From Jason Payne, Market News Analyst …
This week’s Market News Update features a timely analysis you probably won’t find anywhere else on the Internet:
Comparative Investment Yields for U.S. Residential Real Estate.
How do we know that this important information is seemingly impossible to obtain? Because we’ve been searching for it – relentlessly – ever since I joined the team here at Real Estate Mogul…
…and we simply can’t find this stuff anywhere online.
So we recently decided to begin building our own comparative yield analysis, for the collective benefit of all Moguls.
(You’re welcome!)
Theoretically, the necessary “raw materials” should already be floating around out there, somewhere in cyberspace. After all, the math for calculating the investment yield for a real estate asset is not complicated… Simply divide the property’s annualized rental income by its estimated total value, right?
Well, yes and no.
A Brief Overview of Basic Investment Yield Calculation
On one hand, yield calculation truly is a simple process.
Whether analyzing rental yields for real estate assets, dividend yields for corporate equities, or interest-related yields for various debt investments, an investor only needs to answer two basic questions:
-
How much income will this investment generate during the next 12 months?
-
How much will it cost for me to make this investment today?
When these two variables have been reasonably determined, a curious analyst can easily divide the investment’s expected income by its total expected cost in order to calculate the investment’s expected yield.
And this simple calculation is important for investors of all stripes, because it generates a standardized estimate of long-term profitability for most investment opportunities, regardless of the asset class in question (stocks, bonds, real estate, etc.).
Accordingly, once you have identified the investment yield for one particular investment opportunity, you can (and should) compare it with the expected yields for various other investment opportunities…
…to help identify where you might receive “the biggest bang for your buck”.
Sidenote: This is the way many successful investors and corporate executives make their most basic decisions for allocating the various capital resources entrusted to their care.
For example, a portfolio manager who oversees 401k investments might bypass the opportunity to invest in a certain stock that costs $10 and yields 2%, because he prefers a certain bond that costs $100 and yields 3%. Although the two investment opportunities come from separate asset classes, and although the bond’s upfront cost is ten times higher than its counterpart’s, the portfolio manager knows he will earn more income this year from the bond’s relatively higher yield.
Yields Are Especially Important in Real Estate
And investment yields are especially important for real estate investors.
In fact, after more than six years of professional investment analysis, we are hard-pressed to think of any other asset class for which yield comparisons are more fundamentally vital.
(Hence our bewilderment regarding the apparent dearth of online yield comparisons for residential real estate investors!)
You see, real estate is the consummate “buy-and-hold” asset class. Although dynamic price fluctuations in other asset classes may allow savvy speculators to regularly profit from “buying low” and “selling high”, real estate investors typically cannot build sustainable strategies in this manner – because real estate price growth is famously stable over the long-term.
For example, think about all those poor souls who bought a house in 2006, at the peak of the recent U.S. housing bubble. Many of those price-centric speculators had been profitably “flipping” houses for the better part of a decade, riding Alan Greenspan’s seemingly endless wave of easy money policies and watching real estate prices increase with the same velocity as technology stocks…
…which was a fine thing to do…
…until it wasn’t.
Real estate prices came back down to earth – hard – and the carnage would have been much worse without an unprecedented multi-trillion dollar intervention from the U.S. government. Almost overnight, real estate speculators who relied solely on price-based strategies lost their entire businesses, and everybody learned a valuable lesson:
Price bubbles in other industries may “burst” and cause significant short-term concentrated damage, but price bubbles in the real estate industry tend to violently “collapse” and catalyze long-term widespread recessions.
That’s because real estate is unlike any of the other major asset classes. Healthy real estate prices are built upon an entirely different economic structure of supply and demand than the prices within most other industries.
Specifically, the real estate industry’s supply of available land is almost universally constant, and once that land is developed, it becomes very difficult to un-develop it. Therefore, while new technologies and dynamic asset growth may frequently justify volatile price fluctuations in other investment classes, this will rarely be the case for real estate.
Unless somebody is developing entire new swaths of land (eg. Alexander the Great) or discovering entirely new regions of the world (eg. Christopher Columbus), then “what you see” is usually “what you get” regarding healthy real estate price growth.
Even today, in this post-recessionary era of artificial economic stimulation and record home price increases, the price-centric real estate investor is unable to sleep with a clear conscience. Each night, he tosses restlessly on a bed made of pins and needles, wondering what will happen to his family when the Federal Reserve inevitably decides to confiscate his checkbook’s borrowed lifeboat.
Don’t be that guy.
Don’t pretend that you can build a satisfying real estate career by consistently “buying low and selling high” in an industry with “buy-and-hold” economic fundamentals. A few investors may be able to pull it off, but they are statistical anomalies. And you’re probably not one of them.
Instead, strive to base the majority of your long-term investing success on a thorough mastery of real estate yields. In the same way that real estate prices are famously stable over the long-term, the yields in our industry are famously lucrative over the same time long-term period!
