Owning rental properties only ranks fifth out of my eight best passive income sources. However, as interest rates decline, the value of rental properties and their cash flow has increased.
As a financially savvy individual, your goal should be to accumulate as many underpriced cash flow-generating assets as possible. I believe this permanently low-interest-rate environment is once more favoring owning rental properties.
As a tired father who yearns to earn 100% of his income 100% passively, it’s tough for me to accept that owning physical rental properties is once again the right thing to do. However, building up a rental property empire is one of the most promising ways to get richer today.
Rental Properties Are Doing Well
For proof that owning rental properties is a valuable asset class, look no further than the share price performance of Invitation Homes Inc. and American Homes 4 Rent, the two largest landlords in America. They are up ~80% and ~60% respectively since stocks bottomed on March 23rd. The S&P 500 is up about 50% during the same time period.
Outperforming the S&P 500 index is one financial benchmark worth pursuing. It is my belief that landlords such as American Homes 4 Rent, which has over 53,000 properties, will likely continue to outperform the S&P 500.
The stock performances of these two companies can be seen as proxies for how your rental property has performed this year. Of course, each rental property market has different characteristics.
However, the most important signal from Invitation Homes and American Homes 4 Rent is that there is an opportunity for individuals to own more physical rental properties of their own.
Why You Should Own More Rental Properties
The stock market is much more efficient than the real estate market.
Stock markets are quick to fall and quick to rise. Real estate, in comparison, moves at a glacial pace due to paperwork, higher transaction costs, long-term leases, and inventory imbalances.
For example, during the 2008-2009 financial crisis, I was able to keep the rent the same for one rental property thanks to a one-year lease. By the time the lease expired and I was thinking about lowering the rent by 2.5% to entice my tenants to stay, the recession was over. Two years after those tenants first moved in, they decided to move out and new tenants were willing to pay 10% more.
The lag in real estate performance is one of the main reasons why I published, Real Estate Buying Strategies During COVID-19.
As some home sellers were stuck thinking the world was coming to an end in March 2020, I made a bet the stock market would rebound.
The key for homebuyers was to take advantage of lagging sentiment and buy real estate from “doomers.” Less than six months later, primary residence demand is strong. Thankfully, the doomers are still out there today despite so many V-shaped economic indicators.
Let’s move beyond buying a primary residence and focus on buying rental properties with an example. Rental properties have lagged the stock market, the bond market, and the primary residence market. But not for long.
Why Rental Properties Are Undervalued
We learned from my Proper Safe Withdrawal Rate post that returns are intertwined with the risk-free rate of return. With this understanding, let’s review how a rental property can significantly rise in value. This rental property valuation calculation is important to understand, so review it multiple times.
January 2020: 10-Year Bond Yield = 1.85%
Value of rental property: $1,000,000
Net Operating Income (NOI): $35,000
Cap rate: 3.5% (NOI/market value)
Although the owner of this coastal city property had a cap rate of only 3.5%, it was still 1.65% higher than the 10-year bond yield. The 1.65% annual premium is the extra reward the homeowner earns for having to be a landlord. Let’s call it the “risk premium.”
Further, for the past 10 years, the homeowner has increased his equity through faster principal appreciation than the national average. Now let’s calculate the value of the rental property after interest rates decline.
October 2020: 10-Year Bond Yield = 0.6%
With the 10-year bond yield falling to 0.6%, what is the value of the rental property if the NOI is still $35,000 a year?
One way to calculate the value of the rental property is by adding the old 1.65% premium to the current 10-year bond yield to get 2.25% (1.65% + 0.6%). You would then take the NOI of $35,000 and divide it by 2.25% to get $1,555,555.
In other words, if we assume the NOI and the risk premium stay constant, the value of the property has increased by 55.5%.
For most properties, the NOI has remained the same from January 2020 to October 2020 because most tenants haven’t moved out and are still paying rent.
However, there is obviously a possibility the NOI could decrease or increase with a new set of tenants. Further, with eviction moratoriums, there could be the risk of non-payment as well. It is up to the investor to make such a calculation.
