Why Invest In Rental Properties In 2019?

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Includes: BPR, O, PLD, SPG, SRC, UMH, VNQ
by: Jussi Askola
Summary

Stocks are too expensive and bonds do not yield enough.

Rental properties may provide higher rates of returns with lesser risk in certain cases.

Fundamentals are strong, pricing is favorable in many states, and the resilience of rentals can help stabilize a portfolio in times of volatility.

Those needing to generate high income from investments in 2019 face more financial uncertainty than ever. The stock market is still hovering near all-time highs and considered by many metrics to be significantly overvalued. At the same time, it's facing immense uncertainty and increased volatility due to geopolitical and macroeconomic factors, leaving it teetering on the edge of a bear market. Meanwhile interest rates remain near historic lows, making investments in bonds nearly as risky and unattractive as stocks. With the odds seemingly stacked so heavily against income investors looking for a safe place to allocate their life savings, what's one to do?

We believe that now is time to look for less conventional alternatives such as investment properties. In a recent survey, 97 percent of investors indicated that they intend to increase capital allocation to real estate in the next 18 months. When you consider that real estate has historically generated higher rates of return with lesser risk than most stocks and bonds, this is not really a surprise to us:

We have invested in rental properties in the past and benefited from their appreciation and high-income generation potential. Heading into 2019, we believe that the rental market remains attractive relative to stocks and bonds with favorable cap rates, rental growth, and low-cost financing. We take an updated look at the pros and cons of rental investments in 2019 and explain how we seek exposure to this market niche to generate high and passive income.

The Pros of Rental Investing:

A rental is a residential property for which the owner receives monthly payments from its occupant, known as the tenant, in return for the right to live in the property. It can take the form of a small single-family house or even a 100-unit apartment community:

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Rental investments are very popular among income investors and rightfully so. Renting living space to other individuals is one of the oldest professions in the world, and it's still a very lucrative business to be in today. We note five main reasons why investors may want to invest in “rentals”:

1- Consistent and high income:

Since having a roof over one's head is a vital necessity, the cyclicality of the demand for properties is greatly reduced, regardless of economic conditions. In a recession, tenants may receive a rent cut to keep occupancies at high levels, but overall, the income tends to remain relatively resilient and consistent over the full cycle.

2- Long-term appreciation:

Well-located rentals are a limited commodity with ever growing demand. The result is price appreciation - often well in excess of inflation with growing rents and values. Moreover, there's a clear trend toward ever lower ownership rates and therefore rentals continue to benefit from an ever-larger pool of demand.

3- Benefits from rising interest rates:

Unlike most other property sectors which may under certain conditions suffer from rising interest rates, rentals tend to always win here because higher interest rates make it harder for people to buy their own home. Therefore, when interest rates rise, the demand for rentals increases – allowing landlords to raise rent.

4- Inflation protection:

Real estate and especially rentals can serve as valuable hedges against the risk of accelerating inflation. Leases are generally no longer than one year long - allowing for regular rent increases when warranted.

5- Leveraged returns:

Leverage may boost returns, but also amplifies risks. That said, since rentals tend to produce relatively consistent and predictable income, investors are often able to get away with moderate leverage over the full cycle without sinking the ship. It may result in greater asymmetrical risk-to-reward outcomes over time. Rental investors commonly buy properties with only a 20-30% down payment and finance the rest with debt. As such, even with just $50,000 in equity, you may end up controlling a quarter million worth of properties paying you on a monthly basis while you progressively pay down debt and create wealth.

6- Tax Optimization

Private real estate has valuable tax benefits to certain specific people who may deduct all property-level expenses, plus depreciation and interest expenses. Especially the deduction of depreciation can prove to be valuable since it's a non-cash expense and properties tend to appreciate over time.

When it comes to taxes, it is hard to deny that rental properties are more tax efficient than stock investments. Rental investors can take depreciation starting on the first year, and by doing so, they can lower their "income" with a non-cash expense. Moreover, they can also deduct all the other property-related expenses, including interest from their income. Exactly how much a rental investor pays in taxes will depend on a case-by-case basis, but many investors are often able to earn cash flow completely tax-free.

Stock investors won't enjoy the same advantages of depreciation and may have greater tax burden, but they may also use tax-deferred accounts.

7- Control over your investments

One of the biggest reasons for people to invest in rental properties is that you can touch them, feel them, live in them. It is tangible. They want to work on these houses to improve their value and increase rents. In other words, they want to have full control over their investment.

With stocks, you will have to rely more heavily on middlemen and management teams for the day-to-day operation of the business. It creates "principal-agent" risk that many feel uncomfortable taking.

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The Appeal of Rentals in 2019

Note: The fundamentals and pricing of rental properties are subject to local market conditions. Certain markets are overpriced with low cap rates, while others are underpriced with exceptionally high cap rates for landlords. This section takes a bigger picture and looks at the appeal of rentals as a whole.

Fundamentals and pricing

The investment prospects of rentals are directly tied to their their income generation potential and their pricing on the day of the investment.

