Prices in my local market have reached or exceeded those of the 2008 crash, yet nobody seems worried. To the contrary, I’m hearing a lot of “this is different,” “lending standards are tighter,” “rents are higher,” and especially, “interest rates are lower.” I grew up around complete financial illiteracy, so sometimes I hear things that are mathematically false but which sound and feel true. Take, for example, that last one: interest rates are lower so price doesn’t matter.
I decided to investigate the interest rate truism to see if the homespun wisdom of my lotto-playing kinfolk was rooted in truth, and if I should indeed be buying more houses.
Historically Low!
Interest rates certainly are lower, and interest rates and prices are inversely correlated (rates go down, prices go up) so it makes sense that prices have boomed in lockstep with the Fed keeping rates low. Demand is outstripping supply, adding to the boom. The questions I posed for my study are what should I pay, and, to what extent should I overpay simply because I can lock in a historically low interest rate for 30 years?
I took a random real example from Zillow of an average-priced duplex in a hot neighborhood where I also own a duplex. For context and comparison, I paid $100,000 for mine in 2016, using a 30-year mortgage at 4.75%. It rents for $1545 per month.
The duplex I’ll be examining is slightly larger than mine, so it’ll rent for a premium over my rents. It’s a few streets over, and our tax rate is the same. I’m using a low interest rate in my example, but I’ve kept it consistent by taking the average lowest rate for the years in question from Freddie Mac (http://www.freddiemac.com/pmms/pmms30.html). I tried my best to use historical data by looking up the actual property tax rate and the purchase price of the home.
Numbers, Assumptions, and Charts, Oh My!
I wanted to track this house as an asset for 10 years, from 2015-2024. I know that 2021-2024 is a projection, but the outcome of my example is so wildly skewed that I feel confident in my conclusions.
Here are the basic numbers on my target property:
1234 Rust Belt Road
Duplex – Two units of 2 bed 1 bath
30-year fixed at 2.7%
$289,900 sale price
$2088 projected gross rents in 2024
Insurance $75
Utilities (water) $100
Vacancy 5% of gross rents
CAPEX + Maintenance 20% of rents after vacancy
Property taxes are tracked separate from expenses, as I found the taxes to be the real driver of cash flow when considering price and interest rates.
Rent starts at $800/unit in 2015 and will increase 3% per year. This is about what we’ve seen in this neighborhood. The rent numbers below are gross rents.
Deal or No Deal?
Here’s all my data for the 10 years. Monthly property tax varies within $5 or so each year, but I kept it consistent from 2022 on where I was projecting the amount.
Rent Mortgage Property Tax Expenses Cash Flow*
2015 $1,600 $563 $329 $495 $133
2016 $1,648 $563 $329 $504 $169
2017 $1,697 $563 $329 $514 $205
2018 $1,748 $563 $331 $524 $241
2019 $1,801 $563 $364 $535 $248
2020 $1,855 $563 $365 $546 $288
2021 $1,910 $938 $372 $557 -$52
2022 $1,968 $938 $770 $568 -$407
2023 $2,027 $938 $770 $580 -$363
2024 $2,088 $938 $770 $592 -$317
*5% vacancy rate applied to rent before deducting Mortgage, Property Tax, and Expenses to arrive at cash flow numbers. Left out to simplify chart.
The $563 mortgage payment represents the 2015 owner’s payment on a mortgage of $120,000 (or a purchase price of $150,000 with 20% down) at a rate of 3.85% (rate taken from http://www.freddiemac.com/pmms/pmms30.html). This payment changes to $938 in 2021 when a new owner purchases the house for $289,900 at a rate of 2.7%.
Here’s my chart with key events numbered.
From 2015 – 2020, this house produces solid cash flow in addition to saving a healthy $2000/year for maintenance and CAPEX. I’d expect $10,000 over five years to cover most CAPEX issues, and I might even cap my savings at $6000 and pocket the remainder if nothing serious occurs. Now, what happens when Mr. Low Rates comes around and dupes the newbie investor into paying nearly double for this house in 2021?
C’mon ya’ll. Buffett would like to remind you what “margin of safety” means.
1) On paper, this still looks like a deal, especially if I’m a newbie, my banker didn’t explain a lot to me, and my friends are making fun of me because I own 0 houses and no Bitcoin. 2.7% is historically low. No doubt about that. My $938 payment is basically covered by one unit. I’m rich!
