this country dropped precipitously from a peak of 69.2 percent in mid-2004 to match the 1965 figure of 62.9 percent in mid-2016 before rebounding somewhat to 64.2 percent today, compared to the long-run (since 1965) average of 65.2 percent. This lower-than-historically-normal level of home ownership (which is also a partial cause of elevated levels of home affordability via downward pressure on home prices) is the result of both economic factors (i.e. tighter lending standards, damaged credit and lack of affordable entry level housing) and changes in consumer preferences (i.e. millennials who saw their parents’ homes go into foreclosure may prefer to rent).

Largely because of the data points in the two preceding paragraphs, renting has become more expensive relative to owning in many markets in recent years. In finance parlance, an “arbitrage opportunity” was created. Meaning, if it is expensive to rent and cheap to buy, you should become a landlord. Indeed, we suspect capital invested in residential rental real estate has earned above-historically-normal returns in recent years. However, no asset class or investment strategy (whether it be rental homes or stocks) can be expected to earn above-average returns indefinitely. Additionally, like all things where a return is expected, there are risks involved with rental properties, some of which seem to go unnoticed (and perhaps uncompensated) based on conversations I’ve had with investors.

We are not implying that people should avoid owning rental homes. Many people have done well in this field for long periods, and there is obviously a demand for it. However, we do encourage people to think of their real estate returns as part labor (although this can be reduced via the employment of a manager at a cost), for which you earn a wage, and part return on a concentrated position in a risky asset. Also, just because real estate is not marked to market every second like publicly traded stocks, their resale values and the rental streams they command are subject to change.

Consider an investor with several residential rental properties in a suburb with a better-than-average school district. Now imagine a scenario where the school district breaks in two or three and there is a clear haves-and-have-nots dichotomy between the schools. If one’s holdings are on the wrong side of that dividing line (where neighborhoods with high concentrations of rental properties would likely fall), the homes become less desirable, which would bleed through to rental rates and resale values.

This column should be taken with a grain of salt as I am just a finance guy who has never, and probably will never, own a rental property. Just a friendly reminder that there are no panaceas in investing.

Chas Craig is president of Meliora Capital in Tulsa (www.melcapital.com).

This column has been prepared by an employee of Meliora Capital, LLC. This column is for information and illustrative purposes only. It is not, and should not be regarded as investment advice or as a recommendation regarding any security mentioned herein. Opinions expressed herein are current opinions as of the date appearing in this material only and are subject to change without notice. Reasonable parties may disagree about the opinions expressed herein. The representations made in this column are based upon publicly available information and assumptions about future economic variables which may or may not be reflective of actual occurrences. Meliora Capital, LLC its employees or affiliates may have an economic interest in the securities identified herein.

All investments entail risks. There is no guarantee that investment strategies will achieve the desired results under all market conditions. This information is provided with the understanding that with respect to the material provided herein, that you will make your own independent decision with respect to any course of action in connection herewith and as to whether such course of action is appropriate or proper based on your own judgment, and that you are capable of understanding and assessing the merits of a course of action.

By accepting this material, you acknowledge, understand and accept the foregoing.