Unusual real estate market with seemingly huge rental returns

Question

Experts, we've lived all over the world for a year or two here and there. Presently I live in a central US urban region which leans to government-technology.

Housing is tremendously cheaper here than (say) SF or NY or Paris. You can get a perfectly reasonable 5-10 yr old large house for 200k and you can get a lovely McMansion for 400k or even less. That's all great.

Now, I've noticed prices are going absolutely nowhere, there has been no increase for 10-15+ years (perhaps because there's just plenty of green fields for the municipalities to grow in to with new divisions) - so buying here I'd just assume prices will never especially go up - and that's fine too.

Further, I've noticed that houses here wait to be sold for LONG periods of time, it's totally normal for a house to sit unsold for a year+ (this is astounding if you're used to London, Sydney or whatever).

But most astounding to me. Rental returns seem enormous - to me. (Maybe I'm clueless.) One can quite easily today buy a house for 180k-270k that would rent out for 1700-2100 / month. There's a house for sale asking 400 (been on the market 2 yrs! could probably get for 350) which rents for 2800 /month. There's a specific house I could buy for 190 (perhaps even less) that rents for exactly 2000 / month. That seems an incredibly high return to me. (Again if I'm wrong, tell me.)

And indeed, there's a big demand for rentals, it's very easy to rent out a house - there's a shortage.

I've never owned any property I've rented out. I am 100% aware of the costs that can come up, ongoing and sinking. Even so, the rental returns here seem "ridiculously high" to me based on other markets I've noticed.

What I want to know is,

• am I missing something, will you rental experts tell me "oh there's lots of markets like that but, what you don't know is _ _ _"

• is it just kind of a flukey unusual situation - are there any markets known to be like this? should I just "grab with both fists"?!

• maybe I'm all wrong and this is actually suck rental returns, if so, feel free to slap me around with the facts!

Thanks for the insights!

Answer 1

I would not claim to be a personal expert in rental property. I do have friends and family and acquaintances who run rental units for additional income and/or make a full time living at the rental business.

As JoeTaxpayer points out, rentals are a cash-eating business. You need to have enough liquid funds to endure uncertainty with maintenance and vacancy costs. Often a leveraged rental will show high ROI or CAGR, but that must be balanced by your overall risk and liquidity position.

I have been told that a good rule-of-thumb is to buy in cash with a target ROI of 10%. Of course, YMMV and might not be realistic for your market. It may require you to do some serious bargain hunting, which seems reasonable based on the stagnant market you described.

Some examples:

The main point here is assessing the risk associated with financing real estate. The ROI (or CAGR) of a financed property looks great, but consider the Net Income. A few expensive maintenance events or vacancies will quickly get you to a negative cash flow. Multiply this by a few rentals and your risk exposure is multiplied too!

Note that i did not factor in appreciation based on OP information.

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Cash Purchase with some very rough estimates based on OP example

• $200000 property
• 2100 rent/mo
• 2% tax estimate
• 2% maintenance estimate (probably conservative!)
• no renovation costs
• Initial investment is price paid + costs of purchase

ROI = (RENT - TAX - MAINT) / (PRICE + OTHER COSTS)
ROI = (25200 - 4000 - 4000) / (200000 + 2000) 
ROI = 8.5% per year

Net Income = (RENT - TAX - MAINT) = $17200 per year

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Finance Purchase rough estimate with 20% down

• $200000 property
• $2100 rent/mo
• 4.5% mortgate with 20% down
• same tax and maintenance estimates
• initial investment is price paid + closing costs
• Equity in property added to the ROI calculation (first year estimate)

ROI = (RENT + EQUITY - MORT - TAX - MAINT) / (PRICE + OTHER COSTS)
ROI = (25200 + 2500 - 9700 - 4000 - 4000) / (40000 + 3000) 
ROI = 23.3% per year

Net Income = (RENT - MORT - TAX - MAINT) = $7500 per year

Answer 2

You are suggesting that a 1% return per month is huge. There are those who suggest that one should assume (a rule of thumb here) that you should assume expenses of half the rent. 6% per year in this case. With a mortgage cost of 4.5% on a rental, you have a forecast profit of 1.5%/yr. that's $4500 on a $300K house. If you buy 20 of these, you'll have a decent income, and a frequently ringing phone. There's no free lunch, rental property can be a full time business. And very lucrative, but it's rarely a slam dunk.

In response to OP's comment - First, while I do claim to know finance fairly well, I don't consider myself at 'expert' level when it comes to real estate.

In the US, the ratio varies quite a bit from area to area. The 1% (rent) you observe may turn out to be great. Actual repair costs low, long term tenants, rising home prices, etc. Improve the 1.5%/yr to 2% on the 20% down, and you have a 10% return, ignoring appreciation and principal paydown. And this example of leverage is how investors seem to get such high returns.

The flip side is bad luck with tenants. An eviction can mean no rent for a few months, and damage that needs fixing. A house has a number of long term replacement costs that good numbers often ignore. Roof, exterior painting, all appliances, heat, AC, etc. That's how that "50% of rent to costs" rule comes into play.

Answer 3

The way to resolve your dilemma is to consult the price-to-rent ratio of the property. According to smartasset.com:

The price-to-rent ratio is a measure of the relative affordability of renting and buying in a given housing market. It is calculated as the ratio of home prices to annual rental rates. So, for example, in a real estate market where, on average, a home worth $200,000 could rent for $1000 a month, the price-rent ratio is 16.67. That’s determined using the formula: $200,000 ÷ (12 x $1,000).

Smartasset.com also goes on to give a table comparing different cities' price-to-rent ratio and then claim that the average price-to-rent ratio is currently 19.21. If your price-to-rent ratio is lower than 19.21, then, yes, your rents are more expensive than the average house. Smartasset.com claims that a high price-to-rent ratio is an argument in favor of tenants "renting" properties while a low price-to-rent ratio favors people "buying" (either to live in the property or to just rent it out to other people).

So let's apply the price-to-rent ratio formula towards the properties you just quoted.

There's a specific house I could buy for 190 (perhaps even less) that rents for exactly 2000 / month.

190K/(2000 * 12) = 7.92

There's a house for sale asking 400 (been on the market 2 yrs! could probably get for 350) which rents for 2800 /month.

(400K)/(2800*12) = 11.90

(350K)/(2800*12) = 10.42

One can quite easily today buy a house for 180k-270k that would rent out for 1700-2100 / month.

Lower Bound: (180K)/(1700*12) = 8.82

Upper Bound: (270K)/(2100*12) = 10.71

Even so, the rental returns here seem "ridiculously high" to me based on other markets I've noticed.

Considering how the average price-to-rent ratio is 19.21, and your price-to-rent ratio ranges from 7.92 to 11.90, you are indeed correct. They are indeed "ridiculously high".

Qualification: I was involved in real estate, and used the price-to-rent ratio to determine how long it would take to "recover" a person's investment in the property. Keep in mind that it's not the only thing I care about, and obviously the price-to-rent ratio tends to downplay expenses involved in actually owning properties and trying to deal with periods of vacancy.

There's also the problem of taking into account demand as well. According to smartasset.com, Detroit, MI has the lowest price-to-rent ratio (with 6.27), which should suggest that people should buy properties immediately in this city. But that's probably more of a sign of people not wanting to move to Detroit and bid up the prices of properties.

EDIT: I should also say that just because the properties are "ridiculously expensive" right now doesn't mean you should expect your rents to decrease. Rather, if rents keep staying at their current level, I'd predict that the property values will slowly increase in the future, thereby raising the price-to-rent ratio to 'non-ridiculous' mode.