Why rents will probably go down.
If all things are equal ( and they never are ) rents should continue to provide a reasonable return to the investor of about 1 to 3 percentage points above the 10 year note. The return varies of course depending on many variables the most important being price, condition and location. But, if you assume that the only variable that is changing is price, or the value of the property then the return will be lower on the lower price properties. For example a typical good quality property in my area might sell for $250,000 new and return 6% gross, or $15,000 per year. That doesn't sound like the return is high enough but new property will also provide considerable price appreciation as compared to older property which barely keeps up with inflation. Now if that same property is only worth $200,000 it will provide the same return to the investor... 6% or $12,000 per year. For the investor that paid $250,000 and his property is now worth $200,000... Too bad.
There are many things that skew the return assumptions and over the long term one of the most important considerations is the current interest rate... Again assuming all things are equal, if the interest rate goes up and I can make just as much putting my money in the 10 yr note, why bother and also take the risk of rental property? If my rents are providing 6% and the 10 year which we call risk free is paying 6% I need to decide weather or not I can raise my rents or stop buying property until things get better for the investor.
When real estate prices come down rents will follow but the investor will still be able to have a return that pays him for taking the risk of ownership and management. The investors that paid higher prices and now the values are lower will be in trouble if their mortgage is higher than what the current rents will provide for a return. After all, an investor can purchase the property at the lower price and receive a fair return. It is not likely that investors will receive higher returns on property that is worth less than it was a year ago... That's not the way it works.
Some investors will go bankrupt and others will pick up the pieces. I just purchased a high quality property in a gated community, HOA, community swimming pool, double garage, street lights etc and I already know that my rent will be slightly lower but, I paid considerably below the current market at what I consider a distress sale. I don't think we are at the bottom of the real estate cycle just yet but, when opportunities present themselves you have to make a decision. This property would not last long at the price I paid. I have been investing in real estate all my life and we know our area very well. In the current real estate environment it is very important to build in sufficient cushion in your assumptions and commitments so that as the current market variables unfold that you will still be in business. I hope we made the correct decision.
Dick Milde
AI
