The Next Real Estate Bubble: Rentals

Ah, the life of a Realtor! It’s 94 degrees on a sunny day in North Florida, and I’m showing my customer the fifth foreclosure of the morning. It wouldn’t be so terrible if the vacant homes had air conditioning, but most have had the power turned off for months. The air is stale and hot as we trudge from room to room, looking at stained carpets, moldy showers and kitchens without appliances.

And yet, it wouldn’t surprise me to hear that this property has multiple offers on it, for this is the state of the under-$100,000 housing market in my neck of the woods. Foreign investors with cash are competing with U.S. investors who sold their stocks at the April highs, and that leaves the would-be homeowner with the FHA mortgage out in the cold … or heat in this case.

If that doesn’t sound like a housing market that’s widely regarded as anemic, read on. It’s not such a clear-cut situation out there.

Consider, a couple of weeks weeks ago, Bloomberg TV featured a debate between economist and long-time housing bear Gary Shilling and Mark Kiesel of Pimco concerning the current state of the real estate market. Shilling’s decidedly downbeat contention was that house prices have yet another 20% decline ahead, due to the impending release this year of over 2 million more foreclosures. Kiesel presented a bullish case, saying that housing inventory levels are improving, and that since buying is now cheaper than renting, renters will soon discover it’s better to buy.

I think both were dead wrong in their analysis, but if I have to choose sides, I would tend to agree more with Shilling. However, I don’t think another 20% decline is in the wind. I see it more like 5% to 10%. Even though foreclosures tend to drag neighborhood values down, and are sometimes as much as 20% cheaper than regular sales, the increased demand right now for investment property will likely temper the likelihood of a significant price decline.

Kiesel was boasting that he himself had sold his house at the peak of the market in 2006, and had only recently bought a new home. But his gloating overlooks the fact that six years of renting puts zero equity in one’s pocket, and one can only imagine what renting a home for those six years cost him.

Kiesel also fails to realize that a large group of renters right now have no intention of ever buying a home. For them, the American dream of owning a home has died. Instead, their nirvana is the convenience of having access to a community pool, workout rooms or bike trails, even if they have to pay higher costs to their landlord to derive these luxuries.

Along with this group are several million renters who won’t buy a home anytime soon because they have a recent foreclosure on their credit report. Either they can’t qualify to buy for another few years, or they’re still smarting from their last experience and have simply lost any desire to be a homeowner again.

Is a “Landlord Bubble” Ahead?

Instead, I’m now seeing what could be the early stages of a new real estate bubble. Unlike the last one, it won’t be fueled by speculators flipping ever-higher-priced homes for quick profits, but instead will be made up of investors scrambling to pick up cheap rental homes for long-term cash flow.

At least at the present time, the demand for rented housing is strong. Says John Burns, CEO of John Burns Real Estate Consulting: “We’ve never seen anything like this,” describing the huge increases in families wanting to rent homes. He estimates that the foreclosure crisis will drive 3 million former homeowners into renting single-family homes in the years between 2010 and 2015.

His thoughts are echoed by Justin Chang of investment firm Colony Capital, who expects to see tens or even hundreds of billions of dollars of private equity pouring into the single-family rental business in the next few years.

But eventually, the flight among investors into rental homes could create an imbalance of rental supply over demand, with a subsequent large reduction in rents as competition among landlords heats up. Renters could have their pick of homes and demand all kinds of concessions.

Fred Wilkinson, president of Bankers Home Mortgage in Jacksonville, Fla., takes a different perspective. In a recent interview he told me that today’s renters will eventually become new homeowners, and homes will once again appreciate. That will alternatively offer landlords an opportunity to sell their recent acquisitions at a profit. In addition, large companies that buy properties in bulk will take inventory off the market, rebalancing the supply and demand.

The Obstacles to a Housing Rebound

But the key point here is if these renters become homeowners. In addition to the reluctance or inability of many renters to buy a home, a number of obstacles are still derailing the real estate market from moving forward.

The step-up market is virtually dead, because many owners are still upside-down on their mortgages and can’t sell their current home. Appraisals continue to come in low on a large percentage of pending sales, causing many deals to fall apart. Buyers don’t have the extra cash or willingness to buy a home above the appraised value, and sellers don’t have the equity to be able to lower their price.

But the main hurdle continues to be poor jobs growth. Last Friday, we had a disastrous job report showing just 69,000 jobs were created, along with downward revisions for the previous three months. As if that weren’t bad enough, a large percentage of the new jobs are only part-time. These numbers aren’t conducive to sustained growth in housing.

Wilkinson says there’s a great deal of misconception among renters that you have to put 20% down on a home, even though the  VA and U.S. Department of Agriculture still offers 0%-down loans, and the FHA requires just 3.5%. He thinks far more renters would be in the market to buy if they knew the actual dollars needed.

So, Kiesel’s argument that the real estate market is improving because of declining inventory levels is weak. Yes, the supply of the cheapest homes is falling because of increased investor demand — but that’s not enough to propel the entire market forward. And another wave of 2 million foreclosures will only add to existing inventories at least through 2012 and 2013.

So, while it may be a great time to buy due to lower prices and historically low interest rates, it’s not a cinch that values have bottomed, or that we can’t see lower prices ahead. If you don’t have at least a five-year time horizon for remaining in a home, renting still makes more sense than buying.

And if you are contemplating buying a rental property for income, make sure that your return on investment is at least double digits, in case we see a rental market bubble down the road and a subsequent decline in rental rates.

Article printed from InvestorPlace Media,

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