Guest Post: Some Thoughts On Investing In The "Bottom" In Housing

Tyler Durden's picture

Submitted by Charles Hugh Smith from Of Two Minds

Some Thoughts On Investing In The "Bottom" In Housing

Investor buying has helped put a floor under the housing market. The rental housing market is currently robust, but that is dependent on a highly artificial economy supported by unprecedented government stimulus and transfers.

In my previous entry on housing's presumptive "bottom," ( The Housing Recovery: Based on What? June 20, 2012), I showed that the conventional foundations of the housing market were impaired: demand was weakened by demographics and declining income/employment, and supply was still well above the organic growth of new household formation.

The housing "Bulls" who think the millions of young people living in basements can afford to buy a house despite having high student debt, little job security and declining incomes are either delusional or they are studiously ignoring the causal relation between buying a house and qualifying for a conventional mortgage, i.e. the financial factors of current debt loads, income, the need for a down payment, etc.

The majority of wage earners have seen real incomes decline and most households have high debt levels.

Not buying a house is a choice for a relatively few who qualify but who choose to rent. The vast majority of people who do qualify to own a home by conventional standards already own a home (65% of all households). Those who don't own generally do not qualify due to insufficient income, heavy debt loads, poor credit, etc.

There are two significant pools of buyers, however, who have become very active in the U.S. and Canadian real estate markets: domestic and overseas investors. Their buying has soaked up quite a bit of inventory--up to 40% of all home purchases in some areas have been all cash, a transaction that typifies investor buying rather than young people moving out of basements.

Each pool of investors is motivated by different forces. Domestically, the Federal Reserve's ZIRP (zero-interest rate policy) has turned cash into trash, and investors desperate for a return above 2% without the risks of the stock market casino have flooded into the rental housing market.

In California, roughly 30% of all house purchases have been for cash (investors). Some may be planning to improve and then "flip" the house as the market improves (the housing bubble redux strategy), while others are assembling a portfolio of rental properties.

I recently came across a local real estate listing in a desirable Bay Area (Northern California) location (near a University of California campus) for a multi-unit rental building: $4.9 million for 40 units, with a net of all expenses of $150,000 (not counting depreciation or tax benefits). That's a 3% return on a cash purchase, but the real yield is much higher if the buy is made with a 35% cash down payment and 65% mortgage. Regardless of the financing, the yield instantly doubles with depreciation and basic tax benefits, and could even be higher in some circumstances.

The higher yield and relatively low risk of owning rentals in a high-demand area make real estate more attractive than other investments such as 10-year bonds or dividends. As a bonus, if housing does recover, there is the potential for a capital gain.

The appeal of rental housing is understandable, and it has long been a favored investment for households (as opposed to institutional investors). According to a March 1996 report from the Census Bureau (I couldn't locate any more recent data), 92% of the nation's rental housing was owned by individual investors. In other words, owning rental property has long been a localized "Mom and Pop" enterprise.

Here is a Quick Fact Sheet on rentals in the U.S. from the National Multi-Housing Council (NMHC). According to this data, there are about 40 million households in rental housing and 78 million households in owner-occupied housing.

Owning rental property as an investment is not like owning a bond or stock or gold. Housing is a "real-world" investment that irrevocably decays with time. Heaters fail in the dead of winter, the roof eventually needs to be replaced, the yard must be maintained, and rapacious local governments generally view property owners as tax donkeys who they can load with ever-higher property taxes unless they are restrained by Prop 13-type limits.

Rental housing is also a "people business:" some tenants might disturb other tenants, others might not pay the rent, and so on. A renter is a customer, though newly minted landlords often seem to regard the tenant as an ATM machine whose only function in life is paying the rent.

The point here is the higher yield promised by rental property must be earned. Those with no experience in rental housing will learn this the hard way. All the rosy projections of steady profits vanish if vacancies rise above a very low level.

The price of rentals, like almost everything, is set on the margins. If the inventory of rentals rises above demand, then prices will eventually decline. In areas with limited inventory and strong demand (Manhattan, San Francisco, etc.), rents are generally high and the rental properties fetch a premium.

In areas without such geographical constraints, the market for rentals might not be so favorable.

In other words, it's quite possible to lose money buying and managing rental housing. There is nothing guaranteed about the return, as there are so many inputs and variables. It can be a profitable business, but that is not guaranteed.

In this chart, we can see the decline in rental income as marginal buyers became homeowners in the housing bubble, and the subsequent rise in rental income as former homeowners returned to the rental housing market.

