When the Rental Market Chicken Comes Home to Roost

Shamon Asks:
In the event that interest rates rise, and, in the event this causes a significant deflation of real estate values, and in the event that this causes many homeowners to sell/walk away from/get foreclosed on - then how/what impact would this have on the rental market? On one hand, landlords would have higher carrying costs resulting in potential rental rate increases, while potential demand from would be renters (i.e. former home owners) would also increase. They'd have to live somewhere. Naysayers would probably argue that the renters would not pay these inflated rates...

Thanks for the question Shamon.

Nearly 70% of Americans own the home in which they live. This is because home ownership is almost sacred in North America. Almost everyone who can own a home does so. Most people consider home ownership to be a good idea and few even bother to (or think of) crunching the numbers to determine whether this is true or not in their case.

On the other side of the pond, only 30% of the Swiss population owns, while most rent. They consider home ownership to be a poor use of their money.

So which is it? Who is right: the Americans or the Swiss?

Unfortunately, (and it pains me to say it) the Swiss.

After all costs are considered, home ownership is often of marginal investment value. Now, people have made a lot of money on houses over the last 20 years, but that has been because of an abnormal period of artificially low interest rates which made it much cheaper to carry a mortgage, which had the predictable effect of increasing demand and raising prices, which made owners a lot of money. (you can read about this period in history here)

Over the last several decades, because of low interest rates , house prices rose. Also, because few people wanted to rent, rents have been somewhat stagnant.

Here is how the rental business should work (and how it works in Switzerland): a property manager calculates the costs of owning and maintaining the home, adds a bit of profit, and that is the rent price they will charge to tenants.

Here is how it has been working in North America: Because of low interest rates and how badly people want to own their own home, home prices have increased. This leaves owners of rental units competing with each other for a small number of people who want to rent their homes, while paying relatively high costs and being able to charge low rents.

This is about to change.

As interest rates rise, demand for home ownership will decline.
As inventory of  homes on the market increases, home prices will drop.
As people walk away from their homes (or lose them), demand for rental homes will increase. (This could also result from fewer and fewer people aspiring to home ownership, due to recent declines)
As landlords buy cheaper houses and rent them out to more and more people who are demanding rental units, rents will rise.

Now, landlords who bought their rental units at high prices during the bubble might not be able to charge rents high enough to cover their costs, let alone make a profit, but as the overpriced inventory works through the system (ie, default, short sales, and bankruptcy), eventually most rental units should become profitable.

So, having made that caveat, I will predict that profitability is about to return to the rental market.

Cheap Money is the Opium of the Masses

Blake asked about the prudence of buying rental property in the current economic environment.

Thanks for the question Blake.

 There are many kinds of recreational drugs. Some begin destroying your body in obvious ways immediately (think crack or meth), others take a while and then might kill you suddenly (like the stroke you might someday have from smoking opium).
The advantage to the drugs that show horrible and obvious signs of damage immediately is that it give the user pause for thought regarding their current "recreational" activities. Conversely, the drugs that start killing you in unseen ways might give you the impression that they are not hurting you at all, making you feel safe to continue taking them.

North America have been on a 20 year drug binge, but the drug of choice has been the "few side effects, followed by a stroke" kind.

After the dotcom crash in 2001, western governments reduced interest rates many times in order to "stimulate"* the economy.

• *Economists who follow "Keynesian" (named after a British economist named John Maynard Keynes) economics believe that governments should "stimulate" their economies by lowering the rent people pay when they borrow money (AKA interest rates) and spending more (so more money is flowing through the economy) when times are tough, and raising interest rates and spending less when times are good. This policy works well in theory, but what often happens (and what happened over the last 20 years) is that governments will reduce interest rates and spend more when the economy is slow, but when it speeds up, they don't raise rates or cut spending (since these actions are not popular with the voters), which results in an "overheated" economy, inflation, over-investment,  and eventually a crash.

These declining interest rates made it possible for people to afford bigger and bigger houses with the same monthly payment. The result was an enormous increase in the amount of outstanding mortgage debt.

As people continued to buy houses, property values began to rise. As property values went up, people began to borrow more and more money to afford the bigger and bigger houses. Since the economy was humming along, unemployment was low, and economists were predicting the good times to last, consumers and investors felt comfortable taking bigger and bigger risks.

