So you want to be a real estate investor
It seems live everyone is chasing the same golden rainbow. There is an old saying that a stock bubble can be predicted when your barber provides investment advice, similar could be true in real estate. Just the other day I got a haircut and the stylist was providing advice on investing in real estate and how she is getting into flipping houses and holding properties for rental income. I started to wonder, can anyone make millions in real estate?
As discussed in my prior article: Is the flip over in Denver? , demand is quickly outstripping supply therefore increasing prices. The increased prices have dampened the “flip” as margins compress. With the flip very difficult or not impossible, many real estate investors are transitioning to more longer term holds of residential. Is holding real estate a wise investment strategy verse other investment choices like an index fund of the S&P 500 that has historically produced average annual returns around 8 percent?
As more in migration occurs, housing prices continue to rise at a nice clip in the metro area. This increase in prices impacts long term real estate investors as well. Assume you could buy a house at $250,000 as a rental house a few years back as opposed to the new average of $311,000, the return on investment would be much lower today since rents are not able to climb as fast. With all this increase in prices, Bloomberg just named Denver one of the 12 least affordable markets for Millennials (see article).
Does it make sense to invest in real estate for the long haul given the high prices in Denver? Before making any decisions, it critical to look at financial metrics to see if the investment will actually pay off and see how a real estate investment might compare to other alternative investments. There are two metrics to look at to see if investing long term in a rental property makes sense. The metrics are price to earnings ratio (similar to stocks) and net operating income analysis (similar to how commercial properties are valued). These two methods should give investors a good indication of whether the return justifies the risk and hassle of a rental property.
First, the price to earnings calculation is a common tool used in valuing stocks. It basically allows an investor to measure the stock price relative to a company’s earnings and compare this to other companies. In real estate this same tool can be used to look at the market price (house price) in relations to its earnings (rental income). This is one metric to see if a house is fairly valued based on its earning potential. According to Moody’s this ratio is historically around 16, so a ratio of around 16 means the property is fairly valued based on its price in relation to its rental income.
For this analysis, I used the average home price from Bloomberg $311,000, and I took an average rental rate between the Denver Post and Zillow (these are estimates since unlike sales with recorded prices the rents are based on market surveys). In the calculation below, home prices are too high based on historical averages (or rents are too low). Just like a stock calculation, the higher PE ratio is an indicator of the asset being overvalued. So what this calculation is telling us is that with a PE of almost 20, on average home prices are considerably higher than they should be based on the underlying rental income.
Average Home Price
* Average of Denver Post & Zillow
With the Price to Earnings ratio higher than the historical average, I wanted to take a look at how a rental property would look using the Net Income approach. This valuation tool is used in commercial properties and is calculated by taking the Net Operating Income (revenues-expenses) divided by the rate of return (Capitalization rate- CAP). In essence I wanted to see what rate of return one would expect based on the purchase price and average rents. I ran a number of scenarios based on the average return to back into what the price of the property would need to be. Based on the average home price and average rents, one would expect about a 3.5 percent return on their real estate investment (this assumes the property was bought in cash).
Net Operating Income
7% of Gross Income
5% of Gross Income
Net Operating Income
3.5% rate of return
4% rate of return
5% rate of return
6% rate of return
7% rate of return
8% rate of return
Finally, I did another quick analysis of the income approach to determine what the average rent would need to be in order to provide and 8 percent return (after expenses) based on a the average $311,525 purchase price. The rents would need to be $2,680 per month; this is over double the average rent. To put this in perspective, if a borrower with good credit were going to buy a house for $311,525 today with 20 percent to put down and assume a 5 percent rate on a 30 year mortgage, their mortgage payment every month would only be $1,338 a month, less than half of what the rental rate would be.
Wait you forgot something. What about appreciation? Historically long term appreciation has been around 3 to 3.5 percent, so with appreciation the long term rate of return is closer to 6.5 to 7 percent (3.5 percent rate of return + 3 percent annual appreciation). So factoring in the historical appreciation, the investment is still lower than the market, but not far behind.
So what does all this mean? Should you invest in real estate for the long term? This all depends on a number of factors: how high can you make rents and still attract high quality long term tenants, how low can you buy a quality property, how much are you going to put into the property (I used a pretty low expense estimate in my analysis, one roof replacement of $15,000 blows the analysis out), and finally how much of a hassle do you want to take on with a rental property? Owning a rental property typically is not a passive investment.
Even with a manager, owning real estate takes care and feeding. Before jumping onto the real estate bandwagon or taking the advice of your hairdresser, use the tools above to calculate your desired return to compare to other investment choices. This will enable you make the right decision based on your criteria to maximize your return.