Rental Real Estate Can’t Get Much Better than This

by JT McGee

I like to watch macro trends. They’re like the glaciers to the individual firm’s ice cubes – slow and cumbersome, but they define the landscape.

Housing is number 1 on my macro list. Mostly because it’s a huge part of the American economy, but also because I think it makes for a great investment. I’m slowly trying to convince myself to buy my own home – or maybe a 4-plex on FHA 😀 – for speculative purposes.

Vacancies Down; Rents Up

Residential real estate is the best thing since sliced bread. We all know about the overwhelming weakness in the office and retail corner of the real estate market. The real money to be made is in homes, not cubicles.

In July, Reis reported that apartment rents were rising at their fastest pace since 2007. In the same report, we discover that vacancies are at an 11 year low – you have to go all the way back to 2001 to find the same low vacancy rate.

Here’s a chart from CalculatedRiskBlog.org that details the forever falling vacancy rate:

A declining vacancy rate isn’t all that surprising. Here’s my rationale:

  1. Pent up demand – There are a ton of 20-somethings living at home, waiting for a job that pays enough to warrant a move out of mom and dad’s place. That makes for a good, steady supply of people coming into the rental market over time. Any improvement in job growth injects more demand into the market. I wrote about this at InvestorJunkie in a post about single family homes.
  2. Foreclosures – People who lose their homes don’t go homeless. They find a new place to live, often renting a comparatively less expensive apartment without the 15- or 30-year 800 pound gorilla that is a home mortgage.

Rental Real Estate Cost Structure

The cool thing about rental real estate is that it is not economically feasible to make more of it. Homes are selling for less than their cost of replacement, which means people buy existing homes rather than new homes. Existing homes are part of the current supply. If home prices appreciate beyond the cost of replacement, only then will the supply of homes increase.

Since the financial crisis, the cost of building a new home or apartment has only gone up. Rents should necessarily follow. Only in a select few, very populated cities does it make sense to build new apartments and living spaces for renters. Zelman & Associates forecasts construction of 235,000 apartment units in 2012, 285,000 in 2013, and 320,000 in 2014. As of 2009, there were 17,452,000 units in the United States, according to the National Multi Housing Council. The projected pace of new apartment construction would be faster than the average annualy apartment construction from 1990-2009.

New construction isn’t the real estate investor’s only concern. I remain committed to the idea that online retail will destroy traditional retail, and that the days of the corporate office are limited. Naturally, I think the long term prospects for retail and office real estate is weak. More bankruptcies will be filed, and more real estate will be purchased at a lower, and lower cost.

I eventually expect millions of square feet of office/retail centers to be converted to residential real estate. If I can buy 50,000 square feet of retail or office space for $1, I can easily justify the investment to turn it into 50-1,000 square foot apartments. Or 100-500 square foot studios. It’s an outrageous viewpoint to many, but I’m not betting against the creative destruction that is online retail and telecommuting.

Don’t laugh – proposals are popping up everywhere. In Baltimore, office buildings could be turned into apartments at a price tag of $100-125 per square foot. Apartments in Baltimore, from my quick check, are anywhere from $1.50 to $3 per square foot. The only thing stopping the project is the cost of the building. Don’t worry – office space gets cheaper every year!

The Long Slog in Real Estate

I think you have two converging trends here:

1. A growing population, and also a growing renter population. This is good.

2. A glut of commercial and office property waiting for bankruptcy. This isn’t good.

For investors interested in compounding wealth over time, the trend is excellent. Lower prices are especially advantageous for individual investors, as the rigidity in the capital requirements necessary to add one more home (20% down on $100-$500k is no small amount) slows down the compounding process.

My bottom line expectation is this: rental prices go higher, but housing prices wiggle with conversion costs. Midwestern cities will probably fare best, since there isn’t any tangible “location premium” in old office space relative to that of a beastly city like New York.

{ 6 comments… read them below or add one }

William @ Drop Dead Money September 10, 2012 at 10:54

Good analysis. I’m also a big Bill McBride fan.

There is one variable out there that’s hard to account for: Many people who lost their homes to foreclosure and/or bankruptcy had their credit score trashed and they can’t qualify for a new mortgage. These people are FORCED to rent, but in all likelihood their natural preference is to own again. So their tenant status is temporary.

And as soon as their credit scores make them bankable again, they’ll exit the rental market and re-enter the home buying market.

This means there’s a pent-up demand building for purchased homes, new or used. Personally, I suspect that’s what will drive new residential construction. From what I’ve heard (and please correct this if it’s wrong) there’s roughly a 3-4 year period for rehabilitation to occur to a point where these people can buy again. If true, that would indicate a bounce back in home sales this year and next.

Thoughts?

Reply

JT McGee September 10, 2012 at 11:13

Bill McBride is the king of the internet as far as I’m concerned. CalculatedRiskBlog is great.

From what I’ve seen, you can short sale and then qualify for another mortgage 2 years later. I would venture to guess that the 2 year period covers most any kind of default, and probably even bankruptcy.

Personally, I don’t expect crazy homebuilding for years. Housing starts flattened between 2009 and 2011, and have trended moderately positive since. My best guess is that much of the country is still in a position where it costs more to build a new home than to buy a comparable “used” home. So, I’d give it another 1-2 years, but not because of mortgage qualifications, but because of the economics of the whole market.

That’s just my 2 cents. I have zero inside information into the market.

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Jonathan September 10, 2012 at 11:27

In the market I invest, rents are not going up and vacancy is not low. The leasing service we use to market and show our properties has been scratching their heads trying to figure out why they aren’t signing leases. Meanwhile their inventory has increased and we finally had to lower our asking rent (which they swore was the right price) after 4 months of no interest (yeah, yeah, should have done it sooner…we’re getting a bunch of applications in now).

I don’t have the know-how to consider the macro trends like you do JT, but I definitely feel residential real estate is where it’s at right now! That said, the past 4 months of trying to rent the latest purchase has soured us on the idea of continuing investment in the same market, and we just put all our spare investment cash toward a small interest in a midwestern retail center instead (which should have similar returns to what we’re experiencing with our housing purchases, but without any work at all on our end).

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JT September 11, 2012 at 06:27

I’m surprised to hear this! Did you shoot for a higher price point on the latest rental? Four months of vacancy does seem like a long time – one of the many reasons it’s great to have reserves you can fall back on.

How’d you get involved in midwestern real estate? You’ll love the cap rates in the middle coast, I’m sure!

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Jonathan September 11, 2012 at 17:44

Yeah it wasn’t any problem weathering the vacancy from a financial standpoint, but certainly prefer the major boost in cash flow that comes with getting a tenant! Between the rent coming in and not having to pay for water, gardening, etc., it’s a big boost! This home was going to be the cheapest rent of the 3 we own (it’s the smallest) right from the start. Now that we’ve dropped the rent, it’s even cheaper. Still makes a healthy chunk of cash flow though because of the low purchase price and because the taxes on it are approximately 50% as high as on the other two (due to being in a different subdivision).

Midwest real estate – kinda a long story, but buying a piece of a larger piece relatives are buying. I am looking forward to seeing how it develops long term. In the short term it should return 15% cash on our purchase (plus build equity), but within a few years it could easily be 20-25% return on cash because of built in rent escalations.

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Darwin's Money September 11, 2012 at 16:22

That’s what I was thinking when I got into college real estate last year. Until Animal House set in. From a pure investment standpoint, I’d throw every last dollar at rental real estate if I didn’t have to spend any time managing it. But by paying a property manager, you shell out a lot of profit and still have headaches anyway – and without a property manager, it can be even a ton more time. Hence, I also like REITs.

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