Real Estate

Tough Rental Times Now? Wait for Rebound: Investors Can View Sinking Rental Market as only Temporary

The stagnant or even falling real estate prices throughout the United States make this is an opportune time for investors to add residential rental properties to their portfolios. With the income and other benefits they generate, rental properties can go a long toward fulfilling the goals set out in real estate investment plans.

At the same time, the glut of unsold properties on the market in many areas of the country is the result of many people losing their jobs and then their homes. Some of those people moved to rental properties; this should have led to increased demand for rentals.

Instead, many of the unemployed and underemployed, including those who lived in rentals, have moved in with family and friends. This has led to a glut of vacant rental properties in some areas and, in turn, to rental amounts that are suppressed or even reduced. In short, these are tough rental times for many landlords.

Tough Rental Market Now, But Rebound Likely

An article by Prashant Gopal in the April 21, 2014 issue of BusinessWeek painted a bleak picture of the rental market to the end of 2013, predicting that the continuing drop in employment will mean a decrease in rents and an increase in vacancies. However, the article also stated that when the economy improves and companies start hiring again, the rental market will rebound due to increased demand.

Thus, there is reason for investors in residential properties to be cautiously optimistic. Gopal’s article suggested that there may be growth in the rental market from 2011 through 2017, particularly because there has been little new construction of apartments and single-family homes and this will mean a shortage of rental properties for several years. Property and Portfolio Research made a similar prediction of a rebound in a May 1, 2009 article in Multi-Housing News Online.

Understand Return on Investment

When determining whether it makes sense to hold on to a property, a landlord needs to consider all of the components of return on investment (ROI) in real estate:

Cash flow. This is calculated by subtracting the sum of the annual expenses of operating a property and total debt load (mortgages) on the property from the annual gross income (rents collected). The annual gross income changes from year to year if the rental amount is increased or decreased or if rental units are vacant for all or part of a year.

Appreciation. This refers to an increase in value, which translates into a higher sales price that a property can command. Additionally, because equity is the amount of real estate that is owned free and clear of debt, appreciation in value increases the owner’s equity. Inflation and demand are the main drivers of appreciation, but appreciation can also be forced by making improvements to a property.

Equity Growth through loan reduction. The down payment on a property is an owner’s initial equity. The more the owner pays down the mortgage loan, the greater the equity grows. However, there will be zero equity if the value of a property plunges below the amount of the mortgage.

Tax benefits. The U.S. tax code provides real estate investors with several tax breaks, including: the deduction of costs involved in buying investment property, the deduction of operating expenses, and depreciation, which is essentially a paper loss that can be deducted from the taxable income produced by an investment property.

Each component of ROI can vary significantly from state to state, region to region within a state, even neighborhood to neighborhood. While one area may produce high cash flow but low appreciation, another area may offer good appreciation rates but few tax benefits.

ROI, Goals, and Local Markets

After taking into consideration all of the components of ROI, the objectives of their real estate investment plans, and the state of the local real estate market – in other words, the likelihood of finding a buyer for rental property – investors can decide whether it makes sense to sell their rental properties or to hold on to them until the rental market improves. If necessary, investors should consult their tax advisers before making a decision.