Summary: In this article you’ll learn what a good rate of return is on rental property now, and how Coronavirus has changed the real estate game today.
The coronavirus has changed the way we work, the way we play and the way we interact with one another. The real estate landscape (including what a good rate of return is on real estate) is changing, too, and how investors respond in the weeks and months to come could make a world of difference in whether they continue to make money from rental properties or become the latest economic victim of COVID-19.
But first, let’s define what the new environment looks like to investors like you.
More Inventory, Less Available Financing
When people aren’t sure what to expect, markets become unstable. People sell assets, especially where they feel overextended. Credit starts drying up, and as the credit markets shrink, property buyers are forced into more conservative positions.
With less access to capital, inventors can’t buy property as easily as before. Those who are still in a position to purchase are less willing to take risks (since they are risking their own money). Prices inevitably fall as supply exceeds demand.
Before we get into the implications, let’s go over a few terms:
- The return on investment (ROI) measures the profitability of an investment. For example, in normal circumstances, 15 percent ROI would be considered fantastic. As we’ll see later on, those expectations may need to be tempered in the age of the coronavirus. In other words, a good rate of return on rental property is little different these days.
- The capitalization rate (cap rate) shows the rate of return taking into account your method of financing. It is based on the net operating income (NOI). The cap rate investors generally consider “good” is 8-10 percent. Again, those are “pre-pandemic” numbers.
- Cash on cash return (CoC return) measures the annual return on your investment based on the NOI and the total cash investment. It’s a measure of your “cash flow,” or the amount of profit you bring in after collecting rent, paying all expenses, and setting aside cash reserves for repairs.
Amy Gromowski, a Senior Leader with CoreLogic’s Science & Analytics Center of Excellence, recently confirmed on the Real Wealth Show podcast that foreclosures and bankruptcies are expected to increase as unemployment rises. She says investors should expect a “significant increase” in delinquency rates.
“That could put more inventory on the market,” she said.
Amy went on to highlight the key differences between the environment of today and the environment leading into the 2008 recession.
She said there’s no need to expect another recession in 2020. As the prospect of bankruptcies and foreclosures rises, we can avoid disaster if the jobs market remains strong. But those markets differ from place to place. Economies that depend on entertainment and tourism will soon have more housing supply, for example.
Which leads to our next topic …
Where Should You Buy Rental Property?
Pandemic or no, the fundamental things to look for when you look to buy a rental property remain more or less the same. Determining if a rental property is a good investment means looking at:
- Market cycles. Is it a seller’s market or a buyer’s market? Even within the same city, you can have more than one real estate market.
- Location. Where the property is may be the most important factor in determining a property value. The best places to buy rental property for cash flow and equity growth often have three features:
- Job growth
- Population growth
- You always want a good neighborhood, a good school district, a strong job market and local amenities. During times of uncertainty, you want to ask a few additional questions: Where is the low negative equity? Are the jobs in a diverse range of industries that aren’t hurt by the pandemic?
- Property type. The single-family home is generally regarded as the simplest way to get started as a new real estate investor. But at least one person we talked to recommends apartments (more on that in a bit).
Of course, you always want to buy high cash-flow rental property while prices are low, so you can watch your equity grow. But in a healthy market with lots of available credit and stable demand, it’s less important to sit on a mountain of cash than it is to go out and actively grow it by investing in opportunities.
That’s why there’s something even more important than job growth and population growth to remember when buying during the pandemic. And that something is:
Now More Than Ever, Cash Flow is King
Things are different in the age of the coronavirus. Thanks to social distancing and the workforce shift to telecommuting, some people are seeking single family homes instead of apartments. These workers are leaving crowded, expensive cities and moving deep into the suburbs.
Indeed, rent in the most expensive apartment market in the U.S. (San Francisco) is falling fast—the apartment vacancy rate there was 6.2% in May, up from 3.9 percent when stay-at-home orders went into effect.
Whether you’re eyeing single-family homes or multi-family units as a real estate investment, know that every property you buy should generate cash flow from day one. You don’t want something purely speculative, based on the hope of appreciation—especially during unpredictable economic cycles.
And yes, the coronavirus has made things unpredictable. We don’t really know what’s happening with the economy or what the future holds. There’s huge unemployment, peoples’ habits have changed. You need to make sure your property is generating income from day one.
Factors such as job growth and population growth have become less important during the COVID-19 market shakeup. Since unemployment is going to be giving us headaches for a while, growth and appreciation shouldn’t be the primary goal. Instead, investors should focus their attention on markets where they can make conservative plays.
“I would look at places that have high levels of government employees and major corporations like Google and Amazon” says Scott Royal Smith, an asset protection attorney who specializes in real estate investing. “These kinds of tenants are going to be able to support the rental market even in a downturn.”
Pre-pandemic, most investing advice was just the opposite—to go where the growth is, because that’s where you typically see the most appreciation.
In other words, a conservative purchasing strategy is the smart play in 2020. Cash flow and the stability of the economy where the property is located are now your two big factors to consider.
What is a Good Rate of Return on Rental Properties?
Many investors, as we enter into the second half of 2020, are downgrading their expectations of what a good rate of return is on rental property. Seasoned, aggressive investors may still be seeing 10 to 12 percent ROI on their rental properties. But the average investor should be targeting something more around a 7 percent return.
Single-family rental units continue to be popular with the individual investor. However, apartment complexes, in spite of a higher barrier to entry, will give you safer, better yields in the long-term. Although COVID has motivated many renters to seek homes with yards, they may not be able to afford them. That’s why B-Class apartment complexes in particular are in a better position to weather a possible storm.
Regardless of where you invest, what ROI should you expect?
