Submitted by Jim Lazar
IF there is a “housing crisis” then we need more rentals. For there to be more rentals, there must be more investors willing to tie up and risk their money. For that to happen, the return on investment has to be there. And, to attract individual local investors, rather than corporate investors, the hassle of being a landlord cannot be too burdensome.
Everyone should save for their retirement when they are working. I started when I came to Olympia to work for the State in 1977. Some people invest in mutual funds, including, for example, the State of Washington’s “deferred compensation” program. Others invest in rental housing. In both cases, the purpose is to have a nest egg available when your salary income stops.
Investing in mutual funds is easy and effortless. You can put money in on your own schedule. You can invest in oil companies or solar companies, in real estate companies or food producers. Or in “index funds” that buy little bits of every industry.
Easy + Boring = 10% return
It takes almost no time to manage the asset. You receive quarterly dividends, which you can spend for current needs, or reinvest for longer-term benefits. And you can sell shares and have the money available for a vacation, medical costs, a home improvement, or any other purpose in one day. The most boring mutual fund in the world, SPY (an S&P 500 Index Fund) has averaged about a 10% annual return over the past 10 years.
Rental housing investments are lumpy and risky
By contrast, investments in rental housing are lumpy. You need $100,000 or more for a down payment, all at once. You never really know exactly when a $1,000 appliance replacement, $2,000 plumbing repair, or $10,000 roof replacement will be needed, so you need to have cash reserves. A tenant may leave, and then you have fix-up costs and the cost of finding a new tenant at the same time you have a lapse in rental income. To get your original investment back out, you have to sell or refinance the property, which is time-consuming and expensive, unlike the very simple market to buy and sell mutual funds. The point is that you don’t get to “put money in” and “take money out” on your own schedule like you do with a retirement account at Etrade or Vanguard.
And you may have a tenant who actually damages the place or is unable to pay rent, and then you may have a lapse in rental income, extra repair costs, or even legal expenses for an eviction.
In short, it’s a lot riskier than investing in boring mutual funds. Therefore rental housing needs to carry a higher expected rate of return to attract investors. If mutual funds are providing an average return of 10%, the reward for investing in rental housing must be higher than that, or these retirement investors are better off putting their money into boring mutual funds.
Beyond that, some recent changes in the housing market make it a lot more expensive to invest in new rental housing than in the past. That investment is needed to expand the rental housing supply, but the costs are very high in comparison to previous decades.
Fasten your seat belts for some real numbers.
Five years ago, the average home in Thurston County sold for about $300,000, and interest rates were around 3%. An investor could buy a house with $60,000 down, and their mortgage payments would be $1,020/month. Add in maintenance, property taxes (these alone are about $300/month), utilities, and other expenses totaling $500/month, and their cost of ownership was about $1,500/month before any return on their investment. Then, if they are to get a 10% return on the $60,000 they put down, they need to earn $6,000/year, or $500/month on their down payment. So rent five years ago would need to be about $2,000/month to provide a current return equal to a mutual fund. Cut all of these figures in half for an apartment.
Many real estate investors take less income in the early years to attract good tenants with lower initial rents. I did not earn any return on my rentals for the first few years I owned them. But investors expect those rents to go up over time, and the value of the property to rise, eventually producing an adequate return in the long run.
Today that same house costs the new investor $500,000 to buy, and interest rates are more like 7%. First, the new investor now needs $100,000 for a down payment. Then, because of both a higher mortgage amount and higher interest rates, their monthly mortgage payments will be $1,700/month. Even if their maintenance, taxes, utilities, and other costs were still $500/month (these probably went up also over five years), their continuing cost of ownership is about $2,200/month (up from $1,500/month five years earlier) before any return on their investment.
This new investor also has a larger down payment to earn a return on, $100,000 instead of $60,000. A 10% return on that investment (same as a mutual fund) is now $10,000/year, or about $800/month. That means rent would now need to be $3,000/month for the same house to cover the mortgage, maintenance, taxes, insurance, and a return to the investor no greater than they would get by investing the same money in a boring mutual fund. Again, cut all of these figures in half for an apartment.
New regulations will add to these costs
But wait, there’s more. With the strict new rules adopted by the City of Olympia for rental management and other changes being considered by the State Legislature, the costs will be higher. The rules have gotten so complicated that many rental owners are hiring professional management companies to make sure they don’t get crosswise with the regulations. Hiring a professional manager also helps to make their investments less hassle, more like mutual funds. Ignoring any extra maintenance costs needed to comply (I’ve assumed a “good” landlord that does maintain their property in my examples above) there is the cost of paying a professional manager. A typical property manager takes about 10% of the rent every month, plus additional fees whenever they have to find a new tenant. Just the 10% fee adds a cost of $300/month, something that was less necessary before the new strict rules designed to protect tenants took effect.
This means that today, to attract an investor to buy an “average” house, the rent needs to be $3,300/month versus only $2,000/month five years ago. And that only gets the investor a return equal to a boring mutual fund, which is so much more flexible. Wondering where the “50% increase in rent in five years” came from? It’s driven by actual costs in the market to supply new rental units, that’s where.
