It seems that every week, there is a new thread topping the BiggerPockets forums that discusses the probability (inevitability?) that we’re nearing the top of the real estate market cycle.
As much as we all talk about how difficult it is to time the market or to predict market crashes, it’s incredibly tempting to try. The other day, I finally caved. I decided to go ahead and try my hand at predicting what’s in store for real estate investors over the next few years.
I am NOT going to give specifics—I don’t actually know what’s going to happen, and I’m not recommending a course of action or giving any guarantees. I don’t know whether the market will go up or down, how much the market will go up or down, or how that will affect specific properties in specific areas.
But I do hope that this article will give you some things to think about and will help you make new observations. I hope that it gets a discussion going that isn’t just pointing out weird ratios about median incomes to prices or whatnot. And I hope that you point out some flaws in my thinking in the comments, so that my perspective on the market can evolve.
I’m simply putting on my economist hat and doing a good, old-fashioned supply-and-demand analysis of the rental real estate market—and then guessing at the future.
The study that will follow contains data from a variety of sources. Zillow is most heavily relied on for market-level data. The goal here is to provide a summary understanding of the rental real estate market as applicable to the market that BiggerPockets serves and then to provide commentary for discussion about the possible ramifications for the medium-term future of the rental real estate market.
Key Takeaways From My Research
What’s currently going on in the SFR (single-family rental) market?
- Inventory has drastically increased relative to other housing:
- The total number of U.S. households has increased steadily, but almost all of the housing demand in recent years has been filled by rental units.
- Smaller metros have a higher proportion of SFRs (versus larger metros, which have more multifamily complexes).
- SFR rental growth led in Phoenix, Boston, and several large Texas metros.
Who is buying SFRs?
- Most buyers of single-family rentals hold fewer than 10 units.
- Of the 15+ million single-family rentals currently on the market, only 2% are owned by large investment firms, and about 45% belong to landlords who own just one unit.
How is the single-family rental boom impacting home-buying?
- The share of single-family homes being rented out jumped from about 13% in 2006 to 19% in 2016.
- Landlords compete at the lower-end of the market, for less expensive homes. This creates competition with first-time homebuyers. According to Zillow, “Almost 40 percent of rented single-family homes bought since 2012 are among the most affordable compared to 34% of single-family rental homes that were bought before the market crash.” This is forcing homebuyers out and creating more rental demand, perhaps correlating with the increase in supply.
- Said Zillow senior economist Aaron Terrazas, “The combination of foreclosures and growing rental demand following the housing crash was an attractive opportunity for investors—large and small—who were able to buy foreclosed homes and use them to meet the rental demand. At the same time, many long-time owners have opted to hold onto their homes as rentals even after they decide to move somewhere else.”
What’s happening in the tenant marketplace?
- In 2006, 31% of US households rented; today, over 36% of households rent; in 2000, prior to the housing boom, 33% of households were renters.
- Nationally, median rent for houses rose 1.3% from 2016-2017, while median rent for multifamily rose just 0.5%. Through the first half of 2018, median rent for SFRs rose 1.8% compared to 1.3% for multifamily compared to the first half of 2017 (I computed this manually right from Zillow’s database).
What’s driving tenant demand for single-family rentals?
- RENTCafe commentary:
- A little over half of the total number of single-family home rentals on the U.S. market are occupied by families—they offer space for families, privacy, and the kind of neighborhood desired.
- Houses are also the rental of choice for single people who want to share the cost of rent with other single roommates. This accounts for almost half of the renters living in single-family houses today.
- 45% of those who rent would prefer to rent a single-family rental, but only 28% can actually find a single-family home to rent (According to Zillow).
Single-Family Rental Market
There is a large and growing demand for detached single-family rentals, and while there is not nearly as much data on this, I suspect that town-home, duplex, triplex, and quadplex rental demand is growing at a pace somewhere between multifamily and single-family rental demand. Supply is not keeping up with this demand, which is why rents and prices have been growing quickly for the past several years.
Unlike other asset classes, much of the supply in the single-family rental space is owned and is being purchased by ordinary Americans—folks with less than 10 units owned make up more than 87% of the marketplace in buying single-family rentals. It’s likely that people like you and I—here on BiggerPockets—are a significant and growing share of this marketplace.
We here at BiggerPockets like to think that we are continuing to give the advantage to small-time landlords like us—advantages that are difficult for institutional investors to replicate, like the ability to network with local wholesalers, understand the qualitative and subjective decisions that go into buying in specific neighborhoods within specific markets, and make specific tenant management calls.
I believe that the factors driving tenant demand for detached rentals (better neighborhoods, more square footage, bigger yards, etc.) will remain in place, even as fewer people might be able to purchase homes in a recessionary environment. This might lead to still greater demand for single-family rentals and continued strong returns for rental real estate investors.
While overall demand for homes and rental units may contract in a recessionary environment (as people move in with relatives or move in with roommates), I suspect that the price of homes is likely to bear the brunt of this impact. While fewer people will be able to buy homes, folks have to live somewhere, so the total number of renters is likely to either increase or remain flat relative to the number of homebuyers, which will likely decline.
