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Why Rental Value Will Drive Our Next Home Purchase

My confession about losing $60,000 in a good housing market last month was one of the more painful things I’ve wrote.  We’ve now settled into a nice rental house and it left me examining this question:  Would we ever be homeowners again?  Why did I consistently loose money while others I watch make six figures on their home?  Was it just because we moved a bunch for my career?

We’ve lost money on three of our four houses.  They were sold because we needed/wanted to move and could either rent the house or sell it.  The problem was the last three houses would have made poor rental properties.  We were left to sell and after the costs of agent commissions, inspection dictated repairs, and concessions, this has been an expensive lesson taught three times.   

We’ve now experienced living in a swim/tennis community, a walkable university area, and in one of the lowest cost houses in an affluent bubble.   We enjoyed the advantages while we lived there, but these properties were terrible decisions financially.   Ultimately we lost money is we paid too damn much for the house to begin at the start.  Its not the fault of the market, its not the fault of moving too much, and only partially the fault of the realtor’s monopoly, it was our fault for overpaying for a house.  Now any future purchase will consider one factor first and foremost:   Would this be a decent rental?

Why is rental value important?

Assets  are valued in two ways, the cash flow it can generate and the expected sale price it can obtain in the future.   Residential housing has appreciated above the rate of inflation for the last thirty years.  This has driven people to be comfortable paying a price above its rental value because of the belief it can be sold for that or more in the future.  Realtors and mortgage companies will talk about home ownership being the “American Dream”.  They’ll drive you around talking about comparable sales, great schools, friendly neighborhoods, and proximity to stuff.   This “American Dream” is what pays them a commission.

Rarely will you have an agent talk about the value of the property as if you were a landlord and would rent it out.   Why do I think this is important?  I believe residential real estate will not appreciate at the same rate as it has in the past.  The underlying rental value will be the floor of your price.  

Why might housing appreciation slow down?

Reason #1:  Interest rates & lending standards.  People promoting the housing market will say that houses appreciate 5% per year and cherry pick a point in time.   The country has experienced a thirty year decline in interest rates while we tested the outer limits of risk in mortgage lending in the mid 2000s.  Interest rates can get lower, but there are diminishing returns in how high of a price a lower interest rate can support.  Its unlikely lending requirements can be further reduced and even if they are, it can only temporarily inflate prices.    Australian mortgage rates continue to decline, but that’s not enough to keep banks from referring people to food banks.  

Reason #2:  Demographics.   The US Birth Rate was 1.80 times in 2016 and has been below 2.0 since 2009.  Historically household growth has been driven by birth rates above 2.0x plus net immigration.   The birth rate has now been below 2.0x and there doesn’t seem to be any meaningful immigration reform in our future.  If the politicians agree to quadruple the number of legal immigrants into the United States, I may revise my stance.  

Reason #3:  Consumer Preference.  This is entirely a personal opinion, but I don’t believe that housing consumers of the future will necessarily want the housing inventory of the past.   Who will the baby boomers sell their houses to?  Does today’s employee want a grinding 50 minute commute from further and further out in the suburbs?  If they can get a work remote arrangement, what makes us believe that the ideal spot to live is 40 miles outside of an urban center?   I don’t see 20 somethings jamming a garage full of garbage while parking their cars outside in the neighborhood.

Additionally, multifamily properties are one of the hottest asset classes in the country and new apartment development focuses around urban centers and “live/work/play” communities.  You are seeing stories out there of people reversing their home ownership decision and moving back into a rental.   I enjoyed this recent comment from The Happy Frugals:

Some go as far as referring to home ownership as a scam!   

I won’t take it to that extreme, but if times are changing and you can’t count on appreciation, the only protection for your home’s value is its ability to be a rental.  

 So how do you figure out if a house can make a good rental?

If you’ve looked around or read much about a rental property, you’ve probably heard of the 1% rule.   Buy a rental property which can generate 1% of its purchase price in monthly rent or inversely, it would mean you pay 100x the monthly rent for the property.  The purchase price should be the total cost, including price paid for the house, closing costs, and any required renovations.  Thanks to the power of technology (Zillow), you can immediately get an estimate of what your property can rent for.   You can also easily see rent listings and rental history on a specific property.   

The mathematical part of this looks easy, but suppose you can’t find a house you want to live in that would also meet the 1% rule as a rental?  This is a challenge in most of the country now that we’ve seen five to seven years of increasing housing prices.   As a homeowner, you may receive more attractive financing, a break on real estate taxes, and other small benefits instead of being a renter that can justify paying a bit more than the 1% rule would allow.   There may also be some costs that push down an acceptable price, including home owners association fees or maintenance that comes with a house older than 20 years.   I’ll share some examples later.