But this rise in rental income occurred in an era that has been distorted by unprecedented Federal transfer payments, stimulus, etc., and unprecedented intervention in capital and credit markets by the Federal Reserve. The total sum of "extra money" borrowed (or printed) and injected into the economy exceeds $8 trillion, and this does not count banking-sector backstops and guarantees. The U.S. economy was not allowed to experience a "burn the deadwood and rejuvenate the forest" recession, and demand for housing, owner-occupied and rental alike, has been artificially supported by near-zero interest rates, enormous deficit spending and transfer payments.

We can see some of the consequences of borrowing and spending $1.5 trillion a year in these charts. The first chart is employee compensation, wages and salaries. It has recovered smartly from its shallow recessionary trough and has risen above 2007 levels.

One would hope that borrowing and spending trillions of dollars would support employment, but the question raised here is whether the stimulus required to keep employment aloft is sustainable.

Here is a chart of personal transfers, cash transferred by the government to individuals. This has risen by $1 trillion a year in a decade, and roughly $400 billion since late 2007.

If we subtract transfer payments from real personal income, we get a more realistic snapshot of the household economy: minus government transfers, personal income is still about $400 billion below its pre-cression peak.

Thus the rental housing market has yet to experience a "real recession." When it does, household formation may well decline or even go negative and rents may well decline as demand falls and supply of rentals rises as millions of previously owner-occupied units go on the market as rentals.

There are a number of potential (but by no means guaranteed) secondary forces that may influence rents and the value of rental property.

1. Some new landlords may realize the business isn't as easy as expected. Some may decide to cut their losses by dumping their property back on the market.

2. Investors who planned to improve and "flip" the unit may find they can't unload the property, and so they become reluctant (and thus very possibly incompetent) landlords.

3. A peculiar feedback loop may arise as the rental market is flooded with new investor-owned inventory. Rents start declining as landlords tire of vacancy-created losses, and that pushes the value of all homes in the area down, owner-occupied and rentals alike.

4. The trend to "double up" and rent out rooms could go mainstream. These "informal" rentals are already standard practice in high-rent areas such as those found around large universities and geographically constrained markets. For example, it is not unusual for four co-eds to share a 2-bedroom apartment.

Outside these high-demand markets, people who lose their job or see their hours cut to the point they cannot afford their own apartment will move in with family or friends. Anecdotally, I have heard of Mom clearing out the dining room for a returning son and his family.

There are roughly 19 million vacant dwellings in the U.S., of which around 4 million are second homes and a million or two are on the market. Let's stipulate that several million more are in areas with very low demand (i.e. few want to live there year-round). Let's also stipulate that several million more are in the "shadow inventory" of homes that are neither on the market nor even officially in the foreclosure pipeline, i.e. zombie homes.

Even if you account for 9 million of these homes, that still leaves 10 million vacant dwellings in the U.S. which could be occupied. That means 1 in 12 of all dwellings are vacant. Even if you discount this by half, that still leaves 5 million vacant dwellings that could be occupied. Given that the total rental market is 40 million households, that constitutes a very large inventory of supply that remains untapped.

Lastly, it is important to note that the ratio of residents to dwellings is rather low in the U.S., with millions of single-person households and large homes occupied by one or two people. The potential pool of existing homeowners who could enter the "informal" rental market by offering bedrooms, basements and even enclosed garages for rent is extremely large, and that is a difficult-to-count "shadow" inventory of potential rentals.

All of these forces will play out differently in each neighborhood, town and city, depending on the inventory of rentals, the geographical constraints, the employment picture and a host of other factors. The key point here is that the rental market's current robustness is at least partially dependent on unprecedented government stimulus/transfers. The current strength may be temporary rather than permanent.

The second take-away is that demand could weaken considerably in a "real recession" even as supply increases due to millions of investor-owned properties hitting the rental market and the "informal rental" market expanding as people with mostly empty houses seek additional income or accept relatives/friends with a need for shelter.

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Snakeeyes's picture

Ok, rents are skyrocketing and house prices are bobbling round in the ocean. But multifamily construction has suddenly stalled. Only if the government prods MF construction will the rental market bubble burst.

dlmaniac's picture

Never quickly jump back into a market that just had a mega implosion. It usually takes a decade (or longer) for the shock waves to be fully absorbed.

ZerOhead's picture

Good advice. The 'mega implosion' is still swirling around the toilet bowl waiting to clear due to too much waste product still in the pipeline.

This is perhaps the best analysis of where the current situation and future challenges stand that I have read.

Plymster's picture

I have to agree here.  In every housing bust we've had since (and including) the great depression, house prices are flat for at least a couple of years before a recovery ensues.  What we've seen lately have been down, down down, followed by a few months of positive YoY prices as knife catchers bid up the miniscule inventory (meanwhile decades of shadow inventory lurk).

