How Much Higher Can Rents Go When Incomes Are Falling?



OK, time for the real estate investing class to review a lesson from 2008:

What happens to real estate investors when ownership costs exceed cash flow? Answer: Deja-Vu all over again.

Entire Buildling

It’s no secret that Wall Street has been buying up billions of dollars worth of single family homes over the past few years. But when it comes to operating cash flowing properties at a profit, the basic issue always comes down to what the tenants in a given market can afford. Fundamentally cash flows are determined by the economic fortunes of the available tenant pool.  The most recent jobs data was dismal after 4 years of “recovery”, putting continued income pressure on the tenant pool in most parts of the U.S.

Positive cash flow requires that the tenant is paying enough rent to cover the landlords mortgage payment, taxes, insurance and property maintenance.  Some of these expenses can put pressure on existing cash flows, because rents can only go to a certain level in any market, while the costs of owning and operating single family rentals can become difficult to control.

Rent rates have risen steadily for a while now. Wall street investment companies have been turning foreclosures into rental properties at an unprecedented rate, while trying to drive the rents upward. It’s created a situation where there are many more single family rentals available in some markets, than in years past. Further,  just because these properties are for rent, does not mean that tenants can pay the often steep asking prices that Wall Street landlords will need.

The Census Bureau has data showing that real incomes have been shrinking since 1999. Somewhere along the trend line, rental rates and tenant incomes are even now on a collision course, just as mortgage payments were getting out of hand 10 years ago, so the breaking point for rent rates is looming ever closer.

One of the most problematic fundamentals I see on the immediate horizon is the disconnect between steady rent increases and tenant incomes which are losing value.

Inflation is another factor that is significantly impacting middle and lower income workers. The trouble with inflation is that it does not start over each year.  A 2% inflation “target” turns into 20% inflation over 10 years, and that’s a fundamental problem that tenants are facing. Inflation has been slow but steady, virtually wiping out all of the income growth for the vast majority of the baby boomers.

In recent years I’ve personally seen plenty of evidence of the impact of inflation and lack of job growth in the form of increasing ownership expenses, more late payments from tenants, more evictions in two years than in the past ten, and the inability to raise rents to any significant degree, in spite of offering better quality properties in suburban areas.

Many, especially in government, believe that the solution is more money to subsidize tenants – more “section 8” if you will. However, when government starts dangling financial incentives, all of the costs tend to go up significantly, including tax-payer paid rents.  These tactics add to government debt which has lead to increasing taxation in various forms to pay for the cost of subsidizing rent.

That in turn leads to more rent increases, until the cycle reaches the breaking point. This is exactly what happened with mortgages during the housing boom. Prices went higher and higher, leading to higher mortgage payments that were “insured” by the government. Local municipalities regularly handed out property tax increases and mortgage payments went ever higher until the costs began to exceed the monthly cash flow. Rent rates have a limit beyond which they cannot go, but ownership costs do not.   When that happens real estate investors can lose control of their ability to generate positive cash flow. And that would result in Deja-Vu all over again.
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Donna S. Robinson is a real estate industry expert, investor and former agent, located in metro Atlanta, GA . She is well known for her insight into housing market fundamentals and consults with real estate investors and investment companies around the U.S. Donna’s website is www.RealtyBizConsulting.com