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Three reasons why you should invest in the purchase of a rental home

In the first quarter of 2022, we have seen how the stock, bond, and cryptocurrency markets have lost value, while the commodity and real estate markets have gained.

Despite the rise in house prices in Spain, I believe that buying a property to rent can be an attractive investment that could be worth including in your investment portfolio. The three main reasons why I think this are: 1) a rental home is an asset that generates income, 2) housing is an asset that usually appreciates equal to or more than inflation, and 3) interest rates are still low.

Below, I explain each of these reasons in detail.

Reason 1: A rental home is an asset that generates income

Anecdotally, it is heard how the housing rental market is growing in the world’s large metropolises. And also, in medium-sized cities and in some small ones.

In the case of Spain, these anecdotes are reflected in the statistics. As Figure 1 shows, since 2018 the percentage of the population that rents homes have increased.

Figure 1: Percentage of individuals who live in rent or ownership
Source: Fotocasa

But as seen in figure 2, the percentage of individuals who live in rent varies widely by community. For example, in the communities of Madrid, Catalonia, and the Balearic Islands the percentage of people who rents is higher than the average for Spain. On the other hand, in Andalusia, Extremadura, and Cantabria the percentage is below the country average.

Figure 2: Percentage of individuals who live for rent by Autonomous Community
Source: El Diario.es

The reason for this variability between communities is clear, the price of purchasing a home relative to the salary of the population of these regions varies widely. In other words, the income of a person in Andalusia buys more square meters of housing in Andalusia than the salary of a person in the Balearic Islands can buy in the Balearic Islands. Figure 3 shows the complete data for all of Spain.

Figure 3: Affordability of home purchase in Spain

According to data from idealista.com, the profitability of renting a home in Spain reached 6.9% at the end of 2021, which represents a decrease compared to 7.5% in 2020. In this aspect, the variability of the profitability by cities also varies significantly.

Figure 4: Returns on rental housing investment in 2021
Sources: Bankinter, Idealista

In my opinion, it seems reasonable to expect that the profitability of rental housing will remain the same as the present or increase.

Of course, when making investment decisions, several factors must be considered, including the purchase price of the property, the expected rental income, the appreciation of the home, and the cost of financing. I will now focus on these last two factors.

Reason 2: Housing is an asset that tends to appreciate in value equal to or more than inflation

When you buy a home, you want two things to happen with respect to its price:

  1. That its price goes up
  2. That its price rises more than inflation

Homes usually have a good record of appreciating relative to inflation.

Sure, when you buy a home at the end of a market bubble, you can see your property’s price drop or stay the same for years. Just as it happened in Spain between June 2007, when the price per square meter reached €2,053, and October 2016, when it had fallen to €1,496/m2.

Recently, the evolution of housing prices has once again been on the rise. As seen in figure 5, the growth rate of the price per square meter for both sale and rental has increased since 2017 at a rate much higher than inflation. That’s good news for homeowners (and bad news for those who rent and those who want to buy).

Figure 5: Sale and rental price per square meter of homes in Spain compared to the growth of inflation.
Sources: Inflation, Instituto Nacional de Estadísticas (INE); Price per sq. meter sale and rent of houses in Spain, Idealista. 

Inflation in Spain in March 2022 was 9.8%, the highest rate since 1985. In the coming years, inflation will probably not be as high, but in my opinion, it will be higher than the 2% annual target of the European Central Bank. The reason is simple, the time has come to pay the consequences of the massive amount of monetary and fiscal stimuli that were implemented in previous years.

So even if we’re being kind to our predictions and assume 3% annual inflation for the next ten years, that should mean homes appreciate more than that. Rents are likely to go up as many contracts contain clauses for increases equal to the CPI (inflation).

Assuming future inflation of 3% per year mortgage rates found today are lower than that, which is good news for buyers.

Reason 3: Interest rates are still low

As Figure 6 indicates, since the peak reached in 2007, interest rates on mortgage loans progressively fell to reach a minimum of between 1% and 2% in October 2021.

Figure 6: Annual interest rate for mortgage loans in Spain
Source: Banco de España

Given the current situation of rising inflation, in 2022 banks have started to raise mortgage loan rates. Figure 7 shows a sample of the rates offered by some banks.

Figure 7: Indicative interest rates for fixed-term mortgage loans
Sources: Examples taken from the websites of the banks indicated for the purchase of a home valued at 300,000 EUR. Rates without discounts.

