After the Bubble: Rents and Housing Values (May 16, 2006)
Why do bubbles burst? One reason is that the supremely unprofitable nature of the bubble asset becomes abundantly obvious. For instance, housing. Back in the overheated real estate market of 1980-81, (Yes, Virginia, we had bubbles in the past, too) I recall an older real estate attorney shaking his head in dismay as he told me, "It makes no sense to buy a house as an investment now, but people keep buying them anyway." His point was that people were buying into a substantial monthly loss which they presumed/hoped would be more than offset by appreciation.
My friend's point was simple: if an investment doesn't make money in the here and now, it's a lousy investment. As buying a second, third, fourth or fifth house or condo has become a popular investment alternative to a boring, low-yield bond or underperforming mutual fund, my friend's observation becomes highly relevant. It makes no business sense to count on appreciation if you're digging yourself a deeper financial hole every month.
This is, of course, how bubbles form. With interest rates low, safe investments like certificates of deposit and bonds are unattractive; they're barely treading water above the rate of inflation or even losing ground. So the speculative, risky investments attract investors. As the money pours in (to gold, old cars, Chinese Internet stocks, copper futures, real estate, etc. etc.) then the asset prices rapidly inflate, attracting even more money to a "sure thing," "wave of the future," "real value," etc. etc. At some point, the punchbowl of cheap and easy credit is withdrawn, and the bubbly-drunk guests are stunned to find their high-flying jewel-encrusted carriage reduced to a mere pumpkin.
Can't sell that condo or house? "Just rent it out." Fine; but how does rental housing stack up as a business in the real world? Let's take a look. First, a caveat. Any scenario or extrapolation can be nitpicked or challenged in dozens of ways; quibbles abound when someone has a vested interest in discrediting a line of reasoning or evidence.
So don't take my word for it. If you're thinking of renting out your vacation or investment property, go talk to some landlords with five or ten years of experience. As this chart shows, the historic ratio between housing and rents--that is, the snapshot of housing as an actual business rather than a speculative gamble--has reached hitherto unknown heights. "Just rent it out." Easier said than done.
For starters: no uninsured worker ever fell off the roof of a municipal bond. No CD was ever trashed by vengeful tenants, and the plumbing bill for a savings account never rocked you back on your heels. Then there's the uncomfortable fact that rents have declined in many locales since the 2000 heyday, or have been flat for years: Bay Area rents stay the same. As the first chart shows, rents nationally have barely kept ahead of inflation. In other words: even as housing has shot up, rents have remained flat or even declined. Anyone expecting to make money on rising rents may be sorely disappointed. According to Barron's, Rental income nationally has fallen to $147.8 billion from the peak of $186.6 billion back in April 2002.
OK, let's crunch some numbers. Let's take a property purchased for $500,000 that rents for $2,000 a month. Is this a good business? Maybe a $500,000 house rents for more than $2,000 in your city, but in my region, since $500,000 only gets you a rundown bungalow in a lousy neighborhood or a small condo, you'd be lucky to get even close to $2,000 rent for your $500K investment.
First off, unless you "fudged" (i.e. lied) on your loan application, claiming that the property was your principal residence, an investment property carries higher loan rates and requires a 20-25% down payment. So let's assume you put down $100,000 and incurred another $5,000 in loan and closing costs, meaning that your investment in the property has to yield at least what the $105,000 cash would earn in a muni or high-grade corporate bond--at least 6% (but 7% is certainly available) or $6,300 a year.
Next is your loan balance of $400,000. Let's say you have an interest rate of $6.5%--very good for an investment property.The payments of principal and interest, according to the calculator at MSN Money, would total $2,528 per month.
For maintenance, let's assume your condo fees are about $400, or general upkeep on the house (maintaining the yard and typical repairs) will run an equivalent amount. (Remember that every once in a while there will be large bills for items such as replacing old sewer lines, a new furnace, a new roof, tree trimming, a new countertop or bathroom floor, etc., unless it's a brand-new house.)
Then there's management fees, which run about 6% of rent (even if you handle this yourself, your time isn't free), so that's 6% of $24,000 annual rent or $1,400 ($120 a month). Insurance varies widely around the country but let's plug in $100 a month ($1,200 annually). Property taxes also vary widely, but let's assume 1% annually is fair (though it's much higher in many locales such as New York, Texas and California). That's $5,000 a year or about $400 a month.
Since it's unwise to assume the property will never be vacant, let's shave 10% off the annual rent as an allowance for vacancies, reducing the $2,000 per month to $1,800. (Note that realtors are pleased to wave huge summer rental numbers around during the sales pitch but the reality is that many vacation homes sit empty unless someone spends major money advertising and promoting the property.)
As expenses add up to about $3,500 per month, that leaves a net loss of $1,700 per month, or $20,400 annually. But wait, you say--what about depreciation? Fine. The first thing to note about depreciation is that it comes back to haunt you when you sell the property, as all your depreciation is "recovered" when it comes time to pay the tax on your gain (if any). And remember, as an investment, there's no $500,000 giveaway on the gain; you pay tax on dollar one of that gain and recovered depreciation. Also note that you can only depreciate the building, not the land, so you can't depreciate the full $500K value.
Taking a standard 40-year depreciation (let's say the building is $350,000 of the $500K price, yielding an annual depreciation of $8,750), your loss is knocked down all the way to $11,650: about a $1,000 out of pocket a month, even counting depreciation. And let's not forget that you're foregoing $6,300 in net income by leaving the $105,000 cash in a losing investment.
You can quibble--but I got a loan at 5%, rents are going up in my area, I'll maintain the place myself, etc. etc.--but the bottom line is unavoidable: this is a lousy business proposition unless you can collect at least $3,500 rent per month for the property. Then there's the risks I mentioned. If you try to save money by hiring unlicensed, uninsured workers, and one gets injured, you could be facing a lawsuit which your homeowner's insurance may be unwilling to settle.
There are no guarantees in the rental housing business. You may not be able to find a decent tenant no matter how much you advertise, or you may get a tenant who suffers some family trouble or medical emergency and as a result can't pay the rent. The rental housing business is not risk-free. Neither are bonds, of course, but a short-term CD isn't going to get a stopped up toilet or suddenly stop paying the rent.
"Just rent it out." Sure, but be aware it isn't that easy and it almost certainly isn't profitable--unless you bought ten years ago in a desirable neighborhood and have spent serious money keeping the property in tip-top shape.
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copyright © 2006 Charles Hugh Smith. All rights reserved in all media.
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