Friday, May 27, 2011

Rentals, Investors, and the Future of the Market

Viewpoint 05/27/2011

Rentals, Investors, and the Future of the Market

First of all, I need to come right out and say it - there will be some over-simplifying in this Viewpoint.  We'll be discussing very complicated concepts with lots of variables and moving parts, yet this isn't a Harvard reviewed journal - my goal has always been to make things easier to understand and talk about.

Next we'll need to define a very important term:  "Normal Market".

Normal Market:  Think about the 1990's.  Relatively low interest rates.  (yes, 10% in 1991 seems high by today's standards, but it was much lower than the 15% from a few years earlier.)  Relatively stable appreciation.  People could buy a home, then sell it a few years later and buy a bigger home, using the proceeds from the sale as their down payment on the purchase.

Example:  My wife & I bought our first home in 1995 for $132,000, making a 10% down payment.  In 1998 we sold that 3-bedroom home for $160,000, and used the proceeds ($38,000 give or take) as the down payment on our larger, 4-bedroom home.  Our appreciation was a little higher than expected; we were fortunate enough to buy in a desirable neighborhood which was going through a renaissance of sorts.

It might be a generation (20-25 years) before we return to that kind of Normal.  Everyone who bought a house after the year 2000 has been severely impacted by the Great Recession and the decimation of home prices.  Many, if not most, who bought during the peak boom years (2004 - 2006) have lost their home.  Good news is they aren't burdened by negative equity; bad news is they have to start saving for a down payment all over again, along with rebuilding their credit.  Those who bought earlier in the decade are sitting in homes worth about what they paid for them, maybe even less.  Good news is they've paid close to 10 years on their mortgage, and they might have even taken advantage of mortgage rates in the 4's to refinance to a 15 year loan.  Those who bought late in the decade are in a similar position as the early-decade buyers, except they are starting with a brand new mortgage.

So, if it's going to be that long before the market is Normal, what are we left with?

Who are today's homeowners?

1. First-time buyers.  Lots of first-timers have joined the ranks of homeownership over the last few years, especially during the tax credit craze in 2009.  The vast majority of these purchases have been at the lower end of the pricing spectrum - buying either fixer-uppers which have been foreclosed by the bank or already-fixed-up homes from investors (usually).

2. Investors, however, have been the largest pool of buyers over the last several years.  And investors do 2 things with their houses:

a) Fix n Flip - they make the homes pretty & sell them for a profit, often to a first-timer.

b) Fix n Hold - they make the homes pretty & rent them out, often to people who have lost their own home.

3. Longer term homeowners.  Those who bought their homes before the big boom.  Many of these folks are somewhat stuck in their homes, unable or unwilling to make a move until the market heals.

How will these homeowners impact us, and/or be impacted by us?

Let's talk about 1 & 3 first; they're the easiest.

Many first-time buyers are in great shape today.  Imagine being in your 20s and owning a 3-bedroom home which you only paid $120,000 for, financed at 5.5%.  Today you're carrying an FHA mortgage at under $1,000 per month.  And that's on a fixed rate, can never increase, will be paid off in 30 years, mortgage!

Granted, the job market isn't what we'd like it to be.  Nor is the housing market.  So these kids can't move at the drop of a hat.  But, if they stick around for a few years (5, 7, 10..?)  Pretty soon they're making more money, they have equity in this home, and they can think about moving.  They'll have the option of either selling this home (like my personal example above), or keeping it as a long-term rental - eventually this home could be paid for, free & clear, and generating income every month for the rest of their lives!

Longer term homeowners are in a position which isn't too much different.  The job market and home market are dictating they need to stay put today, but eventually our economy recovers and they'll be in a position to make a move.  However, I bet there are many people out there who originally wanted to move, but after being in their home for longer than they wanted, have seen their lives move on while their mortgage has gotten smaller - there will be plenty of people who decide to stay put and pay their home off completely.

And that brings us to the investors - the largest group of recent buyers.  What will happen to them over the next few/several years?  Or more importantly to us non-investors, how will they affect us over the coming decade?

Investor Mindset - Profits

An investor buys a home as a tool to help turn his money into more money.  This can be done in a couple different ways:

1. Rental Income.  If you buy a home for $120,000 and pay cash for it, you've invested $120,000 but you don't have any monthly mortgage payments.  If you can rent that house out for $1,000 per month, you'll earn $12,000 per year, which is a 10% Return On your Investment (ROI).  (yes, I'm ignoring taxes, insurance, vacancy, maintenance, etc. etc. - simplicity, remember?)

