Bag has a friend who owns a residential rental property worth, according to Zillow, 450k at today’s prices. His tenant pays $1750/month (21K/YR). Insurance & taxes run about $2600/yr. Maintenance on the property, conservatively speaking, is $200/month ($2400/yr). In just the last few years, he has replaced the air-conditioner/heat pump, garage door, and garage door opener…not to mention having dealt with broken water pipes, demands from the city to remove dead trees, dilapidated fencing, and broken windows. So yeah, $2400 per year maintenance is conservative. Once taxes, insurance, and maintenance have been accounted for, the math says he nets 16k on a 450k asset, which works out to about a 3.5% return on his money.
As of the time this was written, you could buy 6-month treasuries and get an annualized, risk-free return of 5.33%, which works out to about 24k/year on a 450k investment. So Bag asks, why would anyone who owns a 450k asset continue to take on all the headaches of being a landlord for a paltry return of 3.5%??? The only way it begins to make sense from their perspective is if they believe real estate prices are headed up, and/or interest rates are headed down. Unfortunately for Bag’s friend, or anyone long real estate, interest rates are NOT headed down, and real estate prices are NOT headed up.
Let’s start with the easy one first: Interest rates (Click here for a deeper dive). Rates have been increasing at the fastest pace in history over the last year. The people with the most control over current interest rates (the Fed) are promising more increases in the near future. In fact, it appears they are likely to jack rates another .5% at their next meeting, which means by then, we can expect the return on 6-month treasuries will be about 6%. It is a universal law of wealth, that money goes where it is treated best, in terms of both safety and return. A couple years ago, when interest rates were under 1%, the 3.5% return you could get as a landlord was well above prevailing market rates and, thus, quite appealing. Consequently, money flooded into real estate, chasing those above-market returns. This tipped the supply/demand balance towards the demand side, which drove real estate prices to the record levels we see today.
With interest rates now closing in on 6%, money, and I mean real MONEY (think Blackrock, private equity firms, etc…) with outsized positions in real estate will be left with two options. Option #1, they can continue to play wet nurse to the rental class by putting a roof over their heads, fixing their broken pipes, etc… all while worrying whether the rent check shows up at the end of the month, and netting 3.5% for their trouble. Or option #2, they can pull their capital out of real estate, park it in treasuries, collect 6%, and sit on a private beach somewhere, worry-free, sipping Mai Tais and scheduling massages. Not much of a choice, now is it?
What do you suppose happens to real estate prices as interest rates continue to rise and the disparity between the safe returns of treasuries and the riskier returns of being a landlord increases? What was a flood of money into real estate over the last decade will reverse, and become a flood out, as real money will chase the higher returns found elsewhere. In effect, all the demand for properties over the last ten years will become supply as money leaves real estate for greener pastures. This will tip the finely balanced supply/demand structure in the property markets heavily towards the supply side, crushing prices in the process. To make matters worse, higher mortgage rates are weakening demand as John & Jane Doe are becoming priced out of the market. Homes that two years ago would have cost them 2k/month in mortgage payments, are now closer to 3k/month.
This plummeting demand and increasing supply are starting to show up on the balance sheets of the publically-owned Homebuilders. Consider KBH. In the last two years, the historically stable “inventory” line on their balance sheet is up almost 50%! It’s not just KBH either - it’s all of them - Pulte, Meritage; it doesn’t matter, you pick one - the inventory they carry on their books is skyrocketing because nobody is buying homes at these price levels. Speaking of balance sheets, another scary line for most Homebuilders is the “Cash & Cash Equivalents” line. KBH & Pulte have both seen their cash on hand get whacked in half over the last two years as they continue to pay bills while not selling houses. That cannot last forever. In order to avoid bankruptcy court, they will eventually be forced to liquidate inventory to pay bills. When that happens, and it is coming soon, look out below - as prices will plummet trying to find a bid.
The real question is, who will step in and provide the bid to soak up the excess inventory looming on the horizon? The Blackrocks and the mom & pop landlords won’t want it, as the return in treasuries is better and without worry. Assuming John & Jane Doe haven’t been laid off from their jobs - they could still afford the 2k/month - but because mortgage rates have gone from 3% to 7%, the price of the median home will need to fall almost 50% ….AND … mortgage rates will need to stop rising and stabilize at current levels before the Does could re-enter the market as buyers. If mortgage rates continue to increase - which Bag thinks is very likely - even a 50% off sale will not be enough to bring back John & Jane.
To be fair, it is possible nominal prices on homes may not fall 50% over the coming years. Slowing the inevitable decline is the intentional choice by our rulers to institute a policy of soaring inflation for the sole purpose of camouflaging the price drop. It is no coincidence inflation is raging just as the real estate market is rolling over. The Fed’s choice to push the inflation rate into double digits in the last couple of years has masked the current pullback in real estate prices. Sure, they can hide it for a while with inflation, but make no mistake, Real estate is headed to generational lows. Until then, Bag recommends assuming the crash position; as any Econ 101 student could tell you, falling demand coupled with increasing supply can only be resolved one way - with significantly lower prices.
One question, I heard the other day that some of the home builders were recording record profits or revenue, I can't remember which. How does this make sense with downward pressure on prices right now?
3.5% is a really good return for property. I find that Property in NZ yields approximately zero ROI, except for the capital gain when you sell it... Which makes it an interesting investment because people view property as an investment that's safe, from which you can get an income to retire on... Those people typically forget to capitalize costs such as the roof needing painted every 20 years (a $20k cost here, which capitalizes to $1k pa).
The other thing about property investment vs. other types of investment is that you can leverage it to make money on the bank's money and also borrow to buy more properties, meaning portfolio growth is massive.
The down side is people and regulation risk. Here in NZ, we have a very leftist government (and citizens) who hate landlords. The last bit of legislation put through was to change tax law so you can't deduct cost of mortgages from rental revenue, meaning that you're taxed on revenue, not profits for this type of business. I sold my rentals partly for this reason (increasing hate towards landlords).