Although the rates shown in figure 7 are higher than those observed in previous months, they can still be considered low. Visit Fivent.com to see a comparison of mortgages in Spain and the USA.

With those rates that are equal to or lower than the expected inflation in the coming years, in my opinion, it is advisable to buy a home with the use of financing. The reason is simple, if inflation is equal to or higher than the mortgage rate, that means that you basically have no financing costs.

But it is important to take into account two details 1) that the mortgage rate must be fixed, because if it is variable, it is a matter of time before they increase, and 2) that any contracted financing must not exceed what is prudent to maintain your finances healthy. More about this is below.

Criteria for selecting a home to invest in

When selecting a home to buy for rent, there are other factors, in addition to those mentioned above, that are important to consider. The following are six of them:

  1. Protection of property rights: it is vital that the autonomous community, province, and city where you choose to buy a home have an institutional framework that protects private property and that its political leadership has the unwavering will to enforce that right. We already know how in some places in Spain the issue of illegal occupations (Okupas) has become a nightmare for many owners. These squatters are sometimes protected by the local political leadership and come to form mafias that are quite complex to deal with.
  2. Need to obtain a tourist license: if you plan to rent your property on a seasonal basis, you should check if the local government authority requires you to have a tourist license. If so, you must know what the requirements are and the duties that they imply to evaluate if they make the profitability of your investment feasible. In addition, you must analyze how likely it is that you will be granted the license if you request it, how long it will take to be approved, how often you must renew it, and under what circumstances your license can be revoked.
  3. Do not borrow more than necessary: ​​the famous investor Warren Buffet said it well, “what is intelligent at one price is not intelligent at another.” Beware of thinking that the purchase of rental homes is a good business in all circumstances. It is not. Be particularly careful about the level of debt you take on. While working with other people’s money (the bank loan) sounds great, after a certain point, it is not. A high level of debt makes you more vulnerable to fluctuations in your cash flow, which can lead to situations where you can lose the property (remember the crisis of 2008?). If you want to know more about how much debt is a lot of debt, download the Fivent Debt Management Guide.
  4. Keep fees and maintenance costs low: it may seem like a good idea to buy a flat in a building with attractive common areas, such as gardens or a swimming pool, but from the point of view of profitability it might not be. The experience in Spain shows that tenants are not willing to pay much more in rent for a flat with access to attractive common areas. The same with the equipment you install on the floor if you decide to do so. Choose durable equipment with a low replacement cost.
  5. Make a good, nice, and cheap reform: there is no doubt that a flat that looks well cared for can be rented at a higher price than one that is not, even if the flats are identical in all other characteristics. But it is not worth investing in reforms that you will not be able to make profitable. So focus on cosmetic factors that stand out and are relatively cheap to make look good. For example, a deep cleaning (including odors), painting, and flooring.
  6. Know which are the most and least valued attributes in a home: offer what people want. Remember, you are not buying a flat for yourself. You are buying a property to rent, and perhaps in the future to sell it. In a report published by Fotocasa Research in February 2022, they pointed out the following attributes as the most and least valued by people when looking for housing.

These are some of the factors that you must consider when buying a home to rent, but there are others that you must not forget to analyze, such as the tax regime.

I believe that buying a property to rent can be an attractive investment that could be worth including in your investment portfolio. The three main reasons why I think this are: 1) a rental home is an asset that generates income, 2) housing is an asset that usually appreciates equal to or more than inflation, and 3) interest rates are still low.

However, it must be taken into account that these types of investments do not always return the expected returns. To improve the probability that your investment reaches the desired profitability you should consider other factors such as the protection of property rights, whether you will need to obtain a tourist license, not borrowing more than necessary, knowing what the most and least valued by people when selecting housing, keeping administration and maintenance costs low, and making good, beautiful and cheap reforms.

Disclaimer

This article was written for educational purposes and does not provide investment recommendations specific to individual investors. As such, the financial instrument(s) discussed may not be suitable for all investors and investors must make their own investment decisions based upon their specific investment objectives and financial situation utilizing their own financial advisors as they deem necessary. Past performance of the financial instrument(s) listed in this newsletter should not be taken as an indication or guarantee of future results. The price, value of, and income from, any of the financial instruments showed in this article can rise as well as fall and may be affected by changes in economic, financial, and political factors. If a financial instrument is denominated in a currency other than the investor’s home currency, a change in exchange rates may adversely affect the price of, value of, or income derived from the financial instrument described in this post.