Arnold Kling  

A High-Yielding Investment?

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A real estate agent told a young couple that I know that their house could sell for about $100,000 in today's market, even though it could rent for about $1500 a month. That would make the annual rent equal to 18 percent of the price. That strikes me as a very high yield in an environment of low inflation and interest rates.

I tried putting some money into a REIT fund a while ago, but it turns out that in the everything-is-correlated market a REIT fund is just a high-beta stock. What I really want to invest in is a vulture fund that swoops up properties where the rental yield is high.

Anomalies like this make me believe that the housing market could recover really quickly if the government would just back off and let the market find its balance.


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COMMENTS (16 to date)
lukas writes:
A real estate agent told a young couple that I know that their house could sell for about $100,000 in today's market

How trustworthy is said real estate agent?

Phil writes:

I'd question those numbers. Why would anyone rent a house long-term for $18,000 when they could buy it and pay half that amount in interest and taxes?

And, if the numbers are correct, why wouldn't an established REIT become that vulture fund?

Michael OBrien writes:

I very much doubt those numbers, but perhaps our local market is just very different - In Seattle $1,500 will usually rent you a house with a ballpark $250,000 'market value', for a 7.2% yield before management expenses.

Rick Hull writes:

Dr. Kling,

Who would operate the rentals in this scenario? This sort of entrepreneurship is geared more to operators than investors, I think. Finding a large rental operation with a proven track record would be a prerequisite.

That raises the question of how profits would be distributed to operators versus investors. It seems to lead to purchasing equity in the operation.

Just thinking out loud, here.

sean writes:

i agree that the numbers sound just ridiculous. However, my best friend owns a condo in a nice suburb of detroit and similar units in his development are trading in the very high 90s while he is renting out his place for a little less than 1,500/mo while out of the country on work. If there is a huge glut of homes and people feel like it's a depreciating asset (house was bought in 2007 for ~140k) then it doesn't seem quite so crazy that rental yields would explode. i don't disagree that it's an attractive investment opportunity, though i have not been able to find a REIT that would give me this kind of exposure.

ed writes:

Hmmm....we pay $2000/mo to rent a house in the SF bay area that would probably realistically go for around $600K.

ed writes:

But I agree that it would make sense to have firms that buy up and operate single family homes as rentals, just that the bay area wouldn't be the place for it.

Where is this 100K home Arnold speaks of?

Are there regulatory barriers, or other risks that I haven't though of (e.g. maybe renters effectively acquire more "rights" if the landlord is a big company, so bad renters can impose big costs.)

David J writes:

Those numbers look suspect to me, but that's probably the reason we haven't seen these type of funds surface (or have they?). I'm not sure why a RE agent would purposefully tell someone their house is worth less than it is or that it would rent for more than it would. Their incentives should be pushing them to recommend selling the house.

If I was that couple, I'd keep the house and rent it out. You would think more people would make that calculation and cause prices to rise and balance the ratio out.

IVV writes:

Couldn't this be run as a kind of limited partnership? The general partner would act as operator, buying and renting out properties in the area, while being supported by a group of limited partners who act as investors?

Lots of trust issues involved, sure, but if you've got the trust... you've got the means to make money.

Various writes:

Well you've come to the right place! My partner and I run a fund that does just that. I will say that your buddy's figures sound about right. But...I will tell you that the NOI (Net Operating Income) on a house (which is roughly analagous to the concept of EBITDA, or pre-financing and pre-tax cash flow) is anywhere from about 25% to 55%, depending on the location, condition of the house, etc. Given that your friends house sounds rather inexpensive, I would make a rough guess that the NOI margin is about 35%. 35% x $1,500 x 12 months = $6,300. That equals a cash yield of 6.3%. Still, that's not a bad yield given the likelyhood of home prices being at or near the likely bottom (i.e., good opportunity for appreciation) and tax shield considerations.

Don't feel bad, your assumption that gross rents equals cash flow is a common error made by persons with limited actual real estate experience. If you are interested, the 65% of expenses is going to roughly the following places:

8% Vacancy
5% Unreimbursed utilities
8% RE taxes
2% Insurance
10% Management, leasing and advertising
18% Repairs and maintenance
4% Landscaping
10% Capital improvements (amortized over their useful lives)

JP Koning writes:

It can't be happening.

http://econlog.econlib.org/archives/2011/09/gold_and_treasu.html

Maybe the expected rate of appreciation in house prices is negative, counterbalancing both the low interest rates and the high rental rate?

Joel writes:

A friend / former colleague of mine runs such a "vulture fund". The all-in yields (after fix-up and maintenance and so on) are not quite as high as your numbers, but they're still pretty impressive.

Tms writes:

1500 per month is gross, but you need to back out expenses- taxes, insurance, maintenance, Hoa, vacancy expense, etc.

But I agree, it's getting better. I am seeing "cap rates" in the 10-12 percent where I am, which is in S Florida.

Jeff Hallman writes:

Try looking at mortgage REIT stocks like AGNC. The dividend yields are very high, and they won't drop much unless short rates start rising.

Joe Cushing writes:

I've been thinking the same thing in Metro Detroit. Home values are well below replacement and rents are still normal. You get a high cap rate and once the population stops falling, the price has to bounce to replacement at minimum. It's not uncommon to find a home that is down by 60% but rent that matches the old price.

Stephen Dodson writes:

I've spent some time looking at residential markets in outer Phoenix and cap rates are as high as 15-18%. It's relatively easy to confirm by spending 30 minutes on Zillow and Craigslist. However, markets like SF still have cap rates around 4%.

Many of the natural buyers in Phoenix, et al., already purchased homes during the bubble and are either under water on their mortgages or have already defaulted. Either way, they can't get loans for new purchases. Additionally, many of these properties are auctions and short-sales by banks, requiring cash bids. Most of these properties are being bought by small investors, similar to IVV's suggestion of LPs. There are handful of institutional investors, but the dollar amounts are so low and frictional costs are quite high, that they're a minority of the bidders.

From a policy standpoint, it does seem like the best thing to do would be to let the market clear itself.

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