As soon as the banks blow (which is what Europe will bring), they'll be forced to dump real assets on the market, or hyperinflate, and the FOMC just blinked on their printing threats.

bgilliam83's picture

Never use a flat cookie cutter approach with zero analysis either.   You are going to fade the drunken sailor with ZIRP to eternity?  Umm yeah you should be buying this floor, take a look at Vegas for example. 

Citxmech's picture

You're going to buy in Vegas?  Good luck with those turds.

Las Vegas has no future.

bgilliam83's picture

Where do you live?  I own and not underwater have a great quality of live with relatively cheap living expenses here.  I'm a VIP at XS too what are you?

Jon Bong Jovi's picture

"I'm a VIP at XS too what are you?"

Wow, we should all bow down.

Pharming's picture

You are exactly right Snakeeyes...  Here is a quick example.  Just a single block away from my quiet little suburbian homestead, low and behold what is this?  Those empty "strip mall lots" just got rezoned.  Apartments?  Yes?  The neighbors faught it and faught it...tough to fight attorneys and one of the biggest developers here in west Omaha.  Then ground broke, pipes layed, concrete the economy doing good enough to build these???   Oh...just yesterday, we find out...  wait for it...  Section 8 housing.  Are you shitting me? So, my property values have gone down below what I paid for this home in 2000.  Now Section 8?  WTF?  Let me bend over for the G man a little more...not only do I need the safe inside the safe, but I have to put cameras out now for the neighborhood watch!  That is the only way funding was available to build those 90 units...not big...but big be a stick a fork in us...we are done. 

marathonman's picture

Obamaville, right next door.  That sucks.

mkkby's picture

"my property values have gone down below what I paid for this home in 2000."

I would stop paying my mortgage and taxes immediately and save it all for a rental or buy somewhere else.  If that's their game let em eat it.

LawsofPhysics's picture

Show me a chart that speaks to wages and salaries and then let's talk about housing and rentals, bitchez.  Thanks for another grt post ZH!

Something has got to give.  Place your bets.

Whoa Dammit's picture

Yep, Neighbors down the street, who we think were renters, got evicted yesterday. I couldn't hardly get out of the subdivision for all of the people trying to vulture up the stuff who were driving in/parked on the side of the street. The sheriff was still there, but people were already grabbing shit. Most of them looked like nice white (former) middle class folks. 

ZerOhead's picture

Good point. And lets not forget the wage and salary increases are predominantly in the top income echelons. You know... the guys who already own.

Arnold Ziffel's picture

LOP, don't forget ZIRP. Mortgage rates will regress to the mean (around 7.5%) ... some day.

bgilliam83's picture

Yes, don't forget ZIRP.  Mortgage rates regress to the mean?  Are you batshit insane?  That has 0% chance of ever happening!  The feds would be bankrupt if we go to 1%.  If you mean that some day is after the fall of the US government then were in agreement lol.

GolfHatesMe's picture

another Greek dude goes down.  - Deputy minister Merchant Marine ministry

LawsofPhysics's picture

"For example, it is not unusual for four co-eds to share a 2-bedroom apartment."

Dear Penthouse Forum,

Sorry, couldn't resist.

Cursive's picture


Penthouse forum?  You are showing your age.  Now, this shit is on MTV.

OpenThePodBayDoorHAL's picture

"I rent my house to four students, and you won't believe what happened to me the other day. One student is a tall blonde, one is a saucy brunette, another is a redhead, and the last is a petite Thai exchange student...."

LawsofPhysics's picture

Timeline?  I still have some fiat left there.  when to move?  thinking more physical silver.  Suggestions?

Dr. Engali's picture

physical gold, physical lead ,physical food, physical new location.....

LawsofPhysics's picture

Already have like-minded and well-armed neighbors.  No one makes it through what is coming alone.

T-roll's picture

You couldn't be more correct.  I am starting a "prepping community" of like-minded individuals.  Those who think they can go to Montana alone with their family and make it through this will be in for a rude awakening.

AustriAnnie's picture

But the flip-side to that is:

Thinking you have "like-minded" friends who turn on you when TSHTF.

The majority of people become pretty nasty when panic hits.   A "prepping community" can quickly turn into a mob.  

Given the choice though, its still a better option than trying to go it alone.  Just be very careful how much information you share regarding what you have stored.  Also keep in mind the gov't will be encouraging these people to turn you in for hoarding or other "suspicious activity".  Many people who think growing organic veggies is quaint and trendy now will run straight to gov't for a handout when the going gets tough.

