Are Rental Properties the Next Big Investment Opportunity?
Owning a house with a white picket fence is a quintessential part of the American dream. But an increasing number of Americans are deciding that renting a home is a better fit for their families than buying one. “Over the next 15 years, new renters will outnumber new homeowners — causing a sustained surge of rental housing demand,” concludes a recent study by the Urban Institute entitled “Headship and Homeownership: What Does the Future Hold?”
Rent or Buy? A Tough Financial Decision
Many young people dream of buying a home of their own. But it may not always be a wise investment, depending on where their lives are headed and how stable their jobs are. It’s harder these days to make a short-term profit on real estate, so first-time buyers should generally be in it for the long haul.
Financially savvy young people often wait to make the plunge into homeownership. The Urban Institute study reports that when Millennials have reached their prime home-buying age in 2030, only 38% will own homes, compared to 46% of Baby Boomers in the 1990s.
Total Costs of Owning a Home
Here’s a closer look at all of the costs that first-time home buyers should factor into the decision. It’s also important for rental property investors to consider all of these costs when estimating a property’s potential return on investment or setting lease rates. Besides monthly mortgage and interest payments, consider:
- Property insurance,
- Property taxes,
- Homeowners association (HOA) dues, and
- Property maintenance.
When real property is bought or sold, the parties also may be required to pay closing costs and fees for realtors and attorneys, depending on how the deal is structured and where the property is located. These transaction costs should be factored into the rent vs. buy decision, too.
The Bright Side of Homeownership
Homeownership does offer several upsides, however. Interest costs and property taxes are generally tax-deductible if a home buyer itemizes expenses on his or her federal income tax return. The tax code allows homeowners to deduct:
- Interest on up to $1 million in “acquisition indebtedness” — debt that’s used to buy, build or substantially renovate a home, and
- Interest on up to $100,000 in home equity debt that’s used for any purpose.
The interest deduction limits apply to the combined principal of all loans secured by principal and second homes. If an individual’s tax status is married filing separately, the limits are cut in half to $500,000 and $50,000, respectively. The IRS has clarified that homeowners who have more than $1 million in acquisition indebtedness may deduct interest on the excess as home equity debt (subject to the $100,000 limit). The rules are more restrictive for taxpayers who are subject to the alternative minimum tax. If you have questions, consult your tax adviser.
As an added bonus, homeowners who lock into today’s low interest rates can be assured a fixed monthly payment. Conversely, renters are likely to experience rent hikes each year as they renew their leases, especially in markets where the demand for rental units outpaces the supply.
This trend could create lucrative investment opportunities in certain geographic markets. Here’s a closer look at what’s driving the shift and where investors can earn the highest potential return on rental properties.
Study Predicts a Hot Residential Rental Market
Although homeowners will continue to outnumber renters, homeownership rates are expected to decline in the coming decades. The Urban Institute study estimates that 22 million new households will need homes to rent or buy in the next 15 years, but only 9 million of these households will choose homeownership. By 2030, the homeownership rate is expected to drop to 61.3% from 65.1% in 2010. The increase in demand for rental properties is expected to drive up lease rates in markets with a limited supply of rental properties.
Why are more people choosing to rent? Many are skeptical about whether homeownership is a smart investment, after factoring in allof the costs of owning a home. (See “Rent or Buy? A Tough Financial Decision” at right.) Following many years of strong appreciation in the housing market, homeowners received a harsh wake-up call. During the recession that persisted from 2007 through 2009, home values plummeted. Although some markets are recovering, property values generally haven’t recovered from their pre-recession peaks.
In addition to having cold feet, some renters simply can’t afford to buy a home, especially as interest rates rise. The Freddie Mac Weekly Mortgage Survey shows that the average fixed interest rate on a 30-year mortgage has increased from 3.73% for the first week of 2015 to 3.89% for the week ended September 3. And, the mortgage rate is likely to increase even more if the Federal Reserve increases the Fed Funds rate later this year, as many analysts expect will happen.
Saving for a down payment will also be harder for first-time homebuyers if rents rise due to a short supply of rental properties. Even if they have the cash to put down, Millennials with high student loans and people with poor credit may not qualify for affordable mortgages given today’s tougher underwriting standards. Individuals who are forced to delay their homebuying plans will likely rent until they can afford to buy their dream homes.
Opportunities Emerge for Investors
Regardless of whether the choice to rent is voluntary or involuntary, the trend is good news for investors. Housing research firm RealtyTrac estimates that the annual gross rental yield averaged 8.94% in the first five months of 2015, based on its buy-to-rent analysis. The rental market also is becoming more stable and predictable as the real estate market improves.
RealtyTrac reports that the low supply of rental properties has caused average rental rates on 3-bedroom properties to increase 3% from last summer. “Buying rentals continues to be a brilliant strategy that allows investors to hedge their bets in a real estate market shifting away from homeownership and toward a shared economy,” concluded Daren Blomquist, vice president of RealtyTrac.
Location, Location, Location
When investing in real estate, location is everything. So rental property buyers need to choose their markets carefully. According to RealtyTrac, the top five counties in which rental rate growth is outpacing home price growth, providing investors with increasing rent-to-buy returns, include:
- Orange County, Calif. (Los Angeles metro area)
- King County, Wash. (Seattle metro area)
- Santa Clara County, Calif. (San Jose metro area)
- Philadelphia County, Pa.
- Suffolk County, N.Y. (Long Island)
Other cities with hot rental markets include:
- Cincinnati, Cleveland and Columbus, Ohio,
- Atlanta,
- Charlotte and Raleigh, N.C.,
- Milwaukee,
- Jacksonville, Fla., and
- Denver.
When deciding where to buy, it’s important to consider both rental rates and property values. Ideally, you want to buy the property at a low price and then rent it out for as much money as possible. You want to buy in a market where the supply of rental properties is low and the demand for rentals is high, based on demographic trends and property values.
How to Become a Real Estate Mogul
The stage is set for a strong residential rental market for the next 15 years. That may be bad news for people with unfulfilled dreams of homeownership. But it’s good news for investors with extra cash to purchase single or multi-family rental units. If you’re interested in hearing more about rental property investment options, talk to your financial adviser about the tax rules, mortgage alternatives and most advantageous places to invest. Together, you can devise a prudent strategy to minimize your risk and maximize your return.
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Brought to you by: McClanathan, Burg & Associates, LLC
