Rental Property Fundamentals

By Brad Thomason, CPA

 

The act of determining what to invest in is essentially an exercise in comparing alternatives.  In theory, an investor figures out what they want (in terms of target returns, duration, risk profile, etc), and then they go looking for assets which fit the goals.  Once they have a list of candidates, they pick the best ones.

Real estate has historically been the classic diversifying asset.  It is the most commonly considered alternative when looking for choices outside of the classic stock/bond paradigm.  The reasons are plain enough.  Real estate has a physical appeal (you can visit it, see it in action) in comparison to financial assets which today aren’t even represented by a piece of paper so much as a number on a computer screen.

More substantively, real estate has a tendency to perform based on a set of factors other than those which move stocks and bonds.  The degree to which two assets move together is referred to as correlation, and for diversification purposes, low levels of correlation are a plus.  Real estate gets to “check that box” as part of a larger portfolio that also contains more traditional stock and bond holdings.

So how is real estate doing these days?  Well, back in December of 2013 the Joint Center for Housing Studies at Harvard University put out an interesting report titled America’s Rental Housing:  Evolving Markets and Needs.  A couple of interesting statistics jump out which would tend to support the report’s assertion that recovery from the 2008/2009 meltdown is well underway.

According to the report, since 2009 the overall percentage of vacancies across rental properties of all types has fallen every year.  The total decrease across the period went from 10.6% in 2009 to 8.5% at the end of 2013.  Significantly, during this same period, the overall number of rental units has increased every year by an average of about 2%.  So today there are more units, AND a smaller percentage of them are vacant.  That’s a pretty clear indicator that there is still a strong appetite for rentals; and that the underlying properties themselves have the fundamentals on their side in terms of preserving value both as a store of capital, and a generator of yields.

Some periods of time are better than others for getting deals.  That’s true of all asset classes.  In the midst of the meltdown it was not uncommon to hear war stories about investors picking up extremely discounted deals as a result of wide-spread panic and distress.  But just because those circumstances have abated over the past couple of years, don’t assume that there aren’t any deals left.  Banks still hold a lot of troubled paper which they are unloading more quietly today than in the recent past.  Tax lien forfeiture remains a great way to end up with a significantly discounted property, too (although it is probably better to view this as a nice added benefit from tax lien investment, rather than the goal itself.  If you want a specific property it is still usually more workable to get it through more conventional means, since there is no way to know if the tax lien is going to go all the way to maturity.  Most of them don’t.).

Beyond that, there are always deals to be found.  Even if you pay closer to market than you would like, if the house can generate a good cap rate at that price, and has some prospects for additional appreciation to boot, you may have a much better alternative than what the stock or bond market is offering.

Now, real estate is definitely not the only place to look for assets to diversify away from the classic stock/bond mix.  But it is usually the first place where most investors look, and for good reason.  Real estate can offer significantly different return characteristics; and given the size of the industry which has grown up to support property ownership, investing in real estate certainly doesn’t mean that you have to manage it yourself.  There are long lines of seasoned pros waiting to do it for you, at fee rates which still make your net earnings very attractive yield-wise.

So if your current mix is not to your liking, don’t overlook real estate.  The deep discounts of the meltdown years may be harder to find.  But the good news is that may not matter.  You can still find really good deals which will outperform many of your other investments.  And the indications are that the space is back on very stable footing.  Which is always a nice thing, amidst the chaos which often accompanies investing in other asset classes.

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