Major headwinds are converging on the real estate investor. Perhaps you’ve felt a slight breeze and haven’t thought much about it, or maybe you are already feeling the winds picking up in a changing economic climate. Three major conditions are shifting against real estate investors: high property prices, rising interest rates, and the increasing number of new apartments.
According to the Case Shiller Home Price Index, home values have risen 62% since the lows during the financial crisis. This, of course, makes it increasingly difficult to find a deal…. And by “deal,” I mean a house or condo priced below comps or market value. For an income investor, it can also mean a property that has a low price to rent ratio. There may be pockets in the country where “deals” can be found, but they are increasingly rare.
Another major macro challenge is the rise of interest rates. With conventional thirty year mortgage rates currently in the 4.5% range, lenders typically want a point more for investment properties, or 5.5%. According to CoreLogic, there is (surprisingly) not much of a historical correlation between interest rates, home sales, and home prices. While buyers looking for a primary residence may not be put off by rising rates, investors live or die on cash flow and make decisions on the projected return on investment (ROI).
For example, here in Nashville, if an investor purchases a property for $250,000 and puts 20% or $50,000 down, they’ll need to borrow $200,000. At 5 ½ %, they’ll have a mortgage payment of $1136. Let’s say taxes, insurance and maintenance adds another $300 for total monthly expense of $1436. If they rent the house for $1600, that only leaves $164 in monthly profit or a cash-on-cash return of only 3.9% ($164 x 12 months equals $1968 in annual profits divided by the $50,000 down). The only reason to consider a deal like this is if you believe the property has major upside appreciation.
If rates go up another point and the investor is paying 6.5%, the mortgage payment would go up another $100 to $1264 a month. Adding the extra $300 for taxes, insurance and maintenance puts the monthly outlay at $1564. Unless you can get significantly more than that for rent, the numbers simply don’t make sense. Of course, this all depends on your local prices and rental rates. Also keep in mind, those examples assume twelve months of occupancy and no surprise maintenance issues.
The third headwind is the increasing number of apartments being built. According to RENTCafe, 345,000 new apartment units became available in 2017, a 21% increase compared to 285,000 in 2016. 8500 new apartments hit Nashville in 2017 and more are being built everyday. While they are supposedly needed, they have also made the rental market more competitive. Apartment complexes often offer amenities and signing incentives, such as waiving the deposits or reductions for the first month.
Where does that leave the real estate investor? We can scour the country for real estate markets where pricing is still low relative to rents. However, most investors stay local and are dependent of the prevailing conditions in their specific market. That means, for many of us, it may be necessary to stay on the sidelines. This may be a good time to upgrade any properties already in your portfolio and pay down the principal as much as you can. (See my article, “The Conventional Pay-Down Plan”).
According to the National Association of Realtors, investors currently make up around 15% of the home buyers market. As interest rates rise, that percentage should begin to significantly drop, and that could contribute to cooling off the overall market. That is okay too. There is a time to invest and there is a time to wait the market out. Until home prices, interest rates, and/or rental inventories comes down, the headwinds may be too strong for most investors.