A similar story is likely to unfold in an environment of rising interest rates. Rising interest rates will make mortgage payments more expensive, putting downward pressure on home price growth, but upward pressure on rents. Rising interest rates will not change the qualitative factors that currently make single-family rentals more appealing than multifamily rentals to tenants, but they will make it harder for your typical owner-occupant to make payments and actually purchase a home.
In fact, a recessionary environment in the U.S. housing market may actually increase the number of mom-and-pop rental property investors, as prices may fall or flatten, but rents may continue to rise or remain flat. This means that while folks may lose equity, their cash flow might be reasonably secure. And, of course, it may be easier to find rental properties that produce satisfactory cash flow at a great price in a recessionary environment.
I suspect that it is your typical homeowner, not your typical buy-and-hold rental property investor, who is at more risk of losing property to foreclosure in a recessionary environment when their primary or only source of income (their job) is no longer there.
Furthermore, assuming that rents remain at least relatively flat, many of those current investors with fewer than 10 properties (remember, these folks make up 87% of the single-family rental market) will have 30-year fixed-rate conventional mortgages. With a fixed-rate mortgage, small-time investors of single-family and small multifamily rental properties have reasonable odds of sustaining satisfactory cash flow in an environment of rising interest rates. About 90% of homebuyers chose fixed-rate mortgages in 2016.
While I don’t have the data to back this claim up, I suspect folks continue to largely opt for fixed-rate 30-year mortgages through the present and that a large majority of investors who have the option in the single-family and small multifamily space are choosing 30-year fixed-rate mortgages as well.
In short, I think that your typical buy-and-hold rental property investor on BiggerPockets is producing reasonable cash flow from his or her rental properties right now. I expect that rents are not likely to drop drastically and that even if they do, single-family rental property rents will not be hit as hard as rents in other parts of the market.
And even if rents are hit hard, I think that the peolpe like us here on BiggerPockets, usually with fixed-rate 30-year mortgages, are likely to be at less risk of actually losing our properties to foreclosure than our friends in the commercial market, where financing is much more exposed to interest rate risk.
So, what could crush single-family rental investors?
While there are plenty of scenarios that could crush individual investors, I believe that one of the few market conditions that would systematically put a majority of BiggerPockets’ investors at risk would be a period of heavy deflation, coupled with rising interest rates.
This would put downward pressure on rents and increase financing costs. This is one possible scenario where real estate investors may lose categorically—if rents fall, they lose equity, and their financing costs remain high. I believe this is an unlikely future scenario, looking at recent monetary policy. But you always have to be aware of what can kill your portfolio.
I invest in real estate personally because I believe that inflation is more likely than deflation and that prices and rents will rise over time. If I did not believe that, I would not be investing in real estate.
Commercial Real Estate
One major threat (or opportunity?) to the small-time investor—investors like those of us on BiggerPockets—is the rising supply of large multifamily units in many major metros, relative to demand. We see that rent growth for single-family rentals continues to outpace rent growth in multifamily, even as more single-family home inventory is being converted into rentals.
If single-family rentals continue to become more expensive than multifamily, then tenants may decide that renting an apartment unit is more cost-effective than a single-family home. This may keep market rental growth for single-family rentals flat or drive rates down.
Related: I Used to Think All U.S. Markets Were Too High—Until I Started Investing in This City
However, because of the advantages of single-family rentals and the clear preference of tenants for these rentals, I suspect that rent growth for single-family homes will continue to remain healthy for the foreseeable future—at least, in relation to multifamily rents. If rents fall across the board, I suspect that multifamily will be hit harder than single-family.
We’ll need either an increase in the supply of single-family rentals or a reduction in demand from renters to change the current trajectory of the marketplace of tenants.
The future of the commercial multifamily real estate market, with a particular eye towards large multifamily apartment complexes and retail, is what’s more interesting to me—and, in my opinion, more dangerous.
In the commercial multifamily space, we see continued growth that is outpacing demand, relative to single-family rentals. You can see visual representation of this in most major metros—just stroll through Denver, CO and count the cranes—and you can see it in the numbers in the studies I produced and linked to earlier.
Some of this growth presumes continuous demand for multifamily rental units, often in the luxury or higher-end space, and I wonder if that demand for apartment units and condos is actually going to materialize for many of these builders and institutional investors over the next few years.
It’s the click-bait question posed by so much media in the real estate space: Will Millennials continue to flock to cities, or are they finally going to settle down and move to the suburbs? And, when they do, will they rent or buy?
I don’t have a crystal ball, and while I’m doing my best to pretend like I do, I don’t actually have any real insight into what Millennials will end up doing. But my guess is that the least likely outcome for Millennials is that they continue to rent high-end apartments. I just don’t see that as the long-term goal for most of my peers, but I could be biased by my peer group and categorically wrong about that! Instead, I see it as much more likely that they move into homes with yards and raise families in good school districts. And I can absolutely see a large portion of them being happy to rent those homes rather than own.
