“As soon as the land of any country has all become private property, the landlords, like all other men, love to reap where they never sowed, and demand a rent even for its natural produce.” ~Adam Smith, Wealth of Nations
In Chapter 8 – Renting, we discussed reasons why renting makes financial sense: it’s for the short term, you may not have enough money for a solid down payment, or it’s the rare case that the cost of renting is cheaper than buying. Additionally, some people don’t want the liability of a mortgage or they like the freedom of renting. Either way, in this chapter, we’ll further explore the rental market.
Normal financial advice recommends all housing costs should account for/take up no more than 35% of your (post-tax) income. We discussed this principle in depth in Chapter 7 – Housing. When you’re renting, the costs normally include the initial security deposit (usually amounting to the cost of one month’s rent), monthly rent, and utilities not covered by the property (or rental contract). You don’t have to pay for any repairs except for some minor wear and tear, but renters should carefully read the details of the contract for specifics of repair responsibility. Some renters treat the property like it’s their own, however, others may have little regard for the property. For many property owners, having tenants destroying their property is their #1 fear of owning a property.
If you are a property owner, you calculate rental yield by 12 months of rent divided by the value of the home. If you plan on renting out your property, you should consider the average rental yields for your state. Rental yields are affected by interest rates, and the market’s supply and demand. Most property owners look for passive income generated by renting their property, and capital appreciation of the property by using the rental income to pay down the mortgage and/or the home value going up over time. If you’re a renter, you’re providing the rental income, while the house may or may not appreciate. Property owners retain all the risk and profits of the rental, while the renter retains less risk but typically doesn’t “profit” by renting.
Although it’s rare, some cities with little demand for home ownership may see mortgage costs exceed rental costs. In this case, renters profit off the opportunity cost (or gain in this case) by choosing the cheaper option. This is a trade off between renting and buying: over the long term, renting doesn’t contribute towards the renter’s net worth, but there’s also a lot less risk or liability incurred.
Remember in Chapter 8 – Renting we discussed that there are different types of property owners. You have an owner, which is an individual that owns one or several properties; private investors are companies that invest in properties to rent out; and public companies which invest in properties such as Real Estate Investment Trusts (REIT).
In Chapter 19 – Economic Power of an Individual we discussed that you have economic power in the financial genome. As a renter, you have a lot of power over an individual property owner that owns a single property. Bad renters can cause significant damage, they may not pay or be late on rent, or they can continuously call for repairs that are basic wear and tear. For those who own many properties, risk is decreased as there are more properties that may have good renters, depending on how good the tenant screen policies are. Without proper screen policies, the risk may increase if there are more renters. Conversely, being a good renter to that individual with one property can positively impact the owner and contribute to his or her future financial goals.
We discussed that people can positively or negatively influence your financial goals as well. As there are good and bad renters, there are also good and bad property owners. For example, I rented a house from an elderly property owner who did not use a property management company and it was an unpleasant experience for my family. He was unresponsive to maintenance issues and difficult to work through administrative processes.
Some property management companies professionally manage apartments or condos and can provide a pleasant, professional experience, while some company portfolios are so large that customer satisfaction is irrelevant to the company, leading to a negative experience for the renter. Similar to my experience with my property owner, these companies can also be unresponsive to maintenance issues or have complicated contracts leaving tenants with outrageous miscellaneous costs.
I’d like to discuss the economic power and influence a property owner and a renter have on the financial genome separately. But before I can do that, I want to discuss how money works. This will be a subject discussed in many Financial Genome chapters in the future.
In most developed countries, we have central banks that uses fractional reserve banking. This means someone deposits $100 in a bank and then the bank can use $900 in loans. So, at any time, any bank in a developed country only actually has a fraction in reserves. We as humans all agree that the $900 is real and is part of different types of money calculations. Similarly, as a property owner, you gave a bank a deposit and they give you a loan to buy a property. The only actual money is the initial reserve in issuing bank and the deposit the property owner gave the bank.
The bank uses a small amount of deposit (its reserve) to lend a large amount of money to property owners to give to other banks. The receiving banks can then use that money to make other larger loans. The real money is paid monthly with interest back to the banks. All the other money is tracked with modern accounting, enforced by our laws, and our acceptance in the process.
THE PROPERTY OWNER
As mentioned above, property owners could be individuals, private companies that own many properties, or public companies (REITs). The owner may or may not have a loan on the property, but will always pay property taxes. Under ideal conditions, the rent charged covers the loan payment, escrow, taxes, possibly a property manager, and profit.
From an annual average high of 16.63% in 1981 to an annual average low of 3.66% in 2012, interest rates on loans and the down-payment requirements were so low that it was more financially advantageous to buy a house than to rent. Now that interest rates are increasing and down-payment requirements are increasing, renting may become more viable. However, the biggest factor facing property owners is they own all the risk.