(It’s one of the most classic economic trade-offs around!)
Investors far and wide should embrace our industry’s opportunity to collect robust monthly rent payments over the long haul, because these rent payments typically dwarf the dividend yields and interest payments generated by most other external investment vehicles.
And, if you’re keen to invest in multiple property types, then you should even keep your eyes peeled for internal yield disparities amongst each of our industry’s various subsectors.
“But how can I compare all these yields to one another?” you may be wondering.
“If nobody on the Internet is creating comparative yield analyses for residential real estate investors, then how will I know that my properties are providing me with ‘the most bang for my buck?’”
Great question! That’s where Mogul comes in…
Filling the Void for Residential Real Estate Investors
As mentioned at the beginning of this lesson, yield calculation is generally a simple process, in theory. All you need to do is divide a property’s annualized rental income by its total value.
However, our research has revealed that most market data providers are either unwilling or unable to combine these two important variables for residential real estate investors, due to two primary limitations:
Limitation #1: Apples vs. Oranges. Most market data providers who specialize in U.S. housing prices don’t have access to comparable rent-related data on an “apples-to-apples” basis. These price-friendly data providers may be aware that residential home prices increased 12.8% in August 2013, but they are typically blind to details about the underlying pool rental properties included in any particular survey. And although other data providers may provide insightful rental rate data, any cross-pollination of the separate price- and rent-related data sets would result in a statistically invalid “apples-to-oranges” analysis.
Limitation #2: Gross Rents vs. Net Rents. A few market data providers do posses good “apples-to-apples” data for both housing prices and their complementary rental rates, but those providers face a significant analytical limitation – because they only have data for gross rents. And since every real estate analyst worth his salt is interested in net rents, these rent-friendly data providers are understandably reluctant to build any comparative yield analyses, even on an “apples-to-apples” basis.
Fortunately, as we have spent the last few weeks exploring new analytical strategies here at Mogul, we have had the opportunity to begin adjusting some of the latest “apples-to-apples” market data from our friends at Zillow.
And as a result, we are now able to enjoy a basic comparative analysis of investment yields for U.S. residential real estate – driven by reasonable estimates of average net rents.
(There doesn’t appear to be anything else like this on the web, folks!)
And the results are very encouraging, to say the least!
Peeking Under the Hood & Going for a Test Drive
You see, fundamental investors who “buy and hold” residential properties over long periods of time know that certain operating expenses are inevitable.
Although the expenses may vary in size and frequency (depending on numerous market- and asset-specific variables), they typically fall into three major categories:
-
Property Insurance
-
Property Taxes
-
General Maintenance & Repairs
As a general rule of thumb, conservative investors should expect these costs to reach at least 5% of a residential property’s total value, throughout the entire duration of their property ownership. And these regular operating expenses will typically be paid out of the property’s gross rental income…
…which is why yield-centric real estate investors are primary interested in using net rents to calculate their comparable investment yields.
With this in mind, we here at Mogul have adjusted the latest “apples-to-apples” market data from Zillow in order to (i) reasonably reduce the data provider’s historical calculations of gross rent and (ii) generate a historical analysis of net yields for U.S. residential real estate – a unique analysis which may be effectively compared to the historical investment yields of other major asset classes.
Go ahead and take a look for yourself…
Sources: Zillow, U.S. Federal Reserve, Robert J. Shiller & REIology Research
As illustrated by the red line trending upward from left to right, the net yield for U.S. residential real estate has remained relatively robust in the wake of the recent financial crisis – driven primarily by a strong 15% improvement in adjusted net rents since November 2010.
Specifically, at the end of September 2013, U.S. residential rents offered a net yield of approximately 4.6% – which was 180 basis points higher than the popular “risk-free” yield provided by 10-year U.S. treasuries (2.8%), and 260 basis points higher than the weighted average dividend yield for Standard & Poor’s popular S&P 500 Index (2.0%).
Among the other major asset classes, only investment grade corporate bonds remained competitive with residential real estate at the end of the third quarter, as measured by the 4.6% yield on Moody’s index for Aaa corporate debt.
Onward & Upward!
As the real estate industry continues to regain its basic fundamental health, and as the broader U.S. economy is gradually weaned off its current diet of economic stimulus policies, we here at Mogul look forward to watching numerous property types reestablish themselves as premier vehicles for reliably high-yielding investment returns…
…including, but not limited to, the residential housing sector.
And, of course, we look forward to tweaking and refining our growing arsenal of new analytical tools, in order to best explore these fundamental investing metrics – both inside and outside of the real estate industry.
To that end, please don’t hesitate to post any related suggestions, comments, questions or general feedback in the section below.
We may not be able to reply immediately to every post – and we won’t be able to make everybody happy – but we are certainly eager to consider your input regarding this exciting evolution in our business!
Jason Payne’s next Market News Update is currently scheduled for Wednesday, Nov. 27th.