How To Invest When Home Prices Rise

The Problem.

In the past year the average sales price of a home rose 16 percent; in places like Boise and Austin, more than 30 percent. Prices were up 10 percent even in economically depressed areas.

If you’re planning an investment in rental property you might think higher prices are no problem, maybe even a good thing because they mean strong demand; to make up for the higher prices all you have to do is raise the rents.

You would be wrong.

This is one of the most difficult times to make an investment, you need to be very careful, because you can’t just raise rents and expect to find tenants.

Here’s why: one of the strongest economic relationships is between rents and income; people can only afford to pay as much as they make, and they’re not making 30 percent more.

Look at the table of Rents and Income for Austin, Boise and Charlotte. For Austin, average income grew 50 percent from 2010 to 2019, while the average rent increased 44 percent. It’s the same for Boise and Charlotte – an almost uncanny match. These are about the tightest relationships you can find in economics and they apply in most markets, not just these three.

[Surveys by the Census Bureau provide the most accurate measure of average rents in local markets. Because of difficulties with the 2020 Census, 2020 rents aren’t yet available.]

Home prices also are tied to income in the long run but for short periods they can rise much faster. In Austin and Boise, for example, home prices have far outstripped rents since 2010 – and that’s not even counting last year. In Charlotte, on the other hand, prices increased 41 percent, right in line with income and rents.

Rising home prices can pull up rents, but not as much and not for long. Look at the charts of home price and rent increases for Austin and Boise since 2000. They show not only the volatility of the increases, but that rents rarely increased more than 5 percent in any year. Why do we think 2022 will be any different?

Local Market Monitor added the 2021 home price increases to these charts to warn investors about the other danger they face right now: that prices in places like Austin and Boise are very likely to crash – as they have in the past. Price increases like these just cannot be sustained. The danger is greatest in smaller markets like Boise, where rents also would be in jeopardy.

What to Do.

Every local market – down to the zip code level – has a distinctive spread of renters. Some pay $800 a month, some pay $1,500, some $2,000 or more. While the range of ALL rents may be fairly wide, most renters are concentrated in a fairly narrow “best rent range”. Annual surveys by the Census show that this range is very stable, even as rents slowly increase; it doesn’t change just because home prices are higher.

It’s in this “best rent range” that investors are most likely to find suitable renters.

It’s ALWAYS a good idea for investors to target this range, that’s where they have the least risk – but it’s an essential strategy when home prices are rapidly rising.

If you are considering a particular rental property – single-family or an apartment building – be sure you know where your rents will be compared to the local “best rent range”. If they are far above, you’re taking a big risk. The seller will of course reassure you that renters are easy to find – don’t believe it.

A good strategy in a rising price environment – when rents lag way behind – is to invest in a property at the low end of the rent spectrum and upgrade it to the upper end of the “best rent range”.

And in boom markets – like Boise – it may be best to just sit on the sidelines.

This post first appeared on Forbes.com. To see the original, click here.