2) Check out my blue cash flow line. It’s already dipped into the negative. But this is a chart made by a seasoned investor. No doubt the new investor is saving $100/mo, or worse, $0/mo for CAPEX, so their chart shows a bogus +$200 in cash flow.
3) This is my Doomsday Line. It represents when the tax rate catches up to the new home value. At this point, even an Enron accountant would concede you’re in trouble. Our beautiful green property tax line was very slowly rising, with a slight uptick in 2019 when property values were reappraised. These reappraisals happen every three years in Cleveland. Unfortunately, 2022 is another such year and 1234 Rust Belt Lane is now worth DOUBLE, meaning the tax rate is DOUBLE. Cleveland tax rates average just above 3% depending on the municipality. Property tax also leapfrogs all other expenses combined by a large margin. This type of outsized change should certainly be considered carefully.
4) This spot sets the trajectory for the new owner to buy a bucket and attempt to bail out all of the water he is under. Despite historically low rates, tax rates are historically…the same. To make up for this huge increase in tax expense, rents need to go up by 28% to maintain the 2015-2020 levels of cash and profitability. With our historical rate of 3% rent growth, this isn’t promising for our new owner.
5) My bold prediction: 2022 will be a surprise for many in my area who bought cash flowing investment properties in 2021 at historically low rates. By 2023, the busted water heater and defunct furnace will make them consider my historically low offer of $120,000 for their credit ruining brick-and-mortar albatross.
A Perfect Rate for Bananafish
Historically low rates don’t mean it’s a good idea to pay historically high prices. My quick analysis of this one house, which is representative of many houses in my area, seems to indicate that prices are indeed too high, but we just haven’t figured it out yet.
In “A Perfect Day for Bananafish,” the main character, Seymour, explains the habits of the metaphorical bananafish to his young pupil, Sybil, as they wade in the water at a seaside resort:
"Miss Carpenter. Please. I know my business," the young man said. "You just keep your eyes open for any bananafish. This is a perfect day for bananafish."
"I don't see any," Sybil said.
"That's understandable. Their habits are very peculiar." He kept pushing the float. The water was not quite up to his chest. "They lead a very tragic life," he said. "You know what they do, Sybil?"
She shook her head.
"Well, they swim into a hole where there's a lot of bananas. They're very ordinary-looking fish when they swim in. But once they get in, they behave like pigs. Why, I've known some bananafish to swim into a banana hole and eat as many as seventy-eight bananas." He edged the float and its passenger a foot closer to the horizon. "Naturally, after that they're so fat they can't get out of the hole again. Can't fit through the door."
"Not too far out," Sybil said. "What happens to them?"
"What happens to who?"
"The bananafish."
"Oh, you mean after they eat so many bananas they can't get out of the banana hole?"
(Taken from https://foresthillshs.enschool.org/ourpages/auto/2016/9/7/48668131/Salinger%20-%20Bananafish.pdf)
I won’t spoil the ending, but I think you can guess the fate of the poor bananafish. If not…well, click the link.
Now to make the parallel explicit: prices are certainly too high, but the reckoning of their excess will only happen when 1) the new property tax bill arrives and 2) an unexpected CAPEX hit occurs. Perhaps 2022 goes by smoothly with no repairs, no roof leaks, and no vacancies. But here comes 2023 and I’m starting to get nervous. By nervous, I mean ready to buy back some houses at a steep discount.
Final Caveats
With interest rates so low, many investors seek riskier assets just to get a return higher than the paltry ~1.4% on the treasury’s 10-year notes. If you’re savvy and this is part of the calculation you made to overpay for real estate, then kudos to you. Depending on your leverage, the tax benefits of owning real estate, and the possibility that you sell at an even higher price in one year, you’ll probably beat the 10-year treasury.
The big question marks in my high-tax high-price scenario are wages and inflation. If wages rise, inflation should rise, rents can rise accordingly, and the duplex in my example becomes profitable again. An increase in rents of 5% per year over 5 years would yield nearly a 28% total increase, as would a 7% increase over 3.5 years. These are fairly optimistic growth rates for a rust belt state with a declining population and no new Amazon or Google headquarters.
If wages don’t rise, rents are already above 30% of the median household income in Cleveland. They can only go so much higher before they outpace tenants’ ability to pay, or to pay safely. If we’re lucky and inflation tracks the exorbitant rise in property values, we investors will be sitting pretty with fixed debt and higher rents. If not, revisit my bold prediction above.
