High rent, low interest rates and even lower vacancy rates have made these fat and happy days for Minneapolis duplex owners. After all, properties are cash flowing at record rates of return, the overall quality of tenants in the marketplace seems to be high, and they seem to stay for a long time.
In fact, life is so good for Twin Cities landlords, it’s hard to imagine things could ever change.
And yet, history proves there is a season for everything, and in the end, all markets are cyclical. Stocks go up, stocks go down, demand for products increase prices, production increases to meet demand, and prices go down. Demand for housing increases as populations grow, supply rises to meet that demand, and then supply exceeds demand.
The same may be true for real estate investment properties.
Our record high rents are driven largely by a recession and housing crisis which made not only loans with which to purchase property difficult to obtain, but also cast doubt on the value of owning housing in the first place.
There comes a time, however, when the price of rent rises past the cost of home ownership, however, and that’s when tenants begin to take note. And as they realize en masse the savings of owning rather than buying, landlords see both vacancy rates and renter’s concessions rise.
For example, many long term investment property owners in the Twin Cities remember the peak of the housing market, when rental ads began with the words “first month free”, “free Internet” and “free cable” in an effort to attract tenants.
In fact, as far back as 1876, the author and political economist Henry George observed that real estate markets can be summarized into four categories:
- Recovery- As population increases, so too does the demand for goods and services. This demand is typically fueled by government intervention in the form of low interest rates. As things improve, companies expand their businesses, hire more people and buy more equipment. This increases the demand for locations where this increased economic activity can take place, which causes vacancy rates in every class of real estate (office, retail, industrial, residential, etc.) to fall.
- Expansion – This occurs when companies have purchased or rented most of the existing available properties. As unoccupied properties become scarce, rents rise. It takes a long time to build new inventory. By the time these new developments are ready, the economic expansion has been underway for five to seven years. And during this time, rents have been increasing so fast that now, investors build these increases into their economic forecasts. It’s at this point that properties are sold for what they may be worth in the future, rather than the fundamental economics of what they are. This is the hallmark of a boom.
- Hyper Supply – As long as occupancy rates are below normal, rents rise, which makes new construction feasible. However, the first sign of a change is a rise in the amount of unsold inventory and vacancy rates. This is a result new construction begins to satisfy the market’s need for real estate product. Rents no longer rise, but begin to decline.
- Recession – The second indicator of trouble is vacancy rates rise above the long-term average. As a result, new construction stops, but those projects already well under way are completed. Higher inventory leads to lower occupancy and lower rents, which reduces revenue for property owners. The third indicator of trouble is an increase of interest rates; a result of the Federal Reserve attempting to fight inflation. As vacancy rates rise and revenues fall, foreclosures follow. And the cycle starts all over again.
While no one is forecasting a spike in vacancy rates in the coming month and year, it is important to remember that like everything else, real estate is cyclical. And so it stands to reason that “first month free” signs are somewhere up ahead.