Now lets look back at my disastrous history of home purchases against the 1% rule:  

House #1:  Paid $121,000 with a market rent of $975 (124x, or 0.80%)
House #2: Paid $254,000 with market rent of $1,600. (159x, or 0.63%)
House #3: Paid $290,000 with a market rent of $1,700 (170x, or 0.59%)
House #4: Paid $630,000 with a market rent of $3,000 (210x, or 0.48%)

Do you know what that is?  Its a recipe for a rear kicking.  We actually made $35,000 on house #1 due to selling at peak market insanity in early 2007, but followed that up with six figures of combined losses in homes two through four.   House #1 is the only one we ever considered keeping as a rental, but the amount of money we could make  tax-free was too good to turn down.  

Avoiding the Next Mistake:

From here forward, I am looking at every potential property as if it were a rental.   This is no longer an emotional decision, but a financial decision.  A permanent loss of capital is one of the few risks that could send me back to ironing shirts and spending days under the fluorescent lights.   

I’ve built a sample model below based on the 1% rule.   This theoretical house sells for $200,000 and rents for $2,000/mo.   The expenses in this model include an estimated management fee of 10%, home taxes, insurance, HOA fees (if any), and maintenance based off the age of the house.  For the sample, I assumed a 20+ year old home with maintenance costs of 1.5% of its value per year. 

Annual principal payments and vacancy were excluded from this model for simplicity.  This does not account for any price appreciation since this can only be realized at the sale of the property after significant transaction costs and may be limited in the future.

Sample
         
Price $200,000   Interest Rate 3.75%
Downpayment $40,000   Annual Pmt -$8,974
Mortgage $160,000   Down payment % 20%
Rent – Monthly $2,000      
Rent – Annually $24,000   Tax Rate 1.15%
      Insurance Cost 0.75%
Expenses (Annual)      
Management Fee -$2,400   Maintenance  
Taxes -$2,300   New 0.50%
Insurance -$1,500   10-20yrs 1%
HOA     20yrs+ 1.5%
Maintenance -$3,000   Unlevered Return 8.60%
         
Total -$6,800      
         
Cash Flow $8,225      
Cash ROIC 20.56%      
         
Price to Rent Ratio 1.00%      
Rent Multiple 100      

You can quickly see why an investor would enjoy this property if it could be bought at $200,000.   The property returns 8.6% if it is purchased with cash and the return can be improved to over 20% when using a 30 year mortgage and a 20% down payment.   

Unfortunately this is tough to obtain in higher quality areas.  These deals are rare and investors are out competing with you.   You may not require a 20%+ return on a house you’re going to live in, so lets look at some live examples and talk about what would be a reasonable amount to pay.

Example #1:  Our current house plan / neighborhood. 

The current rental house is a 3/2 house built in the early 2000s.  It runs around 1600sqft and includes a two car garage in a neighborhood with many similar houses.  We pay $2,300/mo in rent for a house that is fifteen years old and the landlord pays the homeowners association fee of $200/mo.   In this example, we assume annual maintenance will run 1% of the purchase price per year and recent comparable sales report $310,000 as a potential selling price.  Lets plug in these numbers and see if this is a good purchase:

         
Price $310,000   Interest Rate 3.75%
Downpayment $62,000   Annual Pmt -$13,909
Mortgage $248,000   Downpayment % 20%
Rent – Monthly $2,300      
Rent – Annually $27,600   Tax Rate 1.15%
      Insurance Cost 0.75%
Expenses (Annual)      
Management Fee -$2,760   Maintenance  
Taxes -$3,565   New 0.50%
Insurance -$2,325   10-20yrs 1%
HOA -$2,400   20yrs+ 1.5%
Maintenance -$3,100   Unlevered Return 5.23%
         
Total -$11,390      
         
Cash Flow $2,300      
Cash ROIC 3.71%      
         
Price to Rent Ratio 0.74%      
Rent Multiple 135      

Ouch.  The property has a rent multiple of 135x plus it comes with the drag of a homeowners association.   If purchased outright, it would provide just better than a 5% return.  When using a mortgage, the cash return drops to 3.71%.  Even though the mortgage rate is lower than the unleveraged return, the principal portion of the payment drags down the return on cash.

So what would be a reasonable price to pay?

I did some additional sleuthing in the neighborhood and estimated the market rent is slightly lower than what we are paying and I adjusted the rent down to $2,200/mo.   I then played around with the purchase price in increments of $5,000 until the unleveraged return would exceed 6%.   A house is an illiquid investment, but to an early retiree needing to draw 4%/year off of his money, a 6% return sounds acceptable since we need to have a place to live.

