Having invested in long-term rentals over the last 10 years, I have decided to dive deeper into the history of how long-term rentals became a preferred investment model for Americans to build wealth, and how the model of long-term rental investing is dealing with the rise of short-term rentals, interest rates, and housing prices.
Long-term rental properties have been a part of American society for centuries, serving as a reliable source of income for landlords while providing a home for tenants. The history of long-term rental properties in America can be traced back to the colonial period, where landowners rented out their properties to tenant farmers. Over the years, the concept of renting out properties evolved, and long-term rentals became a preferred investment for real estate investors.
The Evolution of Long-Term Rentals
During the colonial period, tenant farmers rented land from landowners to farm and provide a portion of the crops or goods as rent. The concept of renting out land became popular in the early 1800s when urbanization began. As people moved into cities to work in factories, they needed housing, and landlords began to provide it. During this period, long-term rentals were usually rented out for a year, and the landlord collected a lump sum of rent upfront. Can you imagine paying an entire year’s rent upfront?
By the 1920s, long-term rental properties became more prevalent, and landlords began to charge monthly rent instead of a lump sum. The demand for rental properties increased as more people moved into cities, and the number of renters grew. The government also began to get involved, and the first rent control law was enacted in New York in 1943.
In the post-World War II era, the demand for long-term rental properties continued to increase as veterans returned home and started families. The government also got involved in promoting homeownership, and programs such as the GI Bill helped veterans buy homes. However, not everyone could afford to buy a home, and long-term rentals remained an attractive option for those who couldn't. These early pieces of legislation around home ownership helped cement the reputation of home ownership in America being synonymous with the "American Dream".
The Rise of Real Estate Investment
During the 1960s and 1970s, the concept of real estate investment trusts (REITs) emerged, allowing individuals to invest in real estate without actually owning the properties. The first REIT was created in 1960, and by the 1970s, there were over 30 REITs listed on the New York Stock Exchange.
The REIT industry continued to grow, and in 1986, Congress passed the Tax Reform Act, which allowed REITs to avoid corporate income tax as long as they distributed 90% of their income to shareholders. This made REITs an attractive investment option, and the number of REITs increased to over 200 by the mid-1990s.
During the 1990s, the real estate market experienced a boom, and many people began investing in long-term rental properties as a way to generate passive income. The rise of the internet also made it easier for investors to find and purchase properties remotely. As a result, the number of long-term rental properties owned by individuals and corporations grew.
The 2008 Financial Crisis and the Rise of Institutional Investors
The 2008 financial crisis had a significant impact on the real estate market, causing many individual investors to lose their properties. However, it also created an opportunity for institutional investors to enter the market. During the crisis, housing prices dropped significantly, and large private equity firms began to purchase foreclosed properties and convert them into long-term rental properties.
These firms saw the opportunity to generate significant returns by purchasing properties at a discount and renting them out. As the economy began to recover, the demand for long-term rental properties continued to grow, and institutional investors began to purchase properties in bulk, further driving up prices.
Today, institutional investors own a significant portion of the long-term rental market. According to a report by the Urban Institute, institutional investors own approximately 200,000 single-family homes for rent, with the top five institutional investors owning over 100,000 homes.
The Rise of Short-Term Rentals
Over the last decade, the popularity of short-term rentals has surged in the United States, especially among real estate investors. While long-term rentals have always been a popular investment option, the emergence of platforms like Airbnb, HomeAway, and VRBO has made it easier than ever for investors to tap into the lucrative short-term rental market. The primary reasons why short-term rentals have become more popular than long-term rentals for investors over the last 10 years:
Higher rental income: Short-term rentals typically command higher rental rates than long-term rentals, especially in popular tourist destinations. This is because short-term rentals can be priced on a nightly basis, which allows investors to take advantage of peak demand periods and charge premium rates. In contrast, long-term rentals are typically priced on a monthly basis and have more stable rental rates.
Flexibility: Short-term rentals offer investors greater flexibility in terms of usage. Unlike long-term rentals, short-term rentals can be used by the owners for personal vacations, family visits, or other purposes. This can be an advantage for investors who want to use the property themselves or rent it out during peak seasons.
Increased demand: Finally, short-term rentals have become more popular over the last decade due to increased demand. Travelers today are more likely to prefer short-term rentals over hotels because they offer greater privacy, space, and unique experiences. This has made short-term rentals a more attractive investment option for real estate investors.
LTR investors have historically used the "1% rule" as a benchmark for whether a potential property was worth the investment. The rule states that the monthly rent for a rental property should be at least 1% of the property’s purchase price. For example, if an investor purchases a property for $200,000, the monthly rent should be at least $2,000 to meet the 1% rule. This rule helps investors quickly assess the potential profitability of a rental property and identify whether it is worth further consideration.
In the last 5 years, you would be hard pressed to find any market in the US that gets anywhere close to achieving the 1% rule. Simply put, the return on investment on LTR investments have been significantly reduced due to the massive increase in house prices in most markets without a proportional increase in the rent being charged. Additionally, the cost of capital (i.e. interest rates) are at the highest levels in 20 years, which has made the servicing of the debt that much more expensive for real estate investors - who typically like to use leverage to juice returns.
In conclusion, I am not proclaiming that the LTR model is dead, but there has to be a re-thinking of the asset class when dealing with record high home valuations. Until that happens, cash flow will continue to remain extremely hard to achieve in most markets. I am very interested to see what new ideas sprout up given the constraints in the environment, and what winning ideas will help catapult real estate investing into a new age of profitability. I will continue diving into different real estate investing models and document my findings, (including some utilized in other countries), to see if there are concepts we can glean not only from our own past history, but from the current dealings of our neighbors around the world.
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