- Interest Rates & their Effect on Rentals
- Changes in the Rental Industry
- Interest Rates & their Effect on Rentals
These days the sales market is the largest issue affecting rentals. Since the housing recovery began we have discussed several times how this has led to an overall drop in tenant quality. A large number of higher credit tenants opt instead to purchase their home. A larger than usual number still rent without a doubt, but there are also significantly more rental homes as well.
This has played out exactly as we have expected. Rental rates have leveled off or moved slightly downward, and have most likely peaked. That said, few markets are more resilient than rentals, as was clearly proven during the late 2000 meltdown. We would not anticipate a major drop in rental rates under any but the worst circumstances. What we do expect to occur is a continuation of tenant quality decline, with a slow decline in rates as a consequence.
Days vacant should stretch out slightly, and the spread on rental rates should as well. By spread, we mean the difference in rent for a high income / credit tenant, and one without.
What many homeowners fail to account for is that you rarely have “the” rental price. A savvy investor will have to consider what type of property they have, and what type of credit standards can maximize their specific situation. For example, if you have a 4BR party pad near the college, you certainly should consider that your tenant search needs to go dramatically different than the 4BR on a cul de sac in a traditional neighborhood 4 blocks away.
You also need to know that your expense situation will be very different too, and this is often where landlords go wrong. They hone in on the highest possible rate while failing to consider that a higher rate almost always means higher expenses and more headaches.
This is the exact concept behind banks charging low credit customers much higher interest rates. I believe someone once won a Nobel Prize with a theory that it’s impossible to earn a higher rate of return in a halfway efficient market, without an equal increase in risk. We consider this to be generally true in the rental market too. The point, don’t think you will have your cake as well as eat it. You also cannot go the higher rent, higher expense route, if there is an emotional tie to a property, or you will be unhappy.
So keeping with the example above, we would typically accept the higher rent on the party pad, and work hard to effectively keep costs down. After all, the risk of higher expenses isn’t all bad relative to the certainty of lower rent, if cash flow maximization is your goal.
If however, you plan to sell your home at the first chance you get, you’ll want to escrow a large amount of those funds for a true makeover before selling. This is almost always necessary to sell a rental, but it could be significant in that case. On the 4BR in a traditional neighborhood, we would want to go with slightly lower rent and be much more choosy on credit standards.
So while we would disagree with the method, you certainly could treat the traditional neighborhood like the party pad, and rent for much more than your neighbors. This is where you have a spread of potential rental rates. We always say we could rent all our houses in the first week for top dollar if we didn’t have such high credit standards. Instead, pricing is an art, not a science, and we work hard to balance vacancy (most fail to realize how costly this is), rental rate, and tenant quality, effectively for each situation.
So as more high-quality relocations choose to buy over rent, making them more scarce, you’d need to accept lower rent in order to open up your renter pool. You could opt to maximize your rental rate, but you typically must shoulder much more risk to do so. We do not manage many properties in the party pad fashion as we are firm believers in long-term consistent income and expenses. When we do it’s almost always because there is no other exceptional alternative given the situation.
In fact, while the prototypical party pad will typically net a much higher rent due to the tenants splitting costs, and often receiving subsidies, the 4BR in the traditional neighborhood that runs a strategy focused primarily on rental rates would typically only enjoy about 10-20% higher rent. While shouldering massive risk, and almost guaranteed headaches.
Another major issue that must not be ignored is the fact that most renters are paying an “off the historic charts” % of their income in rent. It’s very hard for the middle class to get ahead when they’re paying most of their income to rent, food, and healthcare, and typically leads to a further bifurcation in the potential rental pool. So you end up with most falling in the extremes as in who is renting for a logical reason, and who is renting because they have no other choice. VRE is a firm believer that when moving to the extreme, by far it’s best to go for quality.
“It’s far better to buy a wonderful company at a fair price, than a fair company at a wonderful price.” Warren Buffett
Since we don’t claim to know where interest rates and energy prices are headed, it’s important to touch on the alternative. Should energy prices rise, that typically hits consumers the hardest but would have a minimal effect on housing relative to interest rates. However, the combination of both moving up at the same time would surely be a massive weight on the US economy. Also a large spike, in either case, would have serious consequences. We’ll focus more on interest rates in our case. Should they spike, this would affect housing in a myriad of ways both generally, and in regard to investments, which is what we manage. In the chart below you get a jolting look at just how much interest rates matter. Home loan rates in 1981 were in the 18% range. Also, this isn’t inflation-adjusted meaning you get a lot less house for 300K.
For housing in general, as you can see above, monthly payments would spike. This would affect both those still stuck in adjustable-rate mortgages, as well as new buyers. For adjustable owners, you’d undoubtedly see a rise in foreclosures, an issue that has been declining for years now. We all know how foreclosures affect housing, and it’s not something that occurs quickly. For new buyers, you’d actually see an early spike in sales, quite possibly significant as people rush to cash in on low payments. One of our gripes about the financial industry is their ability to sell the monthly payment, rather than the much more important issue of net worth.
The largest factor in rental investment in our opinion, is the effect higher interest rates have on investor sentiment. Most have at least a basic knowledge of how this works but to quickly summarize. As interest rates rise, this makes taking risk less necessary as you can get a solid return without it, by putting your money in the bank and earning the higher interest. This creates a rebalancing of the entire economic platform and affects investments of all types.
For example… Today you can get maybe .75% on average for a savings account. That’s $7.5 per $1000 saved, or in other words, not enough to matter. Especially when you compare this to the risk-takers making money hand over fist in the stock market. (S&P 500 gained nearly 30% in 2013).
If you’re like me, given the unprecedented runup in stocks, and the suspect way in which it was facilitated, you’d feel much better about putting your money in a savings account at 18%, as in the example above from the 1980s.
You would see a gradual but consistent flow from riskier assets to safer ones if rates were to rise, and the importance of this cannot be overstated, particularly given current leverage for both private, public, and state. Housing is not considered risky, but many do not love being landlords, and if they can get a decent return on their money in a zero risk bank account, those properties would go on the sale block.
As investors in multi-family, we have witnessed a particularly interesting occurrence. Given the low rates, risk in stocks, and even bonds, investors have been paying ridiculously high figures for multi-family buildings. While overpaying is never a great idea, if you are going to do so, multi-family is probably the best place because as we stated, few sectors are more resilient than middle-income rentals. Of course, this wouldn’t offset bubble prices, and it’s possible we’re heading there, but that’s the reasoning at least. We won’t delve into the bond market (loans of all types from governments, to housing, to furniture), but we do feel it’s important to clear up a couple of misconceptions. Bonds (these days in particular) are just as speculative as stocks and have been driven higher almost exclusively by government intervention, so it stands to reason taking that intervention away would be a problem.
It’s also shockingly large relative to stock markets, so even minor matters reverberate far and wide. Therefore, given the gasoline that has been poured on this giant market in the form of unnatural government intervention, bonds cannot be considered the safe haven they are often billed to be, even though we do think the FED will do everything in their power to keep the party going.
To present this point from a different perspective, we’d actually love to see rates rise. Given that we’re long-term investors who typically opt for the lower rates of shorter-term loans such as 10 and 15 years, these changes would actually flood the market with great-priced housing investments as investors move into safer, easier to manage assets. This is precisely the reason we think central banks around the globe will suppress rates for as long as possible, and that could be a lifetime.