Current Home
         
Price $265,000   Interest Rate 3.75%
Downpayment $53,000   Annual Pmt -$11,890
Mortgage $212,000   Downpayment % 20%
Rent – Monthly $2,200      
Rent – Annually $26,400   Tax Rate 1.15%
      Insurance Cost 0.75%
Expenses (Annual)      
Management Fee -$2,640   Maintenance  
Taxes -$3,048   New 0.50%
Insurance -$1,988   10-20yrs 1%
HOA -$2,400   20yrs+ 1.5%
Maintenance -$2,650   Unlevered Return 6.16%
         
Total -$10,085      
         
Cash Flow $4,424      
Cash ROIC 8.35%      
         
Price to Rent Ratio 0.83%      
Rent Multiple 120      

The result was $265,000, or paying no more than 120x the potential rent.  I went ahead and plugged in a 20% down, 30 year mortgage and it showed the return increases up to 8.35%.   The 120x rent multiple would also be in line with our first purchase!   

I pulled the real estate listing from a similar house down the street.  The market is softening some, but do you think it’ll reach $265,000?  If our lease were ending and we knew this was the neighborhood, it would be tempting to make an offer on this house.

So lets look at my target neighborhood:

We like our current location, but would prefer to be closer in town.  I found a nice neighborhood of smaller houses built in the 1960s and 1970s.   The area is more central and likely a better fit for us.  Unfortunately prices climbed from the low $300,000 to a few sales in excess of $650,000 in the past couple years.   The rental rates for houses of this side in the neighborhood range from $2,900 to $3,300.

The houses are not in a homeowners association, but the houses are older than twenty years so I used the maintenance cost to 1.5% of the purchase price per year and started at a $650,000 purchase price.  

Target Neighborhood
         
Price $650,000   Interest Rate 3.75%
Downpayment $130,000   Annual Pmt -$29,165
Mortgage $520,000   Downpayment 20%
Rent – Monthly $3,000      
Rent – Annually $36,000   Tax Rate 1.15%
      Insurance Cost 0.75%
Expenses (Annual)      
Management Fee -$3,600   Maintenance  
Taxes -$7,475   New 0.50%
Insurance -$4,875   10-20yrs 1%
HOA     20yrs+ 1.5%
Maintenance -$9,750   Unlevered Return 2.14%
         
Total -$22,100      
         
Cash Flow -$15,265      
Cash ROIC -11.74%      
         
Price to Rent Ratio 0.46%      
Rent Multiple 217      

This theoretical house in the neighborhood is trading for a 217x rent multiple, which would be higher than we’ve ever spent for a home.  At this point, buying this house is the equivalent of withdrawing a bunch of cash, putting it in a paper bag, and running a lawnmower over it.   (We could experience the loss quicker and move on with our life).   The numbers scream if we want to move here, renting is the way to go.  

So what price could we pay? 

Lets look at what a 125x rent multiple does

Target Neighborhood
         
Price $375,000   Interest Rate 3.75%
Downpayment $75,000   Annual Pmt -$16,826
Mortgage $300,000   Downpayment  20%
Rent – Monthly $3,000      
Rent – Annually $36,000   Tax Rate 1.15%
      Insurance Cost 0.75%
Expenses (Annual)      
Management Fee -$3,600   Maintenance  
Taxes -$4,313   New 0.50%
Insurance -$2,813   10-20yrs 1%
HOA     20yrs+ 1.5%
Maintenance -$5,625   Unlevered Return 6.20%
         
Total -$12,750      
         
Cash Flow $6,423      
Cash ROIC 8.56%      
         
Price to Rent Ratio 0.80%      
Rent Multiple 125      

$375,000 purchase price equals a slightly better than 6% return if we paid cash and 8.56% if we financed it and ever moved to hold it as a rental.  This sounds much better for an investment return.   

I found this listing in the neighborhood, how do you think that offer would be received today?

Its not surprising here that the house was sold for $350,000 in 2016.  With 2% or so a year in inflation, $375,000 would be a fair price.   I’m going to go ahead and say this 2100sqft house built in the 1960s didn’t really increase from $350,000 to $700,000 in the last three years, no matter how nice that kitchen looks.   

What are the financing variables? 

When you purchase a home as your primary residence, you may get two benefits over an investor, a lower down payment or a better interest rate.   Lets look at each of these variables.

Variable #1:  Low down payment.  If you’re purchasing something as your primary residence, you *may* be able to get into a loan program that allows you to buy the house for as little as 3.5% down.  This would allow you to take advantage of the difference between the underlying rent value of the house and the low mortgage rate and potentially pay more for the house.   Lets maintain an 8.50% minimum return on invested capital and see what a low down payment loan can do.  

