Beyond Rental Yield: How to Answer: “Will My Market Stay Profitable?”

In a previous post, I described the concept of “yield,” a quick way of calculating how much of your investment you’ll be able to get back each year, expressed as a percentage. Once you’ve built up 100%, anything you pocket past that is pure profit. We talked about the fact that “the dream” is to have a property with a high yield, nested in a neighborhood full of properties with a modest yield. But today, we’re going to go “under the hood” a bit and look at couple of factors that will help you decide whether your yield will stay as good as it is today.

House Prices and Supply Elasticity

Yield tends to go up as a function of elasticity of housing supply. Supply elasticity isn’t an easy thing to understand, but it essentially means “when the price of a thing changes, how quickly does the amount of that thing on the market change to match?” So if the price of houses is rising, a high-elasticity market will quickly put new houses up for sale (which tends to decrease prices). If the price of houses is falling, a high-elasticity market will quickly remove houses for sale (which tends to increase prices). On the other hand, a low-elasticity market means that the amount of something available doesn’t change — at least, not quickly — as prices change.

Supply elasticity can trigger increases in yield under two conditions:

• When housing prices are going up and elasticity is low (meaning that the market isn’t adding enough houses to damper price increases), purchasing a house may not be affordable. More people will then rent because rental payments are lower than housing payments.
• When housing prices are doing down and elasticity is high (meaning that the market is effectively keeping the housing supply down in response to lower prices), people can’t always find a house in order to buy one. Dozens of buyers for each house and houses getting snapped up in weeks instead of months make for lots of would-be buyers that are renting because they have no choice.

The net effect is that property investors, given either of those conditions, will mostly turn toward the strategy of renting their houses out in order to maximize profits. This means that hunting down neighborhoods with the appropriate kind of elasticity for your economic environment can help your long-term rental yield remain where you want it.

Distress Sales and Distressed Supply

The ratio of “distressed sales” (short sales, REO homes, and other sales that are going for below-market value due to some exigent circumstances) to normal sales is another solid indicator of yield performance in the short term. The greater the percentage of distressed houses in an area, the more predictably the people in that area will be renting, which means greater yield.

But more importantly, the concept of “distressed supply” — the number of houses being sold under distress and the rate at which they’re selling — is relevant. Because the supply of distressed houses is mostly limited (given that the vast majority of distressed houses entered the market in response to a one-time market crash around 2008), the distressed-to-normal ratio will approach one over time. As it does, yield will predictably decrease — so for the best long-term outlook, renting in an area with lots of distressed houses (or that isn’t selling those houses very quickly at all) is a solid strategy.

Of course, markets all change over time and nothing is ever certain, but by looking hard at the attributes of the neighborhood you’re considering investing in, you can gain some insight into which of a few solid options will probably still be solid a decade or more from now.

(All you savvy number crunches, please note we’re not covering rental market saturation in this post!)

Read more at biggerpockets.com

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