Comes large corporate landlords
The hassle of increasing regulation is pushing a lot of individual investors out of being landlords. More and more will sell their properties to the large corporations that are buying up thousands of houses, in many cases, outcompeting potential individual home buyers in the market. Invitation Homes is an example. They own dozens of homes in Thurston County, and 80,000 homes nationwide. They are “cash buyers” who can close a purchase in days, making them very attractive potential buyers when people are selling their homes. They are highly professional and know how to extract top dollar from a rental.
But, they may not have the same level of understanding or sympathy for a tenant with a temporary interruption in their income as individual investors do, because the individual investors “get to know” their tenants as people, not just as “renters.” So, the corporations will keep the rents at “market” and they may provide tenants a less desirable experience.
What about owners of older houses?
The astute reader might think: “Wait! The person who bought a rental house 5 years ago for $300,000 does not have to charge rent based on today’s costs. They are making plenty of money on their investments at the lower costs of their purchase years ago, and the low-interest mortgage they secured then.” True. But that same person can sell that house today for $500,000, pay off their $240,000 mortgage, and have $260,000 to invest in mutual funds. That will provide them a $26,000 return per year. Why would they be satisfied with the lower income from leaving rents unchanged if they could sell, eliminate the hassle of being a landlord, and get a better return on their investment? That is a choice that several of my landlord friends are considering today: sell their rentals and reinvest the proceeds in simpler retirement assets.
I was a “landlord” for 15 years. I invested a $30,000 inheritance in the down payment for a duplex and a rental house about 30 years ago. After about 12 years, my work had me traveling internationally, so I hired a professional property manager. That ate up enough of the income that it no longer was a “better” investment than mutual funds, and I decided to sell after a few years. The return on investment simply did not justify the hassle for me. I figured this out, sold my rentals, and invested in boring mutual funds. A young family bought my rental house, and a professional investor bought my duplex. I no longer get a call from my tenant on Christmas Eve that the water heater has broken. I no longer have to collect rent from tenants who may have a lapse in income or unexpected expenses. I no longer have to find a tenant when one moves out. And it’s much simpler to calculate my income taxes in April.
The mutual fund dividends provide me a reasonable addition to my Social Security, adding up to an adequate retirement income for my relatively frugal lifestyle. The dividends go up a few percent per year, generally keeping up with inflation. The value of the mutual fund shares generally rises gradually over time. And I can sell a few shares whenever I need to pay for a bathroom remodel in my own home or want to take an extended vacation. No regrets.
The bottom line is simple: if you want to have more rental units available, the return to investors has to be adequate to attract new investors and to retain existing investors. They will compare the potential returns from housing to the potential returns from other options for their retirement nest egg. If the return is not there, the rental housing will not be available. It’s really that simple.
There are some other solutions to the housing crisis.
We should not rule these out.
One solution is the federal tax-subsidized housing assistance payments available through Section 8 housing vouchers. These enable qualified tenants to afford market rents. There is not nearly a large enough fund to meet the need, but that’s a decision Congress makes. Democrats generally support the expansion of Section 8, and Republicans generally do not. With the U.S. Senate evenly divided, and 60 votes needed to overcome the filibuster, I don’t expect an expansion of Section 8 housing voucher funding any time soon.
Another alternative is to provide more public funding to the Thurston County Housing Authority or other public agencies and let them finance, build, maintain, and manage tax-subsidized housing. That is a decision local taxpayers can make. Thurston County has approved a “Housing Fund” to do exactly this, but the amount of funding falls far short of the need.
A third alternative is to support organizations like Habitat for Humanity, a non-profit that helps families build their own homes, using “sweat equity” and donated funds, materials, and labor to help keep costs down.
But imposing draconian regulations on existing landlords is not a “solution” to the housing crisis. This will only drive up costs in the short run, and eventually drive down the supply of rental housing. Local investors will drop out of the market, leaving it to large corporate investors who have full-time lawyers, accountants, and property managers, and can handle the increased complexity.
That’s how markets work. Not always immediately, not always efficiently, but ultimately, markets DO work.
It’s a wage-and-salary crisis
In my opinion, we really have more of a wage and salary crisis and a challenge of expectations than a “housing” crisis. The market will produce housing if people are willing and able to pay for it. People don’t earn enough to pay for the housing they want and think they need. My father was one of four children, growing up in an urban apartment. I did not grow up that way, and came to expect more spacious housing. The generations younger than me seem to share my expectations, not my father’s expectations. That may not be realistic in today’s housing market.
The only long-term solutions are for a combination of rising incomes and moderated housing expectations. And that is the subject for a future article.
Jim Lazar is a retired economist, who worked a career in energy efficiency, renewable energy, and electric utility regulation. He is a Democratic precinct committee officer, and formerly served in countywide elective office as a Thurston County PUD Commissioner.
The opinions expressed above are those of the writer and not necessarily those of The JOLT‘s staff or board of directors. You’re free to post your response, below. Otherwise, if you have something to say about a topic of interest to Thurston County residents, send it to us and we’ll most likely publish it. See the Contribute your news button at the top of every page.
