Description

SUMMARY

Dixon Mills.  Two months ago I visited a $3,500/month Jersey City rental in Dixon Mill (link), a converted factory.  The broker mentioned the owner was also willing to sell for $575,000.  When the broker left the room, I told my wife (and you’ll get a sense of what she has to deal with): “No way it rents for that.  Why sell for $575,000 if it can be rented for $3,500/month?  That’s a good return even without appreciation.  Assume 2% appreciation and you’re looking at a safe, mid-teens post-tax return.”  (Note that the 2% gets goosed by the low-cost, tax-deductible, LBO-style leverage in real estate.)

Not as Competitive as One Might Assume.  Two weeks later we met the same broker at another property, and I asked what happened with the Dixon Mills spot.  He said it rented for $3,500 a week later.  Apparently the owner was retiring to South Carolina and wanted to sell but ended up renting to a British guy who would have bought a place except for his ongoing divorce, which led him to not want to own anything.  In this instance, the retiree would have potentially sold for non-economic reasons (ended up renting though), and the renter would have otherwise bought if not for extenuating circumstances.  I said that if he encountered any others with similar economics to call me, and his partner chimed in that I was standing in one (#12, in my spreadsheet below).

Talking around, this seems more common than one might think.  Sellers are often motivated by non-financial forces.  Then especially on the demand side, down payments can be difficult, renting is easier than buying time-wise and brain-damage-wise, and people value the flexibility of renting (especially in cities).  On the flipside, it’s of course important to avoid markets where the competition consists of “investors” who use US real estate as a safe deposit box (e.g., those trying to get their money out of Russia).

Outline.  In this writeup, I will address why I think the opportunity exists to earn good rates of return in single-family real estate exists in the first place (already touched on).  Then I examine 15 Jersey City properties for which I’ve run the numbers—some financial winners (such as Dixon Mills, #6 in the spreadsheet), some stinkers (in particular, the fancy high-rise condos with high HOAs), and some in between.  I analyze these using (1) a shorthand that’s common in real estate—looking at the Year 1 cash flows, (2) a detailed rental property model, and (3) a buy-then-rent-out model that compares the 10-year NPVs of (a) renting a property to (b) buying it, living in it a few years, and then renting it out.  I assume 2% inflation and appreciation as a base modeling case and 10% for an extreme case.

Spreadsheet.  https://docs.google.com/spreadsheets/d/1-qKMR-6jXw5nksm_oSlQxkoKheD-kErs/edit?usp=sharing&ouid=100785826776745715867&rtpof=true&sd=true.  Input cells are shaded gray.

Side Note.  In the process of writing up a low-liquidity, ~$10M microcap that had dribbled along for 20 years but now seemed like it might turn the corner (eye roll), it occurred to me that this is, in fact, a better risk-reward and worth more meaningful discussion.

TOPICS

• Why Does the Opportunity Exist?
• Pure Rental Investment Property
• Rent vs Buy-Then-Rent
• Why Single-Family?  And what About the “Brain Damage”?
• Do Rental Properties Keep Up with Inflation?
• Risks
• Conclusions
• Catalysts

WHY DOES THE OPPORTUNITY EXIST?

Inflation.  I’ll try to avoid getting too philosophical about the macro environment.  But it makes intuitive sense that we didn’t see serious inflation until now and that it’s likely to continue—though the economics of this idea doesn’t depend on its continuation.  Quantitative easing—printing money and buying financial assets—is best for those who own financial assets.  However, little of that translates to actual spending on goods and services.  Make a rich person richer by pumping up the value of financial assets, and he/she is unlikely to spend much of that on stuff that affects everday inflation.  Bridgewater estimated that quantitative easing was ~8% effective at stimulating on-the-ground spending (couldn’t find the source, but this discussion of the “inefficiency of Monetary Policy 2” conversation hits the point: link).  But send checks to people who will actually spend the money on everyday goods and services, and inflation kicks in.  And to really get inflation, just send $10,000 checks instead of $1,400 checks.  Sending checks pulls two inflationary levers: (1) spending increases and (2) supply decreases (since the checks compete with people’s need to work).  It’s hard to see why this would stop given that voters receive the largesse.  (Note that I don’t mean to imply a political view on this.)