As people and companies borrowed more and more to build more and buy more, the business world responded by hiking production (which stimulated the economy even more). Demand was rising and supply was struggling to keep up. Homebuilders were building as fast as they could and they knew that all they had to do to make money was to build a house, so they built as many as they could, at higher and higher prices.

After a while the market hit a tipping point. Consumers who wanted houses and could afford them had bought them, but builders kept on building. Houses began to pile up. Houses began to sit on the market for longer and longer times.

Eventually, an awareness spread through the economy. The boom was over, house prices were not going to go up forever, and people who had bought multiple overpriced investment properties either became scared and dumped them onto the market at a loss, or held onto them until they could no longer afford the payments and lost them to the bank.

This rapid reduction in demand for houses at the same time as a rapid increase in the supply of houses on the market caused the prices to drop like a rock, and the economy went down with it.

Now, in a much different economic landscape, with asset prices dropping and unemployment rising, governments wanted to stimulate their economies, but alas, interest rates were already at very low levels and the government was already spending lots of money. The only options available were to drop rates even more and spend even more (ie, the bailouts of GM, Chrysler, the big financial firms, and "Quantitative Easing" #1 and #2)

So now, here we sit, with interest rates at record lows and governments spending money at record rates and trying to keep their economies as stimulated as they can.

But neither of these can continue forever.

Governments cannot spend forever, and they can't reduce rates any more than they already have.

When governments stop holding interest rates artificially low (either willingly or not) rates will climb... and they have lots of room to move.

Here is a chart showing mortgage rates for the last 60 years. (source Bank of Canada)

As you can see, where rates are now is lower than they have ever been. Eventually, rates will have to start heading back to more normal levels.

Over the last 60 years, the average mortgage rate has been around 8%. We are currently at about 4%.
If a person has a mortgage at 4% on a $300,000 house, they are paying $12,000 in interest per year or $1,000 per month. If Interest rates increase to 6%, then the interest payment would rise to $1,500 per month, and if rates revert to the historical average of 8%, the homeowner would be paying $2,000 per month in interest.

If you have a mortgage lock in for 5 years at 4%, and rates rise, your payment will not change initially, but when you go back to renegotiate your rate at the end of the 5 years, you would not be able to renew your loan at 4%. You would have to get a new mortgage at the rate available at the time.

Here is a suggestion: take your outstanding mortgage amount and look at your current rate. Could you afford to continue paying your monthly payments if rates went up to 8%?

Now here is another thought. When rates go up, and people began having to renew their mortgages at much higher rates, many homeowners will find their new payments unsustainable, and choose to sell their houses. This increase in the number of houses on the market will have the effect of reducing home prices.

Here is what I am predicting: Just as a reduction in the interest rates had the effect of increasing the affordability of houses, demand for houses and prices of houses, an increase in mortgage rates will have the opposite effect.... reduced affordability, reduced demand, and reduced prices.

So, Blake, buying revenue property could be a good idea, but I would suggest you get the property for a really good price and make sure that even if interest rates return to 8%, you could still make the payments.

If you can find a place that meets these criteria, you might be in a position to rent your houses out to the people who can no longer afford to live in their own.

"Real Estate is Always a Good Investment"

Blake asks:
"People have often touted Real Estate as the most secure and steady of all investments. Conventional wisdom has been to buy a principal residence, and then buy revenue property if you can. What are your thoughts about revenue property given the current economic landscape?"



Thanks for your question Blake.
I will answer your question, but today I will address some prevailing ideas about real estate ownership.


Conventional wisdom (and real estate agents) tend to say that "real estate is always a good investment".


Now, I am not one to contradict conventional wisdom or realtors, but it is not often that you find very many things in life that are ALWAYS anything.


If you ask me if there is money to be made in property, then the answer is, of course, yes.
If you look at a real estate portfolio and a portfolio containing stock and compare them in the areas of risk adjusted returns (meaning returns after risk levels are considered), then yes, the real estate portfolio is usually a better bet.
If you ask me what my personal holdings are in, the answer is mostly real estate.



However, the idea that it is ALWAYS a good investment is problematic for several reasons.
First, it implies that buying ANY property at ANY price is a good idea. (which people who bought houses at the peak of the bubble and are now "under water" learned was not the case)
Second, it does not take several important factors that should become very important to a potential buyer, such as location, market conditions, risk, carrying costs, and condition of the property.
Third, (and this is a big one), people often have an emotional attachment to homes, and therefor make emotionally based buying decisions, which rarely lead to profit.