What Is An Acceptable Risk Premium?
As for the acceptable risk premium, this is what investors will debate the most. On one hand, there is tremendous uncertainty, which should dictate that the risk premium should increase. In other words, investors require a higher rate of return to hold a risk asset.
On the other hand, there is absolute certainty the value of cash flow has gone up due to the decline in the risk-free rate, e.g. it takes more capital to generate the same income. Therefore, the risk premium should decrease.
It is my opinion that risk premiums should stay the same at worst. It is better to own a real asset that generates cash flow in an uncertain environment than an asset with no cash flow and most of its value calculated based on earnings far into the future.
Further, the intrinsic value of a home has gone up given we’re all spending much more time at home. With inventory tight across most of the nation, the risk premium for owning rental properties should stay the same or maybe even go down.
Finally, you should compare the rental property risk premium to the risk-free rate of return. The lower the risk-free rate goes, the more valuable the risk premium becomes.
For example, with the risk-free rate at only ~0.6%, a 1.65% risk premium is 2.75X the risk-free rate versus only 0.89X when the risk-free rate was at 1.85%.
The Opportunity To Buy Rental Properties
Based on my rental property example, an investor can make the case the value of the rental property has increased from $1,000,000 to $1,555,555 in just 10 short months.
Or, more specifically, an investor can make the case that the value of the property’s cash flow has increased by $555,555 in just 10 short months.
Meanwhile, if you had $1,000,000 in cash sitting around, its value has declined. In January 2020, $1,000,000 in cash could have generated $18,500 a year in risk-free income. By October 2020, the same $1,000,000 could only generate $6,000 in risk-free income.
Therefore, anybody with cash will logically want to mobilize the cash into riskier assets that generate higher yields. These assets can be in the form of dividend-paying stocks, bonds, real estate crowdfunding, and rental properties.
However, stock and bond valuations are expensive, hence the focus on distressed assets or rental properties with lagging valuations.
Blue Sky Valuation
Most people will likely argue that the rental property has not gone up by 55% in 10 months, even though we’ve just run the numbers. That’s fine. We can say the 55% increase in value is a “blue sky valuation.” However, if interest rates stay low for a very long time, as the Fed has telegraphed twice so far in 2020, then the confidence of a 55% value appreciation goes up.
With this property example’s blue sky valuation of $1,555,555, your goal is to buy the property as far below $1,555,555 minus closing costs as possible.
You can still buy many of these properties for less than +10% from where they traded in January 2020. Therefore, you are left with a 40% equity gain under a blue sky valuation scenario. If you get lucky, you may be able to buy a rental at the same price or less than a year ago’s price.
Many Sellers Don’t Do The Math
The golden opportunity is when you find a seller who doesn’t think through the logic above and also thinks his city is never coming back. The seller thinks rents are going to go down even further than a worst-case scenario, rates are going to go up, and jobs will be gone for good. Sure, all these things could happen. The opportunity is betting on the degrees to which these things may happen.
Your goal is to AGREE with the seller’s beliefs by highlighting as many bearish articles and anecdotes as you can find. The more you can feed into the seller’s bearishness, the better price you can get. If things don’t turn out as badly as anticipated and there is a tremendous rebound, you will win big.
Not only will you see a tremendous appreciation in principal values based on comparables, but you’ll also be able to increase cash flow through rent increases.
You can easily see a scenario where the owner of the $1,000,000 rental may be happy to sell you his rental property for $1,030,000. He’ll think, A 3% appreciation during a pandemic? I’ll take it!
But as I demonstrated in my example, his $1,000,000 property is worth so much more.
Two More Reasons For Owning Rental Properties
Please spend more time going through my rental property appreciation example above. It is the key to recognizing your potential upside.
Besides potential rental property appreciation, cash flow appreciation, diversification, and a source of income, here are two other reasons for owning rental properties.
1) Tax-efficient income
Most rental property expenses, including mortgage insurance, property taxes, repair and maintenance expenses, home office expenses, insurance, professional services, and travel expenses related to management are all deductible in the year you spend the money.
