Your Rental vs the Market?

October 1, 2023  | By Kevin Smith

Thinking about buying a real estate investment property? With interest rates on investment property mortgages near 8%, it is more difficult to generate positive cash flow on these properties than even a year ago. Investors who can pay for a property with all cash will have much better cash flow, but in either case, the most important question to ask  is “how does this investment compare to my best alternatives?”.

To figure that out, we have to 1) identify a reasonable investment alternative, 2) figure out the expected returns on both investments, and 3) understand the risk of each. This exercise helps establish a minimum required expected return to make the investment property worth the risk. To the extent you feel confident your investment will likely exceed that hurdle, it becomes more compelling.

The expected return on the property is [Net Cash Flow ] + [Price Appreciation] + [Leverage Effect]. Here is an example of the type of analysis we share with clients who are considering a rental or vacation property as an investment:

Your Cash Flow Return on the Property

• Net Operating Income (NOI) is the cash flow return you can expect without a mortgage. It is common to see NOI ranging from 0% up to 5-6%. A $500k property with a 4% NOI generates $40k of income per year. That is rent, minus all expenses.
• Important considerations:
  • Factor in vacancy assumptions, including personal use of the property
  • Factor in leasing commissions
  • Factor in short-term rental expenses (higher cost of linens, etc)
  • If you are not hiring a management company, the value of your personal time should be factored in
  • Managing the property will require additional future investment beyond operating expenses, which should be considered in the cash on cash return
  • Consider the tax benefits of depreciation
  • Can you increase rents in line with inflation?

Price Appreciation Potential on the Property

We just experienced a massive 3 year surge in home values, driven by historically cheap mortgages and significant financial stimulus, but what should we expect for appreciation going forward? If high mortgage rates and a recession slow down the economy, we could be on the lower side of average returns for a while, and maybe worse.

Using historical data, if you hold the property for 10 years or more, you might expect appreciation 3%/year on the low end and 6%/year on the high end. Here is some data comparing average price changes since 1990 in a popular beach town, a fast growing urban area, and the national average.

Leverage Effect of Real Estate

Cheap debt has fueled massive returns on real estate in recent years, particularly in fast appreciating markets. The size of the effect depends on the amount borrowed and the interest rate of the mortgage. The length of the mortgage and future decisions to refinance will also impact the effect. This is a tricky calculation, but the leverage effect can add 2-3%/year in expected compound returns with a modest amount of leverage at a favorable rate. This is a unique quality of real estate investing because our banking system loves to finance real estate.

• Considering Cash Flow, Appreciation, and the Leverage Effect, a (realistic) overall total return expectation might be segmented as:
  • Bad market: 2-6%
  • Average market: 6-8%
  • Good market: 8-10+%
• Again, this is just an example, but these figures are probably not far off.

Potential Real Estate Upside

• Increased rents because of higher demand (either location-specific or an economic bull market)
• Decline in operating costs (less likely).
• Interest rates drop and the economy re-stimulates, driving values up
• A spike in buying demand specific to your property’s location and/or market

Real Estate Risks

• Property damage and ensuing insurance costs
• Operation costs swelling due to inflation (ex: insurance costs increasing)
• Broad economic recession hurting rents and price appreciation
• Local market recession
• Weather
• Damage by tenants
• Lack of liquidity – might not be able to sell when you want to

What is a Reasonable Alternative?

Let’s consider a traditional portfolio, with low-cost ETFs and mutual funds. This type of investment is very liquid, meaning it can be easily bought and sold throughout a variety of market conditions. For a balanced, diversified portfolio with a holding period of over 10 years, historical data suggests the following sources of returns:

• Cash Flow Return: An estimated 4% yield from interests and dividends.
• Price Appreciation: Expecting none from bonds (but it is possible if interest rates decline). If we expect the long term average appreciation of 7.8% on stocks, you might capture 4-5% of that based on your exposure to stocks.

Total Return Expectation (rough estimate, net of fees)

• Bad Market: 4-7%
• Average Market: 7-8%
• Good Market: 8-10+%

What’s the Risk of a ‘Normal Portfolio?

• Broad global stock market recession (also bad for real estate)
• High inflation

Putting It All Together

Compare the expected returns from the Real Estate investment with the Alternative Investment. If the Real Estate investment has significantly higher potential returns in the ‘Average Market’ scenario, it becomes compelling.

But, how much is significant? That us a personal preference varying from person to person. Most investors don’t even do the analysis!

Personally, I would like to see the real estate investment provide a very good chance of 3-4%+ annual compound excess returns, compared to the Alternative Investment, to compensate for the additional property-specific and market-specific risk (and the hassle of dealing with a physical property).

I don’t expect all of this to change the mind of someone who is determined to buy that beach house. It’s my job to help think about the overall economics, and this is how I would go about it if I were considering making the investment myself.

— Kevin X. Smith, CFA