Target Neighborhood – Low Downpayment
         
Price $395,800   Interest Rate 3.75%
Downpayment $11,874   Annual Pmt -$21,533
Mortgage $383,926   Downpayment % 3%
Rent – Monthly $3,000      
Rent – Annually $36,000   Tax Rate 1.15%
      Insurance Cost 0.75%
Expenses (Annual)      
Management Fee -$3,600   Maintenance  
Taxes -$4,552   New 0.50%
Insurance -$2,969   10-20yrs 1%
HOA     20yrs+ 1.5%
Maintenance -$5,937   Unlevered Return 5.70%
         
Total -$13,457      
         
Cash Flow $1,009      
Cash ROIC 8.50%      
         
Price to Rent Ratio 0.76%      
Rent Multiple 132      

Some quick what-if numbers turned up a maximum purchase price of $395,800 to get the same return on invested capital.   I am not necessarily advocating this as a strategy (especially as someone who’s been upside down by $30,000 on a home before), but it does allow you to pay *just a little more* and still have the flexibility of retaining the property as a rental if your life circumstances change.

Variable #2:  Interest Rate Decline.   

Today’s mortgage rates are low, but interest rates in the world continue to creep lower.  What happens if 30 year mortgages do the “unthinkable” and drop all the way down to 2%.  How much more could I pay with a standard 20% down if rates dropped that far and still meet an 8.5% return on invested cash?

Target Neighborhood – Drop in Rates
         
Price $415,000   Interest Rate 2.00%
Downpayment $83,000   Annual Pmt -$14,823
Mortgage $332,000   Downpayment % 20%
Rent – Monthly $3,000      
Rent – Annually $36,000   Tax Rate 1.15%
      Insurance Cost 0.75%
Expenses (Annual)      
Management Fee -$3,600   Maintenance  
Taxes -$4,773   New 0.50%
Insurance -$3,113   10-20yrs 1%
HOA     20yrs+ 1.5%
Maintenance -$6,225   Unlevered Return 5.27%
         
Total -$14,110      
         
Cash Flow $7,066      
Cash ROIC 8.51%      
         
Price to Rent Ratio 0.72%      
Rent Multiple 138      

If the 30 year mortgage rate were to fall to 2%, it could justify paying as high as 138 times monthly rent.  This gives it a slight boost, but only a gain of around 10% above the.

But…won’t rental rates increase?

Eventually, but it might be slow.  Low interest rates that homeowners have benefited from also apply to apartment developers and owners.  Apartments  qualify for long term mortgages too.    The latest stats on housing starts are posted on Trading Economics and you’ll see recently more months reporting slowing in multifamily housing starts.   Why are developers slowing the amount of rental units they are putting on the market?  There could be a few reasons, but my bet is new projects aren’t hitting their projected rental rates.  Inflation may be the best-case scenario for rent rates, its very possible with the low and changing consumer preferences that single family rental rates grow at inflation minus a percent or two.

So what does this all add up to?

Will we ever buy a house again? Are we in our permanent location? The short answer is I don’t know. We plan on doing a lot of traveling over the next 1-2 years to figure that out. What I have figured out from three consecutive losses on housing is the emotional attachment to housing is over. This is a financial decision and our next home purchase will be based on whether it makes more sense to rent or buy. Everything in the market today screams rent, but the softening of the market shows the tide may be shifting out. Fundamentally I have nothing against home ownership, but we will be driven back into the market based on price and nothing else.

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5 Comments

  1. Leenore

    In NorCal home prices have doubled in the past 7 years or so. I didn’t realize this had happened in other parts of the country as well. Are there a lot of all-cash buyers in your neck of the woods?

  2. Jim

    Just curious where did you end up?

  3. Steve

    In this model, you mention the management fee as an expense. However, in what appears to be your total (management fee, taxes, Insurance, HOA and Maintenance), I don’t see the management fee being included, thus negatively impacting cash flow. I like the modeling, not sure if I’m missing something or if the calculation didn’t pick up management fee. Thanks

  4. EFI

    It took me too long to get to this post! It’s a great summary and after downsizing recently and choosing to rent I share your thinking. We sold a house after significant appreciation and did okay, though it was really a break-even after figuring in improvement and a loss once factoring in opportunity cost.

    We are 3-5 years out from potential retirement and renting. We’re considering buying land and building a small retirement home, or purchasing a cheap home base. I’m with you – either will factor in rental potential for sure. We may not meet the 1% rule, but we’ll certainly be closer to it than in our most recent purchases.

    • Stop Ironing Shirts

      Well good news, you get to be first (or nearly first) after I get an issue with people’s comments being blocked.

      I’m enjoying my current book read that I’ll be reviewing in my next post. It’s funny to see what people are saying to justify these insane valuations on real estate right now. It’s just not rational. The patient buyer will be rewarded

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