From a financial standpoint, rental property is at the top of the list of assets to own. It can soon become the biggest headache if you don’t screen properly for the right tenants or buy in a location which consistently attracts poor tenants. Good thing you screen like the CIA and only buy in prime locations.
Rental property is the ultimate hedge against inflation as well as the ultimate asset to make money during inflation from a cash flow and real asset appreciation perspective. With the US Dollar going into the crapper, your goal should be to borrow as much USD as your personal balance sheet allows and buy a real asset in an appreciating foreign currency! If you can’t do that, you just have to do the next best thing and buy American. The foreigners are coming!
MAKING MONEY EVERY WHICH WAY AND SIDEWAYS WITH RENTALS
Declining Inflationary Environment
Let’s say you have one million dollars sitting in the bank earning 2% interest from a long dated CD shall we? Every year, you earn a respectable $20,000. You used to be able to earn $42,000 a year, but thanks to the downturn, inflation is nowhere to be found. During a low inflationary environment, your rental property INCREASES in value. Let me explain with some realistic numbers.
Rents are sticky for the most part, and trend up and to the right. Over the past two years, one of my rentals’ has seen rent go from $3,000 to $3,100 a month. Not that impressive, however you have to compare the rental yield with what risk free rates have done in the same period. 5 year CD rates have plummeted from 4.25% to around 2% during the same time frame. If you capitalize the rental value, you simply take $3,100 X 12 months = $37,200 divided by 0.02% = $1,860,000. In other words, if I had no mortgage and no expenses, at a 2% cap rate, my rental property is suddenly worth $1,860,000 from under $1,000,000 when rates were at 4%.
When 5 year CD rates were yielding 4.25%, the $37,200 annual stream of rental income was worth only $885,714. In other words, in this low interest rate environment, you need to have $1,8650,000 in a 5 year CD yielding 2% to generate $37,200 in income. The importance here is cash flow and opportunity cost.
Increasing Inflationary Environment
As inflation, and therefore interest rates start ticking up you have a commensurate uptick in rent and property valuation as well. Inflation is only bad if you don’t have real assets. If you have zero real assets and just cash, the stuff you buy is inflating higher in prices while your dollar loses its buying power, thereby hurting you. In an inflationary environment, your rental property increases in value by definition, often times by a rate much quicker than the Consumer Price Index as we saw in the bubble!
As a landlord who has a mortgage, the large part of your costs are fixed due to a fixed rate mortgage. Your insurance, property tax, and maintenance costs will creep higher, however these costs generally account for no more than 25% of total costs. During an inflationary environment, there is upward pricing pressure on rents. As a result, you simply follow the market higher and raise the rent to a level where the market can bear.
Back to our example of capitalization rates. You might be asking, ‘Isn’t it bad if cap rates go up, since you’re underlying value goes down in the example of 2% to 4%?” Yes, it’s bad from a balance sheet perspective, but from a cash flow perspective, you are loving it. With rental property, your #1 concern is cash flow generation. Only when its time to sell your asset, do you care about the underlying value.
Since we are in an inflationary environment and CD rates are ticking higher, your responsibility as a landlord is to raise your rent accordingly. You must be vigilant every year in following the market, or else you will lose out on a relative basis. In a 3%-4% inflationary environment vs. our 1.5%-2% environment now, I will raise my rent by 3-4% per annum. In 5 years, my $3,100/month in rent will jump to $3,682/month if I increase the rent by 3.5% every year. In order to calculate the capitalized value of my rent I simply take $3,682 X 12 = $44,184 divided by 4% = $1,104,600 as one means of valuing what the rental property is worth.
Zero Inflationary Environment
In this unlikely scenario, nothing really changes except that every month you are paying down your debt so that one day, you will own the rental property free and clear. You are using other people’s money (OPM) to own an asset and other people’s money to service the debt. For the bank and the renter’s troubles, you provide them a payment and shelter in an exchange deemed fair by both parties.
DEVELOP MULTIPLE ASSET CLASSES
There’s no such thing as passive income. You’ve got to work for everything for the most part. Rental property is a wonderful asset class to own during the good economic times and the bad economic times. Here in San Francisco, rental prices where out of control with people queing out the door during the Internet Bubble because companies where hiring like mad. Property prices were also screaming higher, thereby pushing more people to rent at the margin. When the Internet Bubble burst, the people who could no longer afford to own had to rent, thereby stabilizing rental prices from decreasing.
Cash is nothing more than a medium of exchange and stocks are pieces of nothing that lay claim to a company’s stream of profits. Buy real assets. 10 years later, you’ll be happy you did.
Shop around for a mortgage: Mortgage rates have collapsed after Brexit, and US assets are aggressively being bought by foreigners due to our stability. Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a 2.375% 5/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.
Look into real estate crowdsourcing opportunities: If you don’t have the downpayment to buy a property, are sick of dealing with bad tenants, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today. Real estate is a key component of a diversified portfolio. If you study the asset allocation mix of college endowment funds and high net worth individuals, you’ll see real estate weightings of anywhere between 5% -25%. Real estate crowdsourcing also allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates around around 4% – 5% in San Francisco, but over 10% in the Midwest if you’re looking for strictly investing income returns. Check out my Fundrise review as well.
Updated for 2017 and beyond.