Property owner risk comes from the possibility of defaulting on the mortgage loan, property damage, and defaulting on taxes. The traditional “American Dream” means owning a house. While I believe home ownership is an essential part of financial planning, it must be at the right time and under the right conditions, or else comes with the risks I mentioned above, possibly destroying your financial plans. Vanilla, mainstream financial advice often carelessly minimizes the real risk owning a property.
For example, if you buy a stock for $5,000, you face the risk of losing the entire $5,000. But you are protected from losing more than that initial investment. If you mortgage a property that’s overvalued, then you face the risk of losing money you never had in the first place. For example, you buy an overvalued house for $300,000 and the real estate market drops, you may now own a house that is only worth $200,000, but you STILL have a $300,000 mortgage on a property that you can only sell for $200,000! You just assumed a $100,000 loss on the mortgage loan. You’ll remember that this reality came true for millions of Americans in the 2008 housing and financial collapse.
Owning properties allows you to exert influence on others in many ways, the first being by setting rent prices. If you own only a few properties, then the rent charged is limited to what the market will allow for your location. If you own many properties or own a company that owns many properties, then you can influence the overall market. Large private and public companies can not only influence the local rent market, but they can drive the overall market, increasing or decreasing rent prices as they’d like to increase profits.
Some individuals, companies, and REITs do exactly this: they buy up as many properties as they can for a location and then choose the rent price they want for the type of tenants they want. Some companies buy apartments or single-family homes, partnering with the United States Housing and Urban Development (HUD) office. The intent is to provide low-cost housing for people in need. This program is great, but comes with risks. Sometimes the low-cost housing tenants have little regard for the homes or apartments. Also, in the case of my own hometown, the affordable housing brings crime and entitlement abusers.
A 2016 Standford Graduate School of Business analysis shows that low-income housing installed in low-income neighborhoods can boost property values, while low-income housing installed in high-income neighborhoods can decrease property values. Housing availability is the main driver in prices. When there’s limited supply, demand increases, so home prices increase.
Another way property owners exert influence is through Homeowner Associations (HOAs). Many suburban communities have HOAs that allow property owners to control what happens in the neighborhood through voting systems, where property owners have one vote per property owned in the neighborhood. When companies own many properties in one neighborhood, they are able to control the future, for better or worse, of the neighborhood. This program may prove useful in maintaining the look, feel, and value of a neighborhood, but it too comes with risks. Some companies have used their power and control to keep communities segregated or increase the rents so high that they control the demographics to upper-middle income households. You can read examples of HOAs infringing the rights of homeowners at this link.
Renting out properties is a great way to earn passive income through the principle called other people’s money, and is a key principle of becoming wealthy. You use a small amount of money for a down payment and then rent out the property. The rent may earn you a profit and someone else’s money pays the mortgage. The equity you’re building is yours to keep for savings or additional investment.
There’s a lot of vanilla financial advice that I disagree with, and one of them is “renting is throwing your money away.” Like I said in Chapter 8 (http://financialgenomeproject.net/2017/09/24/financial-genome-project-chapter-8/), there are several reasons why renting can make more financial sense than buying a home. One of the reasons we’ve already explained above and that is home owners exposing themselves to liability. When you rent a home, the initial cash outlay you have is the security deposit, usually one month’s rent, and any utilities you may have to turn on or transfer into your name. Assuming you’re a good tenant, you’re likely get the security deposit back when you vacate the property.
Some jobs, like the military, require you to move frequently, and so renting can be a good option. It’s important for the economy to have a healthy amount of renters; too much home ownership can over-commoditize the housing market. This is where homeowners treat properties solely as profit-making investments instead of providing a basic human need for housing. Additionally, a healthy renting market empowers renters and ensures they have equitable rights.
Many financial planners compare effective retirement planning to a 4-legged chair. One of the “legs” of the chair, is to retire with no mortgage and/or have some passive rental income. If you rent too long, and don’t purchase property, that leg of your retirement plan may be missing. If you’re renting and have a longing to invest in the housing market without actually buying a property, you can buy REIT stocks. REITs have done relatively well because of the high-dividend yields they offer.
UPDATED FINANCIAL GENOME
Below is the updated financial genome. If you’re a homeowner, your rent should cover the mortgage and escrow which goes to your lender, property taxes, which often goes to your lender and are paid on your behalf. Additionally, if there’s profit, it will come to you as income. If you’re a renter, your rent goes to the property owner to be disbursed above.
The key takeaway is owning your own home is an essential part of a sound financial plan, but not always the best decision as determined by your personal financial position. Renting can be a good option if you move frequently, are saving for a down payment, are uncomfortable with the liability, or the market is more favorable for renters.