Rental property investment has proven extremely lucrative. This can be measured by a multitude of metrics, including looking at the performance of single-family rental real estate investment trusts (“REITs”) and the median price of homes in the United States. states. As illustrated in the chart below, the performance of leading single-family rental REIT American Homes 4 Rent (AMH) and even the median price of existing single-family homes in the United States outperformed the broader REIT sector (VNQ) since 2013:
When considering the rental income potential of single family homes as well as the benefits of leverage on return on equity, the difference in performance between single family homes and VNQ becomes even greater. As a result, whether you chose to own your own individual properties and rent them out or just passively invest in AMH over the last 9 or so years, you would most likely have outperformed the broader REIT sector.
While it’s entirely possible that single-family rentals will continue to generate attractive returns and passive income for today’s investors well into the future, we believe that high-yield equities presently offer a better route to a early retirement for the following reasons:
#1. Rental properties are in a bigger bubble fueled by the Fed
While it’s probably true that virtually every investment asset class is in a Fed-fueled bubble, it’s hard to argue that single-family rentals are in the biggest bubble of them all. The reasons are that:
1. Single-family homes have seen an epic price spike in recent years and have yet to see a price correction, unlike publicly traded stocks (SPY)(QQQ)(DIA) which have already experienced a significant drop in prices price this year.
2. Single-family homes – thanks to 15- and 30-year mortgage financial products – are a highly leveraged asset class. To my knowledge, no asset is as easy to acquire as a single family home for the average person with such high debt ratios over such long periods of time. Therefore, the limiting factor in demand for single-family housing is largely influenced by interest rates to a degree not seen in other asset classes. So the Federal Reserve massively subsidized the cost of single-family homes by pumping trillions into the mortgage market and eventually taking ownership of almost a quarter of all outstanding residential mortgages in the United States. Like the Mises Institute reported earlier this year:
Rampant house price inflation continues to characterize the US market. Home prices across the country rose 15.8% on average in October 2021 from a year earlier. US house prices are well above their 2006 bubble peak and remain above the bubble peak even after adjusting for consumer price inflation… Incredibly, in this situation, the Federal Reserve continues to buy mortgages. It buys a lot and continues to be the marginal buyer who sets the price or the big offer in the mortgage market, expanding its mortgage portfolio with one hand and printing money with the other… The Federal Reserve now has $2.6 trillion worth of mortgages on its balance sheet. This means that approximately 24% of all outstanding residential mortgages in this entire great country reside with the central bank, which has thus achieved the remarkable status of becoming by far the largest savings and loan institution in the world.
Today, as the Federal Reserve attempts to turn the tide and allow assets to flow naturally off its balance sheet, mortgage interest rates have soared. As a result, housing is now at one of its most unaffordable levels in years. With buyer demand rapidly drying up, the near-term upside potential for single-family properties does not look at all attractive, and many industry analysts expect prices to begin to decline significantly.
#2. Rental properties are not effective passive income generators
In addition to simply offering investors a very negative risk-reward ratio at the moment, rental properties are also relatively inefficient passive income generators compared to high-yielding stocks. In effect, high-yield stocks are passive stakes in large companies that benefit from considerable economies of scale.
In contrast, by buying rental properties, you are effectively starting your own business from scratch and – given that it is virtually impossible for you to grow to the same size as a listed business – you will inevitably suffer from lower economies of scale. This results in a higher cost of capital, higher transaction costs, higher management and administration costs (either in terms of time and stress, or in terms of expensive property repairs and costs tenant management), and higher property and tenant search and advertising costs. .
Although the initial numbers for a rental property – especially when you apply a ton of relatively cheap leverage to it – might seem compelling, once you factor in the dollar value of the time and stress spent to manage tenants, toilets and garbage, the added value over simply buying passive stakes in professionally managed companies via high-yield stocks is often not worth it. Plus, if you want to retire, why chain yourself to the extra work and stress that comes with a rental property?
#3. Rental properties are riskier
In addition, small portfolios of rental properties come with a significant risk of concentration of tenants, geographical and real estate. If just one of those investments goes bad due to physical issues with the property, bad tenant issues, or that particular area seeing its real estate values plummet, your overall net worth and passive income stream will be significantly affected. In contrast, if you build a well-diversified portfolio of high-yield stocks, if one of these (already large and usually well-diversified) companies is written down and/or cuts its dividend, your portfolio will be much less impacted.
Key takeaway for investors
Although rental properties have made a lot of money for most investors over the past decade, there is no guarantee that these returns will continue to be lucrative over the next decade. On the contrary, the macro situation seems to imply that the party is over for buy-to-let investment for at least the near future.
By investing in a well-diversified portfolio of high-yielding, quality stocks rather than rental properties, investors who are trying to create a passive income stream for early retirement will be better protected against the current tightening cycle of the Fed, will generate more efficient passive income and also reduce long- term portfolio and income stream risk.
Three of our favorite high-yield quality picks for young retirees are Enterprise Products Partners (EPD), STORE Capital (STOR) and TFS Financial Corp (TFSL). A portfolio allocated 1/3 to each of them would be very well diversified across energy infrastructure, real estate and financial sectors, would be supported by high quality management teams and very strong balance sheets, would benefit from strong recession resistance and inflation protection, and would benefit from a safe and growing passive income return of 6.65%. For investors looking to get a good night’s sleep in early retirement while generating high returns to fund their desired lifestyle, these three choices are a great place to start. At High Yield Investor, we populate our portfolio with dozens of similar stocks to minimize our risk while generating similar yield and very attractive total returns.