The One Thing Your Rental Property Won’t Provide

The One Thing Your Rental Property Won’t Provide

With housing prices and rental rates reaching unprecedented heights in the Bay Area right now, it’s tempting to grab any spare cash you have and throw it at the first condo or house you can afford to buy. Indeed, the majority of residential rental property owners I’ve met over the last five years were non-professional real estate investors. I will not attempt to cover the right way to invest in these kinds of properties. That topic is way too broad. But I did want to address an all too common viewpoint many of these investors have articulated when it comes to property value appreciation. I’m referring to the belief that “Although I’m losing money right now, I’ll make it up when I sell the house.”

It’s appropriate to expect home prices to continue to rise as long as supply remains limited while demand increases. That’s basic economics. And here in the Bay Area, especially in San Francisco and on the peninsula, job growth is currently outstripping the supply of homes. As a result, developers are scrambling to build more housing. Barring any artificial political barriers thrown up to limit such growth, supply and demand will eventually reach equilibrium, and prices will level off. That is how capitalism works. But it’s important to come up with a reasonable estimate of future housing price growth in order to make a rational decision about the return you can expect from making such an investment.

The most comprehensive source available for housing price appreciation is the Case-Shiller Home Price Indices. Started in 1980 by two economists, Karl Case and Robert Schiller, they are calculated monthly from data on repeat sales of single-family homes in twenty metropolitan areas. Each index is a three-month moving average of home prices in its particular location, normalized to have a value of 100 as of January 2000. The dataset for San Francisco goes back to 1987.

Although “past performance is no guarantee of future results,” as you’ve read many times in investment publications, it’s still useful to look back at prices historically to get a sense of how they’ve performed under various economic environments.  Let’s look at the two decades 1990-1999 and 2000-2009, which collectively span three recessions and two economic booms.

During the ten year period from 1990 through 1999, San Francisco housing prices grew 3.1% per year on average. In dollar terms, that means that if you bought a $500K house in January 1990, it would have been worth $677K by December 1999. That sounds pretty good. But it’s actually only slightly greater than the 2.8% average annual inflation rate over the same period. And when you subtract the costs of buying & selling, you would likely have lost money in real (that is, inflation-adjusted) terms.

This isn’t to say that the growth rate was steady during that decade. If you had sold the house at the end of 1994 you would have lost $35K on the sale (a decline of over 1.4% per year on average). But if you had bought a $500K house in early 1995 and had sold it in December 1999 you would have reaped a $225K gain. That’s a 7.7% average annual growth rate.

What about the first decade of the 21st century? From 2000 through 2005 San Francisco housing prices grew by a whopping 12.7% each year (on average). Your $500K house purchased at the start of 2000 would have grown in value to $907K in just five years. Yow! But the second half of the decade was not so kind to homeowners. From 2005 through 2009, a $500K house would have dropped in value to $354K, a -6.7% average annual decline. For the entire decade, the average annual price increase turned out to be – you guessed it – exactly 3.1% again. But this time growth outpaced inflation by 0.8% annually on average, better than the paltry 0.3% during the 1990s.

Although it’s anybody’s guess what housing prices will be next year or even five years from now, housing prices long-term have grown historically at a rate slightly higher than inflation. And when prices shoot up much faster than inflation, such as during the period we’re in right now, declines inevitably follow as supply and demand becomes more balanced. If you are planning to buy a residential rental property, or currently own one, make sure (among all the assumptions you are making) that you set realistic expectations regarding your property’s appreciation. Otherwise you might find yourself losing money now and losing more later.

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