My post Someone Had To Buy The House You Rent, asking how people can own rentals in markets that it is much cheaper to rent in than to buy, garnered tons of reactions in the comments as well as a few around the blogosphere. Mike from Quest For Four Pillars contacted me that evening and asked if he could write a guest post response to my post and I agreed. Here is his take. If you like what you see, consider subscribing the the Quest For Four Pillars feed! For a completely different view from a real estate investor, visit the response post written by Wise Bread’s Catherine Shaffer.
Last week, Paid Twice asked a very good question which I’ve paraphrased as “Why would someone own a rental property if it’s cheaper to rent than buy?” In other words, if you can’t collect enough rent to pay for your expenses (including mortgage) then why wouldn’t you sell the rental house and put the money into something more productive?
I’m not a real estate expert by any means but I do have some ideas about why this situation occurs and why it might not always be as illogical as it seems:
Irrational exuberance for owning property
My theory about this phenomenon is that some house owners are irrational and attach great significance to ‘owning property’ and are willing to take lower returns in return. Real estate by itself is not necessarily more or less profitable than any other kind of investment for a given time period – over the long haul it has gone up by inflation plus 1 or 2% – but many people feel a strong connection with owning property that they don’t feel with any other kind of investment. Conceptually real estate is easier to understand than a stock or a mutual fund so some real estate investors just assume their rental houses are doing well and sometimes don’t do the proper accounting.
Reluctance to let go
The recent decrease in real estate values has meant that people who moved in the last year or so often had to take a loss (or sell for less than they wanted) on their house so many of them decided to rent and “wait it out”. This may or may not work out for the home owner but it indicates that the owner is using their heart and not their mind when making a financial decision. This also increases the supply of rental properties which will lower the rents.
Return on investment – not return on equity
The example of someone who has a paid for house is a perfect example of where the owner might be better off selling the house and investing the money into dividend stocks or reits (like a real estate mutual fund) but they like the idea of owning and renting out a house. Because of the huge run up in real estate prices over the last ten years, there are undoubtedly a lot of owners who have done very well with their investment and are reluctant to let something go which has done so well for them. Logically you need to look at the current value of the house when evaluating the cash flow but a lot of real estate investors will think in terms of what they paid for it – which in some cases is so far out of date that it’s meaningless. ie if someone who paid $150k for a house 10 years ago and is getting $15k in rent per year might think they are doing well because the $15k is 10% of their original house price. Fast forward to today and if the house is now worth $350k then the $15k in rent is only 4% which is not enough to make it worthwhile. On the other hand, if you own a rental house outright – it’s easy to think you are doing well if the revenue is greater than your costs.
Investment time frame
Real estate is a somewhat volatile investment so there are periods where there are significant increases or drops in the house value, but that doesn’t mean the home owner is going to sell just because they are doing poorly for a few years. Rental rates are set by supply and demand – not house price, so if there are too many rentals available in a city, then rents might not keep up with purchase prices. This situation has occurred in some areas over the last several years because interest rates were very low and lending standards were relaxed so in many cases it was cheaper to buy rather than rent so a lot of the potential rental pool became home owners which drove up the house prices and drove down (or kept steady) the rents. A real estate investor has to live through good times and bad if they are in it for the long run.
Houses are illiquid
Selling a house is expensive and can be a lot of work – even in a hot market you are still looking at huge transaction fees of 5% or more which means that you can’t treat a rental house the same way you can treat a mutual fund or stock that you can sell very cheaply with a few clicks.
Very few home owners (rentals or otherwise) know how much their house costs them. We know what are various bills are and the mortgage and tax payments, but do we add them up over the years? Do we add up the various remodels? Do we consider the potential lost income or capital gains we could have gotten from investing the money in the stock market?
Some considerations which help the rental owner
If there is a mortgage on the property then the portion of the mortgage payment that goes toward equity is not a cost since it is balanced with the increase in equity of the house. Another consideration is tax write offs – the rental owner gets tax write offs for maintenance, repairs, losses etc so that has to be factored in as well. Leverage is another tool which helps the homeowner if the house value rises in the long run. Because they are borrowing a portion of the house price, even a small rise in house value will get a larger return for the investor.
Recent history and complacency
Prior to 2007, real estate values in most of the country had a pretty good run – 10% annual increases or more for at least five years which is way above the long term average. If you were a rental home owner during that time, you were probably too busy celebrating your new found wealth to do any kind of analysis to determine if the income generated by the rental property was high enough to justify ownership of the property.
Remember that with investment properties, you can’t just look at your cost of ownership – you also have to consider the potential income if you put the money into another investment like dividend stocks.
Eventually things revert to the mean
Whether owning a house is a better deal in your area or if rent is the preferable choice, you should keep in mind that over the long run it may not make much difference which you choose as long as you handle your finances properly. Many renters feel like they are going to be left behind because they don’t own a home but there are some steps they can take to make sure that doesn’t happen.
There are many reasons why there are rental houses in areas where it doesn’t seem to make a lot of sense – owners who don’t care, don’t know or are riding it out and hoping the rental market gets better – reasons abound. Remember that if you are considering buying a rental property yourself then do as much research as possible and whatever you do, don’t trust your real estate agent!