So, yes, real estate CAN be a great investment, but it is not ALWAYS a good investment.


Let's say you are currently renting, and your parents are bugging you to "stop paying your landlord's mortgage" and buy a house.


What should you do?
Or, to put it a different way, which is better, renting or owning?



Well, its true, no one wants to be paying someone else's mortgage, but it should not be assumed that it is a good idea for you to buy a house at this point.



If you want to financially benefit from owning a house, you could do so in two primary ways:

• By saving money each month (by paying less as an owner than you would as a renter)
  
• By selling the house for more than you bought it for.
  

Now, first time homebuyers often get it wrong in both of these areas.

First, they look at the monthly mortgage payment and if it is less than rent, they become homeowners.

The problem here is that they often ignore other costs such as home insurance, property taxes, and (this one can be huge) maintenance that will add to the carrying costs, but not really add to the value of their investment.

Second, people tend to buy properties with the idea that they will buy a house for one price and sell it for twice as much a few years later.

Unless we have another housing bubble around the corner, it is likely that house prices will drop, stay stagnant or creep up slowly for the foreseeable future.

Now, let's say that you find the house of your dreams, and when you consider mortgage payments, insurance, taxes and maintenance, you would still pay less as an owner than you are currently paying in rent.

Should you buy it?

There is one more thing for you to consider that should affect your decision, and that is that you don't know what the future holds.

As of today, you are probably employed.

As of today, interest rates are at all time lows.

These two factors can make home ownership easy today, but they could both could change very quickly.

If your financial situation changes significantly, you could potentially leave your rental house and move to a different one, but if you have mortgage payments, you are stuck.

If interest rates go up (and they will. I will write more about that some day soon), you may find it impossible to afford the mortgage payments you can afford today.

So, to sum it all up....

Buying a house can be a good decision for some people in some situations under certain market conditions.

I am sorry.... I know that statement doesn't roll off of the tongue as well as “real estate is always a good investment” does, but its true.

So, I am not trying to scare you away from home ownership.

I just want to make sure that you know what you are getting yourself into before you take the terrifying plunge into the world of real estate ownership.

The Year Almost Everyone Was Wrong

I remember it clearly.
It was 2007 and 2008.

All around me, I saw prices rising: stocks, commodities, houses...everything.
You could get a job at Wendy's at $14 an hour to start.
A euphoria swept the market and it seemed like everyone was talking about buying a house to "flip" or revenue property.

People were snapping up 5 and 10 Miami and Las Vegas condos at a time....even before construction began.

This market was going to the moon. Everyone knew it. Experts were predicting the DOW to reach 30,000.
The only risk was that you would miss the boat, so you had better buy something now. And people did... Lots of people.

Buyers were lining up to make bids on houses. They were offering $50,000 over asking price, all the while hoping that one of the other 30 bidders would not outbid them.
This was an "Information Economy", not subject to the normal up and down cycles of economies past. This economy would grow forever.
The only risk, is that you might miss the boat, and then you will never be able to afford a house, so buy now.

Oh, no. You don't have enough money to put a decent downpayment on a house? No problem, I am sure you can find a mortgage broker who can pull some strings and get you into a house for nothing down. And don't worry about getting yourself into trouble with your mortgage, house prices always go up. A couple years from now, you will have a nice chunk of equity.

Yup, I remember it well.

Most people were wrong.
House prices did go down..... a lot in many places.
In many US markets, house prices are half of what they were before the bubble burst.

Millions of jobs and trillions of dollars have been lost over the last few years.

If you had asked anyone, (a person on the street or a financial or economic professional) whether AIG,  Lehman Brothers, GM and Chrysler could fail, most would have said "no".

 Now, a few years later, in a much different financial and economic landscape, with markets facing uncertainty, people are feeling anxiety about the future.

Is this a good time to buy stocks or mutual funds, or is better to hold bonds or gold, or even cash?

Where is the economy headed?
Are things going to get better from here, or are there still more rough waters ahead?

Should I sell my house now or wait till prices come back up...... Are house prices going to come back up?


This blog is here to answer questions like this.
If you have questions about financial, economic, investing or real estate topics, this is the place to ask them.

My name is Dan Kremer and I am here to answer your questions.

Please post  your question in the comments section. You are probably not the only person who has it.

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