The fundamentals are today strong with growing rents in most markets and historically low vacancies. The demand for properties has consistently surpassed the new supply in most time periods and the pool of new renters (vs. homeowners) is ever-increasing. With this in mind, it is not unreasonable to expect rental properties to continue appreciating at about 2% per year or in-line with inflation on average.

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Moreover, the pricing of rentals remains (generally speaking) attractive in comparison to stocks and bonds. It is not uncommon for experienced landlords to find rental properties with ~8% cap rates which compares very favorably with the 2.7% 10-year treasury rates and the 1.9% dividend yield of the S&P 500.

Cheap capital to compound wealth

What really puts rental investors ahead is their capacity to leverage their property investments. It is simple to get a long-dated fixed rate mortgage with a low interest rate to finance the majority of a rental investment. Rental investors will often use this trick to maximize returns and often use up to 4-to-1 leverage. I have often shared that this may lead to excessive risk taking; but even with a more reasonable 2-to-1 leverage, rental investors can boost returns significantly:

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Using back-of-the-napkin math, if you can finance your rental property at 2-to-1 leverage, pay a 3-4% mortgage rate, and buy an ~8% yielding property with prospects for 2% annual appreciation, you are set for annual returns that far outperform the stocks and bonds. In this particular case, average annual returns would be closer to 15%.

Safety in times of uncertainty

Rentals provide consistent and stable income. Having a roof over your head is a vital necessity, and therefore, rental investors are likely to earn high income even during recessions. When you consider that we live in highly uncertain world and that we are over 10 years into the cycle, we see a lot of value in the resilience of rental investments.

The volatility of stocks and bonds is likely to remain very high in this environment. Rental investors can keep cashing in monthly rent checks and have the peace of mind in knowing that their investment is not subject to the daily price movements of the financial market.

Rentals can be Good Investments, But…

Now, while we like rentals from a financial perspective, we hate to manage them because of the big, ugly "triple T's":

  1. Tenants
  2. Toilets
  3. Trash

Managing properties takes time, expertise, and a lot of work in dealing with tenants and property upkeep. In many cases, owning rentals gets closer to operating a business rather than just collecting passive income from an investment. Moreover, your property is going to be an illiquid, leveraged, and concentrated investment with high transaction cost and personal liability.

So while there is a lot to like about rental investments, the returns clearly do not come for free. Now fortunately, there is a solution to gain similar exposure without all the downsides of investing in the private market and taking the role of the landlord.

REITs: Our Proxy to Rental Investing

REITs are corporations that generate income through the collection of rent on and from sales of the properties they own for the long term. Just like mutual funds, they allow investors of all kinds to invest in real estate without actually having to go out and buy, manage, and finance properties themselves. Besides, most REITs are publicly traded on a stock exchange and allow investors to participate in the ownership of large scale, well diversified real estate portfolios in the same way as investors would invest in any other industry - through the purchase of stocks.

We are big fans of REITs because they essentially combine the positive attributes of stocks:

  • Liquidity
  • Low transaction cost
  • No managerial work

With the benefits of real estate:

  • Higher total returns
  • High and stable cash flow
  • Inflation protection

As a result, REITs have historically produced up to 4x higher total returns than the S&P 500 from 1997 until 2016:

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So, rather than invest in rental properties and having to deal with tenants, toilets, and trash, most investors would be better off to just invest in the shares of publicly traded REITs which enjoy liquidity, low transaction, professional management and greater diversification.

In fact, REITs have even outperformed private real estate investments, according to EPRA due to their greater scale, lower borrowing cost, and greater access to better deals and resources:

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How to Invest in REITs?

Investing in REITs is much easier than investing in rentals. The easiest option is to simply invest in the broader REIT market, utilizing an index fund such as the Vanguard REIT fund (VNQ). However, this means buying every REIT in the index, regardless of its current price, quality, prospects, or management. While "know-nothing investors" (to borrow a term from Charlie Munger) may find this broad diversification useful, we believe (as does Charlie Munger) that using an intelligent analysis of the qualitative and quantitative aspects of each REIT in order to pick and choose the most opportunistic investments will provide the best total-returns over the long term.

This is however easier said than done! Analyzing individual REITs is no walk in the park and requires specialist skills to sort out the worthwhile from the wobbly. If you know that you have clear limitations in time and expertise, the best option for you may well be to stick with the broader indexes, despite the flaws that they present.

Closing Notes: REITs and Rentals Are Wonderful — if you know what you are doing

Since I started investing in real estate, I have greatly profited from the sector and keep on enjoying high income today. I have made mistakes, but most importantly, I have learnt from them. Today, I am strongly convinced that most investors should invest in real estate with REITs to avoid the managerial complications of owning rentals.

That said, you need to know what you are doing. To demonstrate this, consider that the average investor generated only 2.6% annual returns over the past 20 years:

Clearly, the average investor does NOT know what they are doing. In comparison, passive REIT indexes returned 12.5% per year and outperformed almost all other asset classes:

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Then taking it one step further, active and more entrepreneurial REIT investors who target market inefficiencies have managed to reach up to +22% annual returns over the same time period:

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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.