Are Rental Properties the Next Big Investment Opportunity?

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Owning a house with a white picket fence is a quintessential part of the American dream. But an increasing number of Americans are deciding that renting a home is a better fit for their families than buying one. “Over the next 15 years, new renters will outnumber new homeowners — causing a sustained surge of rental housing demand,” concludes a recent study by the Urban Institute entitled “Headship and Homeownership: What Does the Future Hold?”

This trend could create lucrative investment opportunities in certain geographic markets. Here’s a closer look at what’s driving the shift and where investors can earn the highest potential return on rental properties.

Study Predicts a Hot Residential Rental Market

Although homeowners will continue to outnumber renters, homeownership rates are expected to decline in the coming decades. The Urban Institute study estimates that 22 million new households will need homes to rent or buy in the next 15 years, but only 9 million of these households will choose homeownership. By 2030, the homeownership rate is expected to drop to 61.3% from 65.1% in 2010. The increase in demand for rental properties is expected to drive up lease rates in markets with a limited supply of rental properties.

Why are more people choosing to rent? Many are skeptical about whether homeownership is a smart investment, after factoring in all of the costs of owning a home. (See “Rent or Buy? A Tough Financial Decision” at right.) Following many years of strong appreciation in the housing market, homeowners received a harsh wake-up call. During the recession that persisted from 2007 through 2009, home values plummeted. Although some markets are recovering, property values generally haven’t recovered from their pre-recession peaks.

In addition to having cold feet, some renters simply can’t afford to buy a home, especially as interest rates rise. The Freddie Mac Weekly Mortgage Survey shows that the average fixed interest rate on a 30-year mortgage has increased from 3.73% for the first week of 2015 to 3.89% for the week ended September 3. And, the mortgage rate is likely to increase even more if the Federal Reserve increases the Fed Funds rate later this year, as many analysts expect will happen.

Saving for a down payment will also be harder for first-time homebuyers if rents rise due to a short supply of rental properties. Even if they have the cash to put down, Millennials with high student loans and people with poor credit may not qualify for affordable mortgages given today’s tougher underwriting standards. Individuals who are forced to delay their homebuying plans will likely rent until they can afford to buy their dream homes.

Opportunities Emerge for Investors

Regardless of whether the choice to rent is voluntary or involuntary, the trend is good news for investors. Housing research firm RealtyTrac estimates that the annual gross rental yield averaged 8.94% in the first five months of 2015, based on its buy-to-rent analysis. The rental market also is becoming more stable and predictable as the real estate market improves.

RealtyTrac reports that the low supply of rental properties has caused average rental rates on 3-bedroom properties to increase 3% from last summer. “Buying rentals continues to be a brilliant strategy that allows investors to hedge their bets in a real estate market shifting away from homeownership and toward a shared economy,” concluded Daren Blomquist, vice president of RealtyTrac.

Location, Location, Location

When investing in real estate, location is everything. So rental property buyers need to choose their markets carefully. According to RealtyTrac, the top five counties in which rental rate growth is outpacing home price growth, providing investors with increasing rent-to-buy returns, include:

1. Orange County, Calif. (Los Angeles metro area)

2. King County, Wash. (Seattle metro area)

3. Santa Clara County, Calif. (San Jose metro area)

4. Philadelphia County, Pa.

5. Suffolk County, N.Y. (Long Island)

Other cities with hot rental markets include:

• Cincinnati, Cleveland and Columbus, Ohio,

• Atlanta,

• Charlotte and Raleigh, N.C.,

• Milwaukee,

• Jacksonville, Fla., and

• Denver.

When deciding where to buy, it’s important to consider both rental rates and property values. Ideally, you want to buy the property at a low price and then rent it out for as much money as possible. You want to buy in a market where the supply of rental properties is low and the demand for rentals is high, based on demographic trends and property values.

How to Become a Real Estate Mogul

The stage is set for a strong residential rental market for the next 15 years. That may be bad news for people with unfulfilled dreams of homeownership. But it’s good news for investors with extra cash to purchase single or multi-family rental units. If you’re interested in hearing more about rental property investment options, talk to your financial adviser about the tax rules, mortgage alternatives and most advantageous places to invest. Together, you can devise a prudent strategy to minimize your risk and maximize your return.

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