Why Rental Property Is A Powerful Asset Class

From a financial standpoint, rental property is at the top of the list of assets to own. Why rental property? Let’s explore the main benefits of this asset class. But first of all, you have to be smart about investing in a rental property. Otherwise it can become a huge headache if you don’t screen properly. You need to select reliable tenants and buy in a location that attracts quality tenants. Good thing you screen like the CIA and only buy in prime locations.

Rental property is the ultimate hedge against inflation. In addition, it is the ultimate asset to make money during inflation. This is both 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. Then buy a real asset in an appreciating foreign currency! Alas, if you can’t do that you just have to do the next best thing and buy American. 

Why Rental Property Makes Money Every Which Way And Sideways

Declining Inflationary Environment

Let’s say you have one million dollars sitting in the bank earning 2% interest from a long dated CD. 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. Why rental property? Rents are sticky for the most part, and trend up and to the right.

Let me explain with some realistic numbers. Over two years, one of my rentals’ saw rent go from $3,000 to $3,100 a month. That’s not too impressive. However you have to compare the rental yield with what risk free rates have done in the same period.

5-year CD rates 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. Another way to look at it is this. In a low interest rate environment, you’d need to have $1,865,000 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

When inflation, and therefore interest rates, start ticking up there’s 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.

Inflation Puts Upward Pressure On Rents

Why rental property? During an inflationary environment, there is upward pricing pressure on rents. As a result, you simply follow the market higher. Raise the rent to a level 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 your 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 it’s time to sell your asset, do you care about the underlying value.

Since we are in an inflationary environment, 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, I will raise my rent by 3-4% per annum. For example, five years from now, 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 the unlikely scenario of zero inflation, 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 respectively in an exchange deemed fair by both parties.

Develop Multiple Asset Classes

There’s no such thing as completely passive income with rental properties. You’ve got to work for everything for the most part. However, if you invest in real estate crowdfunding, you can really relax. Not only does the Sponsor handle maintenance and everything else, you can typically invest with as little as $1,000.

Rental property is a wonderful asset class to own during both the good economic times and the bad economic times. Here in San Francisco, rental prices were out of control with people queuing out the door during the Internet Bubble.

Companies where hiring like mad. Property prices were also screaming higher, thereby pushing more people to rent at the margin. Then 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. Why rental property? Because it’s a powerful real asset class. Buy real assets. Ten years later, you’ll be happy you did.

Recommendations

Refinance your mortgage

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Explore real estate crowdsourcing opportunities

If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, 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. Further, real estate crowdsourcing 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 are around 3% in San Francisco and New York City, but over 10% in the Midwest if you’re looking for strictly investing income returns. Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It’s free to look.

Updated for 2020 and beyond.