Choose your friends carefully! 

Lucky Guesst's picture

I recently cleared out the finished basement and turned it into an apartment for my mother. It's too risky to have her stuck with a house in another state and alone.

Pharming's picture

I went to a Infrastructure Protection Conference here locally...I raised the question about an increasing well armed society.  Good or Bad for the law enforcement.  

Two tables of local/state/ and federal government law enforcement..."crickets chirping".  The Lt. Governor asked again... "crickets" and chuckles from the other 250 people or so.  The Lt Gov said he was at Cabelas and asked them how business was. 

At the local Cabela's (Sports / Outdoors) if you don't know what Cabelas is...  the answer was business was unbelievable.  They had sold more guns at the their store than they had sold since they were in business!!  What are the 5 G's?  Gold, Guns, Ground, Grub, and Gas.  God too...makes it 6.  

FEDbuster's picture

Pre 1964 US quarters, timeframe ASAP.  Two years of long term food storage first.

T-roll's picture

Meredith will be proven to be correct in time.  She was just a little off with her timing.

MillionDollarBogus_'s picture

I prefer to rent.

Makes more sense.

mayhem_korner's picture



Unless an owned home is sans mortgage.

LawsofPhysics's picture

Correct, or the interest on the property is well below the revenue generation of said property.  Let him rent, and for that I am thankful.

FeralSerf's picture

About the only way a middle-class individual can take advantage of the large real negative interest rates is with a long term real estate mortgage.  Where else can you borrow with only 20% margin at 3.5% fixed interest for 30 years?  Do you really think inflation is going to average at or below 3.5% per year for the next 30 years?  On top of that there's even a tax incentive!

Dr. Kenneth Noisewater's picture

I just got preapproved for a 94% LTV in Texas at 3.49% (not APR) for a 30 year fixed.


Even if housing prices went down 30-40% more in Texas, that would be survivable, and the $$ I was preapproved for is doable at 60% of my current gross.


Now to find a place with some land outside the city, commutable but without HOAs and nosy neighbors, so's I can have dogs, chickens, maybe pigs, chest freezers, some raised-bed veggie gardens and a greenhouse, solar, cisterns, ground loop HVAC, insulation, a garage with lift and tools, maybe a makerbot, and battery backup with natgas/diesel backup (co)generator..

duo's picture

the first +1 I ever gave you.

You never own real estate in the US.  You only rent it from the government.  Try not paying your property taxes and see what happens.

fuu's picture

psst that is milliondollarbogus_

LawsofPhysics's picture

Don't feed the trolls.  FYI- the rent I am collecting is still buying me all kinds of physical assets.  Truth is, no one really ever owns anything and on a long enough timeline...

It is all about power and control, always has been.

FeralSerf's picture

You never own your own body in the U.S.  You only rent it from the government.   Try not paying your income taxes and see what happens.

grey7beard's picture

>> Try not paying your property taxes

I bailed out to the stix.  I've got 10 acres, a nice little mobile, a well with excellent water, 70X70 garden plot, 17 fruit trees.  My taxes $240 a year.  You can never get out of payin taxes but you can minimize it to the point of not mattering.

Winston Churchill's picture

You can buy alludial title for approx 7 years property taxes.(Varies by State).

No taxes liens or mortgages can be levied/taken  thereafter.

ultraticum's picture

Well said duo. 

ALL real estate on every square inch of United States soil is owned outright by the government.  Period.  Full stop.  I once had a commercial rental property confiscated via the greedy county assessor raising taxes to the point where neither I (the owner) nor the tenent could afford the taxes, which nearly eclipsed the rents.  County became majority partner in the deal, with no skin in the game, over a 10 year period of 10% compound tax increases.

The crooks in city hall do not realize nor care how much of a wet blanket their arbitrary ad valorem real estate taxes put on the economy.  Entrepreneurs would risk huge amounts of capital on projects involving commercial/industrial (and maybe even residential) real estate if it weren't for the massive pound of flesh the Leviathon takes simply because they are the "monpoly on force".

But the sheeple, still deluded into thinking they're free, walk around thinking these egregious taxes ("revenue" is the carefully crafted parlance used by the slave masters) are necessary for a functioning world. 


Dr. Kenneth Noisewater's picture

I'm leaning towards buying some property that I can fortify, as in my local area rents are rising as people flee hightaxland and relocate here.  Plus, I don't like the idea of buying a whole bunch of improvements (solar, cisterns, ground loop HVAC, freezers and food storage, power backup and generation, tools and equipment) for a rental that either can't be moved or moved at great difficulty and expense..

blunderdog's picture

Squatting's an even better value.