“Right now, investors should target a 7 percent return and not anticipate appreciation,” Smith says. “And they should have at least a five-year hold time. Don’t plan on being able to sell your assets for five years.”
Smith warns that your “on paper” property values may tank in the event of a recession, but they’ll eventually bounce back.
“Those numbers are fake,” he says. “The only thing you care about is that cash flow.”
One caveat regarding the “buy and hold” approach: Eviction moratoriums are rampant, so check your local regulatory environment regarding evictions during the pandemic.
What other factors influence your ROI?
As a landlord, your turnover rate is always something you want to keep an eye on. This is the percentage of renters moving out at the end of each contract period. The vacancy rate is a related metric to watch.
Another consideration is the “rental dollar amount.” If there’s a strong major employer (government, university, or corporate), for example, the rental dollar amount is going to remain high because the rental market itself is strong.
A Note On Seller-Financed Properties
Landlords who don’t want the headache of repairs and maintenance might consider seller financing (owner financing) as a way to buy property without having to get a bank loan. As a real estate investor, these transactions can get you better interest rates, lower down payments, less risky terms, and a mutually beneficial relationship with the tenant (instead of the lender).
What about when you sell these properties and discover the occupants can’t pay? Normally this would force us to use a foreclosure procedure. As it turns out, there may be an easier way.
All you need to do is get the occupant to leave the property of their own volition. You can start by educating them about the process. For example, help them understand that if they leave voluntarily, they can preserve their credit score (by not having been foreclosed upon). This gives them access to opportunities in the future and helps take some of the sting away. Try to make it a sweet deal for them so they are willing to leave quietly.
The goal from a legal standpoint is to get them to execute a deed In lieu of the foreclosure. This will move the property back into your name (or, preferably, your anonymous asset holding company).
This scenario can be a win/win for you and the (now previous) tenant.
Make Sure Your CPA Leverages The “CARES Act”
Here’s a way property owners can see a huge boost in ROI during these uncertain economic times.
The Coronavirus Aid, Relief, and Economic Security (CARES) Act (signed into law in March) allows you to apply tax credits you get now against the last three years of your tax returns. If you can find a way to scoop up a bunch of tax credits, you can amend your last three years of returns and the IRS will put a big fat check in your pocket.
There are a couple of moving parts in play. You can always amend the last three years of your tax returns. If you want to evaluate whether your CPA is doing a good job, or whether you should invest in a CPA at all, this is a smart move because it allows you to spend $2,000 to vet a new CPA. The new accountant will either:
- Find nothing to amend, which means you’ve confirmed you’re doing great already, or
- Find tax savings in your prior years returns, which pays for the vetting process and lets you upgrade that role on your team.
So what does this have to do with real estate investing in the age of the coronavirus? One of the special things about the CARES Act is that the IRS will allow you to acquire tax credits today, then apply them against your last three years tax returns. With the right CPA and investment business partnership, you can make real estate investments with tax credits attached. This will let you make an immediate return on your amended tax filings, not to mention whatever return you make from the investment itself.
Needless to say, this isn’t a normal scenario. If you aren’t taking advantage of it you’re losing out on thousands of dollars.
Dealing with The Human Costs of COVID-19 as a Landlord
If things get bad in the months ahead, it’s also important to realize that replacing your rental income could be very difficult. If there is a shortage of demand, an increase in inventory, and a lousy job market, the last thing you want to do is compete against all the other landlords for a shrinking pool of tenants.
Instead, find ways to protect what you have, even if that means taking partial payments or working out some other type of deal. It’s not ideal, but remember: There are real people living in your properties. They have families to take care of, and they’re scared, too.
Your tenants may be inclined to stop payments if they are experiencing a financial squeeze. It’s your job to help them see the benefit of continuing their payments, even if they are partial payments.
Open up the lines of communication and help support the people who are paying you. Once you’ve initiated a conversation, work out incentives to motivate them to keep paying you. A great way to do this is by simply explaining your side of the story and helping renters understand there will be consequences for not prioritizing payments to you.
For example, there may be a government forbearance on tenants paying landlords. But after the forbearance period is over, all of the back rent becomes due. Paying many months’ rent at once will be hard for anyone, even in places where tenants are allowed extra time to pay back the rent after the moratorium is over.
After reading, we hope you have a better understanding of what a good rate of return is on rental property, and how Coronavirus has changed what we consider to be “good.”
In the end, the best action to take may be to take none at all. In other words, take care of what you have and maybe put buying new properties on hold.
“I would tell people to stay out of the markets for at least the next eight months,” Smith elaborates. “Don’t take any action right now. Wait and see. After eight months it’s going to be obvious where the assets are going to be devalued, and I think it’s going to be in the commercial space. We’re going to see tons of businesses buy a bunch of commercial property and hold it for ten years while the economy recovers.”
If you have a high risk tolerance and want to buy, remember the questions you always ask before buying. How risky is the investment? What kind of rehab is needed on the property? What does the current tenant base look like?
Educate yourself. Talk to other landlords in the area before you buy. Check out resources like The Real Wealth Show podcast. It’s ok to miss out on grabbing the absolute lowest price. The reality is that the markets will come back—they always do. Grabbing a modest discount at very low risk will put you in a great position a few years down the road.
“(Expletive) is going to hit the fan,” Smith says. “You will be able to scoop up assets pretty cheaply, we just don’t know where yet. We won’t know until the market happens.”
Stop worrying about maximizing your profits. If you want to come out of a crisis wealthier than you went in, you need to conserve your cash and wait for amazing opportunities. Sure, you’ll probably be able to find good investment opportunities today. But the stakes could be high and the risk of stumbling significant.