However, the best deduction is a non-cash deduction called depreciation. You can begin taking depreciation deductions as soon as you place the property in service or when it’s ready and available to use as a rental. Depreciation is based on the value of the building only, not the land.
Most U.S. residential rental property is depreciated at a rate of 3.636% each year for 27.5 years. In other words, if you own a $1 million rental property, each year you can take a depreciation expense of $36,360. Therefore, $36,360 of rental income can be shielded from income taxes.
2) Assets for your children to manage.
All parents should be worried about their children’s futures. The ROI on a college education continues to go down. Globalization is making everything hyper-competitive. And black swan events like a global pandemic are preventing adult children from launching.
Owning rental properties for your children to manage is one solution to a potentially difficult future. Given rental properties take work to manage, parents can side-step the often guilt-inducing act of giving their children money. Adult children can also feel the pride of working to help their family and themselves build wealth.
There is no joy in inheriting a dividend-paying stock portfolio. However, with rental properties, the adult child can market the property, screen tenants, run background checks, negotiate the lease, coordinate move-ins and move-outs, make sure all insurance policies are in place, collect the rent, and maintain or improve the properties. There is a tremendous amount of satisfaction in finding great tenants at a market rate.
For parents, owning rental properties provides a triple benefit of growing family wealth, providing your children a safety net, and giving your children purpose. If you don’t want to start your own family business partly to help your children, building a rental property portfolio for them to manage may be the next best thing.
What Type Of Rental Properties To Own
In an ideal situation, you want to own rental properties where you call all the shots. Therefore, owning a multifamily or single-family home is ideal.
If you cannot afford to own a multifamily or single-family home as a rental property, then the next best alternative is to own a condo. However, beware of condo association rules and the financial health of the homeowner’s association.
Some condominium associations charge move-in/move-out fees, which will cut into landlord profit margins. Other condominium associations may have penalty fees for noise disturbances or trash violations.
The one benefit of owning a condo is that the association should be responsible for general maintenance and upkeep, such as replacing the roof, painting the walls in public areas, maintaining the elevator, and so forth.
Beware Of Downside Risks
Being a landlord is not for everybody. I was fine with being a landlord in my 20s and early-30s. Once I hit my late-30s, I became less fine due to time constraints.
The main downside risks of being a landlord are:
- You’re a terrible marketer who can’t attract tenants at market rate. The longer you take to find a tenant, the lower your NOI and property value.
- Your tenants don’t pay on time or don’t pay.
- The property gets damaged by your tenants or from natural disasters.
- Time spent dealing with tenant issues as a landlord.
- Higher property taxes. For example, the mayor of Nashville, TN pushed through a 32% property tax increase in 2020 while keeping small businesses closed.
- Your city could indeed get hollowed out as companies leave.
- You are not a people person and are also easily agitated when things go awry.
Build Cash Flow Through Undervalued Assets
The value of rental properties has gone way up because interest rates have come way down. Thanks to an inefficient real estate market, investors are able to still get good deals. It’s like going back in time to buy assets at lower prices.
Conversely, it is very hard to find value in the stock market today. We’ve all already bought our Amazons, Zooms, Teslas, and so forth. It’s time to focus on buying undervalued, lagging rental properties for ourselves.
Publicly listed companies like Invitation Homes and American Homes 4 Rent are raising massive amounts of capital to buy as many rental properties as possible. So should we. Let’s hope wealthy foreign investors don’t start wising up and buy U.S. rental property as well.
Utilizing your cash hoard to build cash flow is a wise move. Just make sure not to overleverage yourself. Further, always have enough of a cash buffer to protect yourself from unforeseen mishaps.
When it comes to finance, I’ve always believed in the saying, if you can, you must. Although I don’t want to create unnecessary burdens in my life, I must take advantage of opportunity in the rental property market. Low hanging fruit needs to be picked!
It’s time to buy a nicer primary residence so I can rent out my existing property. This way, I can boost our retirement income while also living a better life.
Readers, what do you think about investing in rental properties today? What are some other upsides and downsides of buying rental properties? Should rental properties be upgraded in my passive investment rankings?