Sub-3% 30Y Fixed Mortgage.  Despite inflation reportedly running 6.8% (fastest rate since 1982), the 30-year fixed rate is below 3% in a lot of cases and tax-deductible (up to $750,000 for a personal home, but there are ways around the cap).  It pays to safely borrow as much as you can in such an environment, and a 30-year fixed mortgage provides the natural instrument for an individual.  

Valuation.  A natural reaction is a concern regarding valuation.  Sure, you can borrow at low, long-term, tax-deductible rates, but you’re paying sky-high prices—so good luck.  If, however, one knows an area reasonably well, anchors the valuation in rental prices, and avoids common pitfalls (e.g., deferred maintenance, dodgy HOAs, etc.), that can serve as a margin of safety against overpaying.

DO HOME PRICES KEEP UP WITH INFLATION?

Yes.  The chart below relies on Robert Shiller’s data (link).

Figure 1: Inflation and Home Prices

From what I’ve read, whether rent prices keep up with inflation can depend on the area and the landlord.

PURE RENTAL INVESTMENT PROPERTY

Shorthand and Detailed Models.  I compiled two models: (1) Sheet “Shorthand Yield” offers shorthand yield that’s a bit generous—but that I’ve often seen—that essentially looks at the Year 1 cash flow profile (but assumes maintenance of the debt ratio, ignores taxes, and ignores eventual seller transaction costs); and (2) Sheet “Detailed 10Y IRR” offers a detailed model that aims to get the mechanics right.  Since the devil is in the details, (2) is a financial model that orients the investment much as one would with a stock (EV, income statement, free cash flow, balance sheet, return metrics, and IRR).

Dixon Mills, the $575,000 2-bedroom that rented for $3,500 would have shaped up to an 11.9% post-tax 10-year IRR based on my assumptions that include 2% price appreciation (and 1031 exchange).  

Figure 2: Detailed #6 Dixon Mills (2% Inflation)

Results Depend on the Property.  That’s not to say all of the 15 examples post healthy prospective returns.  Example #1 of the 15 in the spreadsheet, a fancy waterfront condo, produces a 2.5% post-tax 10-year IRR if there is no home-price appreciation—not a crazy assumption given the weak rental cash flow profile (why assume someone else would be willing to accept an even lousier rental yield).

Supercharged Performance During Inflation.  The scenario in Figure 2 envisions low inflation.  What happens if inflation skyrockets?  If, say, inflation rises to 10% and we assume home prices keep up (see Figure 1) and, for the sake of argument, rents rise at a slower 6%, it results in a 26.0% post-tax IRR according to the modeling.

Figure 3: Detailed #6 Dixon Mills (10% Inflation)

Why do the returns improve so much?  It appears to stem from the fact that everything rises—revenues (though conservatively at 6% in this example), costs, and so forth—except for the borrowing costs that remain fixed at 3%.  So it’s as if much of the cost structure, priced in real terms, is declining.  While this may deserve a resounding “duh”, it’s poignant to step through the mechanics of it.

RENT VS BUY-THEN-RENT

For those weighing renting vs buying, I compare the two.  The bottom of the “Detailed 10Y IRR” sheet compares the NPV of renting for 10 years vs, say, the NPV of buying, living in it for 4 years, renting for 6, then selling.  In most cases I’ve tested, buying over a 10-year period beats renting.  If one dials up the discount rate to Cathy Wood’s 20%, then the math flips because one would be better off investing in the stock market at 20% returns than giving up an upfront down payment.

WHY SINGLE FAMILY?  AND WHAT ABOUT THE “BRAIN DAMAGE”?

