Whoops, typo. I mean misinformation.
There are a number of headlines out there that make it seem like rents are out of control. Funny thing, it’s not like it sounds. Let’s dig further into this whole rent thing.
First, you need to understand a major concept few people talk about. Dupre + Scott call this the “same store rent change.” (I like them, they know stuff. You can thank them here www.DupreScott.com.)
Let’s say there is a house that rents for $1,000 per month. Then, a developer builds a new house that rents for $1,500 per month. Previously, the average rent was $1,000, but now the average rent is $1,250, even when the first house doesn’t change at all.
On paper, it looks like rents increased by 25% in a single year. Did they really? No.
What this addresses is that there is a flaw in the data when you look purely at averages in a market with substantial new development.
The misinformation is out there, so be cautious. It is true that vacancies are low. It is true that rents have risen in the last few years. It is also true that neighborhoods are feeling the impacts from new development. But, let’s take a step back.
According to the fall rental market survey from Dupre + Scott, rents in the Puget Sound region climbed 8.3% in the past year. Sounds like a lot, right? It’s not the whole story.
Region-wide, apartments built after 2011 (meaning new construction) rent for a 54% premium compared to those built before 2012 (meaning existing units). So we’re clear… if I could get $1,000/month for my “old” apartment, then I can get $1,540/month for my “new” one.
Developers have opened up more than 30,000 units since 2012 in our region. With that “premium” in mind, this will continue to distort the numbers going forward in locations with a lot of new construction. The other side is that locations without a lot of new construction will look flat in comparison.
Now that we know people pay more for new, what does that mean? When you strip out new construction units, apartment rents are up 6.2% annually, not 8.3%.
Seattle was NOT the fastest growing in rental rate increases. Seattle ranked 32nd, out of 66 cities in the region. That’s right in the middle of the pack. Let’s look at the rest. (Psst… check the chart inside please.)
Based on the last few years, it seems like rents always go up. Sometimes…. (drumroll please)…. they go down. (Womp womp.)
We have gone through five cycles in the past 45+ years. Despite the recent increases, when you look at the average rents, they have climbed 4.2% a year since 1981.
If you have ever sat down with me to discuss the value of your property, I probably said something to the effect that “real estate is like the stock market. It’s about supply and demand.” Rents are the same way. Rents climb faster when vacancies are low, just like they have been doing. As vacancies increase, rental rates will slow or may even fall.
YOU KNOW WHAT ELSE DISTORTS RENTS? RENOVATION.
Many of you know, I like to buy “troubled” homes in neighborhoods, and then clean them up. Neighbors usually like me. During renovation, I will add products and amenities found in newer properties. Many times a nicer kitchen, extra bath, add a garage, etc. I do this partly because I want to make a nice place… and partly, because I’ll get higher rents.
For apartments in the Puget Sound, we estimate that 3,200 units were significantly renovated in the past year. That’s just 1.2% of the entire market, but these units averaged a rental increase of 34%.
Think of it like iPhones. The iPhone 6 might have a base price of $550, but if you want the 6 Plus, you might pay $750 for it. It has more features and stuff.
LET’S TALK ABOUT COSTS.
Rents are cyclical, but expenses are not. It’s not enjoyable when expenses outpace income, but that’s what we’re seeing.
Between 2004-2014, apartment rents increased an average of 3.9% per year, while total expenses increased an average of 4.5% per year. Taxes and utilities combined went up 5.3% annually, with no real slow down in sight.
Knowing that utility costs are outpacing income, could it be time to consider either revising your leases or maybe investing in other more energy efficient items? I’ll let you decide.
THE PARADOX.
Remember when we said rents can go down? In some cases, investors are raising rents because they are just playing “catch-up” from the previous market. It is all too often I talk with a property owner who immediately “warns me” that they haven’t raised rents in the last 7 years, because they were just letting it float. I get it. It’s easy that way, but doesn’t add any value to your property.
Let’s say the property used to rent for $1000/month, and then all of a sudden it increases to $1,250/month, that might seem steep… but it works out to just 3.2% per year. Tenants don’t see it this way… but think about the part again where you’ve been paying increasing property taxes forever.
Rents fall during economic downturns, as quickly as they rise in times of expansion. We had rents fall as recently as 2009, a downtown in 2001, one in the early 1980s, and one in the early 1970s.
WHAT IS IT WORTH?
We have been talking so much about rents, we haven’t even touched on apartment values.
You know how single family homes fluctuate based on market appreciation and depreciation? Apartment values move in tandem with rental income. The higher your net income, the higher your value… and vice versa.
Sidebar: I’ve talked about cap rates in the past. Consider the cap rate like a gauge related to the risk an investor is willing to take on. If the property sells at a 5.0% cap rate, then it’s probably pretty stable (lower risk-lower return). If the property sells at an 8.0% cap rate, then maybe the location is less desirable or the property needs work (higher risk-higher return). Compare this to your 0.10% return in your savings account or maybe a 7% return on a stock… get it?
If you actively increase your rents with the market rates, then you don’t need to worry about values. If your rents are the same and expenses keep going up, then all you are doing as an investor is eroding the value of your property as the net income drops. Don’t do that.
Right now, our cap rates are down a little this year, but have been pretty stable over the last 12 months. In King, Pierce, and Snohomish Counties, the average cap rate has been 5.1% for apartment sales.
Investors seem reluctant to compress cap rates any further, as they are concerned about rate increases. If anything, I am seeing cap rates start to creep back up in some of our outlying markets. As a result, we assume that cap rates are probably compressed as far as they will go.. which means your value is higher today than it may be later.
I don’t have a crystal ball, but if we are close on the estimates for construction and rent growth, then apartment prices (which are totally dependent on increasing net operating income), will grow through 2016-2017. With the additional supply coming to market and vacancies already starting to creep up, it is possible that rent growth will slow or even decline slightly in 2017-2018 bringing prices back down to their current levels.
HOW DO I GET MORE OUT OF MY PROPERTY?
If you want to get every dollar you can out of your property now, know what you do?
Clean it up, raise rents, and sell it. Then leverage that money into another deal you want to hold as we ride through the next cycle. Preferably a deal that will produce greater cash flow and value later.
Regular people think of prices as what you grumble about at the store. Economists think of prices as the logic that organizes our world… and I like economics.
All these figures are just organization in the market place. It’s stuff that I watch so I can try to avoid the misinformation that abounds. Well, at the very least, I want to know when I need to question something and dig further.
Want to cut through the fluff and discuss real estate for real?
Call/text me at (206) 293-1005 or email: Jen@HudsonCREG.com.