The example above works even if the home isn't bought with cash.  If the investor puts $12,000 into the home (10%) and borrows the rest, he only needs to earn $100 per month, which is $1,200 per year, to earn that same 10% ROI.  So as long as the rent covers his mortgage payments, this is equally profitable.

2. Profits from Sale.  Let's again assume you pay cash for a $120,000 home.  You rent it out for whatever the market bears - $700, $800, $900?  But then, after a few years, the market comes back, home prices go up, and you sell the house for $160,000.  You end up earning $40,000 in rents and then $40,000 in profits:  $80,000 (a 67% ROI) in 4 years.

So, given that, investors stand to make more money when either rent rates or home prices rise.

What happens next?

We talk about recovery and getting back to normal, mostly while looking at the inventory of homes hitting the market for sale.  I've written many times about the distressed and vacant listings being a leading indicator for the recovery.

But I haven't heard anybody address the concept of these thousands of investor-owned homes as a sort of hidden inventory.  The recovery works well if these homes are permanently "off the market".  But what happens if, as prices rise, investors begin putting homes up for sale?  One or two at a time won't have any effect on prices.  Thousands at a time would affect the market the same way thousands of bank-owned homes are doing today.  And if there's an avalanche of new listings competing with each other..  It'll cause the triple dip!

So these investor-owners, the very ones who are saving our collective bacon today by clearing thousands of listings from the market each month, could become a serious headwind against the recovery if they decide to liquidate their holdings as prices rise.

Next let's look at interest rates.

Interest rates are low, and have been for a decade and a half.  But that doesn't mean they can't rise again.  In fact, the longer our economic problems play out, the greater the likelihood that the bond market will push interest rates higher - long before the Federal Reserve decides to take action.  (And if that happens, look out.  Ask Greece what it feels like to lose the market's trust.)

What would happen if interest rates go back to 10%?

That $120,000 home I mentioned earlier, the one a first-time buyer could buy for less than $1,000 per month..  At 10% interest, that same home now carries a monthly payment of about $1,300.  That's a BIG difference.  $300 per month (30%) more for the exact same house at the exact same price.

So our first-time homebuyer has to make a choice:

a) Buy the house and spend 30% more each month on housing payments.

b) Buy a less expensive house to keep the $1,000 monthly housing budget in tact.  (about $85,000 in this example)

c) Forget buying and continue to rent.

Let's assume some first-time buyers choose each of the three choices - some stretch their budget, some buy a smaller home, and others decide not to buy.

We all know about supply and demand's effects on prices.  This scenario would have a negative impact on demand.  1/3 of all these buyers decide to rent, which reduces the demand for homes to buy (but increases the demand for rent...)  Another third of the buyers are going to move their demand to a lower price range - this should put downward pressure on prices at the $120,000 range, yet potentially put upward pressure on prices at the $85,000 range.  And, since 2/3 of the buyers are not looking at $120,000 homes, the lack of demand should put further downward pressure on prices.

Now, while housing prices are probably falling, rental rates could very well rise.  Rents are usually in balance not as much with housing prices, but with the cost of owning a home.  If the cost of owning a home increases by 30%, it's very likely that investor-owners will be able to ask a higher amount for rent.  When it cost $1,000 per month to buy a 3-bedroom home, the rent might have been $900.  But when it costs $1,300 per month to buy, there's a lot of room for rents to increase.  Add in the extra demand from those who can no longer afford to buy, and there's quite a bit of upward pressure on rents.

Let's recap..

Prices are about as low as we can imagine.  Yet rising prices could trigger investors to sell.  And if enough investors sell, they could add enough inventory to causes prices to fall.  So, rising prices could cause falling prices.

Interest rates are at historical lows, coming off record lows just a few months ago.  It's hard to imagine interest rates going anywhere but up.  Yet, rising interest rates could have a negative impact on prices and a negative impact (to the consumer) on rental rates.

In the end..

I can talk about home prices and what-ifs all day long, but when the dust settles and the smoke clears, it's still all about jobs.  As long as the unemployment rate falls, and people can find jobs &/or feel more secure about the job they have, the rest will take care of itself.

It's hard to budget when you don't have any income.  And it's hard to get excited about moving when you're afraid you're going to lose your job.

Sometimes we forget about a key variable outside of our current discussion.  Yes, there are a lot of investor-owned homes which could hit the market as inventory.  But there are also a lot of people who have been taken out of the labor market, who could enter again and hit the market as buyers.

What will happen?  I don't know.  We're in uncharted times.  But I have a much better understanding today of how my grandfather must have felt in the late 1930's.

Your looking forward to the Roaring 20's Realtor,

Chris Butterworth