If I’m right, and continued tenant demand for luxury multifamily rentals does not materialize or does not keep up with supply, many private equity and institutional real estate investors may find themselves with cash flow problems. Market rent will be below the projections needed to produce satisfactory operational cash flow or even break even.
Compounding this is the fact that commercial multifamily often has much more interest rate exposure than your typical landlord with single-family rentals.
Unlike in the single-family rental space, where about 90% of mortgage loan applications are for 30-year fixed-rate mortgages, commercial loans often have more complicated, layered structures and often come with terms like adjustable rates and balloon payments.
Why is that important? Imagine this:
You purchase a fully renovated turnkey multifamily apartment priced at $10,000,000 with financing at 75% LTV, a 6% interest note, amortized over 25 years, with a 7-year balloon payment, projecting a 7% cash flow from operating expenses and CapEx in year one. Annual rents are $1,400,000, and operating expenses + CapEx are projected at $700,000 annually. You assume 2% annual rent and expense growth.
Here’s what your cash flow might look like in year one at the 50% Rule:
- $1,400,000 in rental income
- $700,000 in cash expenses
- $578,784 in financing expense
- $121,216 in cash flow
- 4.85% CoC return on $2,500,000 invested
You think, “Great—I’m doing OK with this. I’m paying down the note, and rents will appreciate and make this investment into a real winner shortly! In four years, I’m generating really strong cash flow, and our firm is better than all those other idiots out there—we can make some operational improvements to bring down that OpEx.”
Oops—instead of rising by 2% per year, rents FALL 2% per year. And somehow the team never actually lowered those operating expenses—OpEx rises by 2% per year.
Your cash flow looks like this in year four:
- $1,291,315 in income
- $757,703 in operating expenses
- $578,874 in financing expenses
- Negative $45,171 in cash flow
Oh, and OOPS again! Your balloon comes up in three years! You need to start looking at a refinance. But interest rates have risen. That means that cash flow may be no better—and might even be WORSE—after the refinance! It’s time to sell and cut your losses. Problem is, everyone else is trying to sell at the same time!
I see this as a very real problem facing the commercial multifamily real estate space at some point in the next decade—and perhaps even within the next two or three years.
Of course, this might never happen—and those who own and hold commercial multifamily in this situation might continue to win in spite of relentless growth in multifamily supply and rising interest rates if tenant demand for luxury apartments continues to keep pace.
If I were betting on a future that saw a decline in the real estate market, I’d bet that we will see a strong buyer’s market in the commercial multifamily space, a market where finding a great luxury apartment or condo at a great price will be extremely easy both for investors and for tenants.
While the effects of this risk may put some downward pressure on single-family and small multifamily (duplexes, triplexes, and quadplexes) prices and rental rates, I believe the single-family rental sector will have strong enough demand and enough insulation from interest rate risk (as buyers have and will likely continue to use fixed-rate mortgages) to weather the storm more effectively than the commercial space, where investors may find themselves with much more interest rate exposure and may face continually increasing pressure to refinance or sell.
I suspect that in an environment like this, demand by tenants for single-family rentals will continue to remain strong relative to supply, but that price appreciation will flatten because of rising interest rates and strong downward pressure from the multifamily and condo markets.
If many or even several of my numerous assumptions come true, I suspect that single-family rental rates will remain one of the strongest relative areas in the real estate market, even though there will, of course, be some challenges for your average investor when facing a reduction in prices across all aspects of the market.
In a recessionary environment with rising interest rates, which is what I believe to be a probable environment at some point in the next few years, those who currently own cash-flowing rental properties may experience relatively less appreciation, but still have reasonable odds of sustaining positive cash flow.
And it might be the perfect opportunity for some of our more seasoned investors to begin scooping up larger commercial assets at a discount.
So, my conclusion is to keep doing what I’ve always done—buy good deals in good areas with good cash flow, not time the market, lock in fixed-rate mortgages, and continue to have a large cash reserve ready to handle operational problems and ready to be used to purchase more great deals when and if they come across my desk.
Sources for this research:
- Urban Wire: Housing and Housing Finance:
- Single-Family Rentals Increased Faster than Apartments in 22 of 30 Big Cities, Led by Phoenix
- Zillow: Share of Renters Rise in Each of the 50 Largest U.S. Cities
- Zillow: Rent Appreciating at a Faster Rate this Spring in Over ¾ of Nation’s Largest Markets
- Zillow: All U.S. Homes Worth Cumulative $31.8 Trillion
- Zillow: Single-Family Rental Boom Lowered Annual Home Sales by 270,000
- Zillow: Renter Demand for Houses Puts Upward Pressure on Prices
Other helpful data:
- U.S. Renter-Occupied Units
- Homeowner Vacancy Rate
- Vacant Housing Units for Rent
- Household Debt Service Payments as a Percent of Disposable Income
- Total U.S. Housing Units
Will the commercial market run into issues in the coming years?
Weigh in with a comment!