Limited Scale.  I leaned toward single-family because of its simplicity and manageability at the individual level.  It’s difficult to manage a lot of single-family homes at scale.  In 2012 (a period of both distressed prices and low interest rates), Buffett spoke to the economics of the 30-year mortgage as an effective way to short the dollar (link); but he said he couldn’t manage it at scale, of course.  This is a different environment price-wise, but the notion of it serving as an effective method to short the dollar is as true as ever.

“Brain Damage” from Having Tenants.  People who have had tenants talk about the misery of it.  That’s a big part of why the opportunity exists.

RISKS

HOAs.  Barring substantial due diligence, with HOAs the condo buyer knows his/her asset (the rentable condo) but not his/her liability (being at the mercy of the HOA).  So one has to be sure the HOA has a healthy financial condition.

Capex.  Big unforeseen one-time costs (plumbing, roofing, etc.) can ruin the IRR.

Rising Rates?  Macroeconomics is complex.  Who in their right mind could have predicted sustained low-to-negative interest rates?  Despite what Figure 1 shows regarding home prices during inflationary periods, it is conceivable that rising mortgage rates could substantially lower property values.  Still, in that scenario, the buyer will have locked in a low 30-year rate, and provided the cash flow profile looks adequate, the long-term buyer should earn a satisfactory return.

Robert Shiller Warning.  I respect Robert Shiller—on real estate in particular—and he warned recently about the dramatic real estate price increases over the past year (link).  Looking at the chart below, one could view this as a repeat of 2006-2008.  But putting my value investing hat on, it does seem like there are attractive things out there on a rental-yield basis, as illustrated with Dixon Mills and others.  If inflation roars, the end of the blue line will adjust to look to more like it does in the 1970s; meanwhile the borrower will have locked in a sub-3% 30-year rate.

Figure 4: Robert Shiller’s Warning

Another factor when considering Figure 4, which shows all-time high real home prices, is that 30-year fixed mortgage rates are below 3% in many cases.  Notice that during the 2012 trough real home prices still didn’t dip below where they were in the 1990s despite real estate armageddon—largely on account of the low rates.  And as we saw in Figure 1, real home prices performed fine during the 1970-1980s inflation.

Smart Money.  Speaking with real estate friends, a couple mentioned that smart money is building on spec to rent.  They anticipate a meaningful housing shortage.  If done in adequate size, this reaction to an anticipated shortage could prevent/correct it, weakening the returns from buying into single-family real estate.

CONCLUSIONS

Two lenses: Micro and Macro.  One can look at this through two lenses: micro proforma modeling and the high-level macro view of tax-deductible borrowing at low, fixed rates against a productive, inflation-resistant asset in this environment.

Micro.  I aimed to focus on the micro lens in this writeup by providing specific modeled-out examples that look to the rental revenue (or potential rental revenue) as a margin of safety against the purchase price.  A strength of real estate is that you can conceivably estimate and control the variables more easily than with most stocks.  Please weigh in regarding any dispute over the integrity of my assumptions.  The micro approach aimed to show that the macro view may not need to hold in many cases for these sorts of real estate opportunities to pencil out.  (Also, if mentally benchmarking the proforma real estate returns to stocks, bear in mind my modeled real estate calculations reflect post-tax returns.)

Macro.  The macro lens basically poses the question: In this environment, would you prefer to lend long-term at fixed dollars or borrow long-term at fixed dollars?  It’s hard to imagine anyone here would choose to lend.  Inflation just makes sense in a lot of ways.  It relieves debt burdens at the cost of stinging the rich much more than the poor.  A nervous retiree with Social Security and hundreds of thousands in savings suffers far more than a low-skill worker with zero savings whose hourly wage is rising with inflation.  Then how should one borrow?  Borrowing against stocks is often irresponsible due to volatility and the potential for margin calls.  On the other hand, it’s hard to imagine a more practical instrument than a 30-year fixed-rate mortgage.

Catalyst

• Inflation