Wall Street Is Muscling in on the Real Estate Market
One of the best asset classes this year is residential real estate. According to most real estate indices such as the Federal Housing Finance Agency (FHFA) or Case-Shiller, the rise in home prices has risen between 18.5% and 19.5%. Although this is below the increase of 24% since the beginning of the year S&P 500, it was still a great year for house prices.
Professionally managed money floods the rental space
While individual landlords buy properties for rent, we’ve also seen a lot of professional money go into buy-to-rent. Investment giant BlackRock (NYSE: BLK) bought Home Partners of America for $ 6 billion. Other large investment firms have raised money to buy rentals.
For institutional asset managers, this strategy is very attractive as they generate rental returns on the properties, deduct depreciation (which can lower taxes) and benefit from an increase in home prices. I recently wrote an article on the Single Family Real Estate Investment Trust (REIT). American houses 4 rent (NYSE: AMH), where I discussed how much the rise in home prices has contributed to the intrinsic value of the business.
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The government has given the institutions an edge for a while
Interestingly, institutional investors had a head start on more traditional mom and pop landlords in the first half of 2021. The FHFA ordered the government funded facilities Fannie Mae and Freddie Mac limit their loans secured by investment properties.
Mom-and-pop investors rely heavily on loans from Fannie and Freddie to fund home purchases. These limits made these investment property mortgages scarce and expensive. Large institutions like BlackRock or American Homes 4 Rent have many other ways to raise investment capital. Eventually, Fannie and Freddie removed the caps and leveled the playing field between institutions and individuals.
The math of investing in rental property
While home prices have risen at high ten percent growth rates, rents have followed with some estimates that one- and two-bedroom apartments are up 21% and 17%, respectively, year over year.
From an investment perspective, rental properties have a cap rate of around 7% per year, which corresponds to the average of the last 10 years. So the property is generating revenue of around 7% per year, and that revenue is growing at a rate of 19%, as is the underlying property. If it were a stock, a one-bedroom apartment would have a 7% return on earnings (in other words, 14 times the price-earnings ratio) and earnings growth of 21% per year.
Famed investor Peter Lynch took a stock’s earnings growth and P / E ratio and combined them in the PEG (or price-to-earnings-growth ratio). That rental property would have a P / E of 14 and a growth rate of 21%, or a PEG ratio of 14 divided by 21 or 0.67. Lynch targeted stocks with PEG ratios below 1, so a ratio of 0.67 would be a screaming buy.
Home hacking, flipping, and residual income
The rental housing sector is still dominated by small investors who want to use this passive income to supplement social security in retirement. Another great strategy is home hacking, where an investor buys a multi-unit property, lives in one unit, and collects rent from the other units, which can significantly reduce the investor’s cost of living.
After all, we see a lot of fix-and-flip investors, but soaring material and labor prices make this strategy risky for investors who don’t have six to twelve months of reserves to rely on until the property is sold.
As long as the stock market remains expensive and bonds have low returns, residential real estate will remain a popular vehicle for investors looking for growth and income.
This article represents the opinion of the author who may disagree with the “official” referral position of a premium advisory service from the Motley Fool. We are colorful! Questioning an investment thesis – even one of our own – helps us all reflect critically about investing and make decisions that will help us get smarter, happier, and richer.