Written by Brent Nyitray, CFA

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Key Points

• Residential rental properties are an attractive investment.

• They carry high yields right now.

• They also offer relatively fast growth rates.

Motley Fool Issues Rare “All In” Buy Alert

One of the best-performing asset classes this year is residential real estate. According to most real estate indices like the Federal Housing Finance Agency (FHFA) or Case-Shiller, home price appreciation has risen by anywhere between 18.5% and 19.5%. While this is below the 24% year-to-date rise in the S&P 500, it still has been a great year for house prices. 

Professionally managed money is flooding the rental space

While individual landlords have been buying properties for rent, we have also seen a lot of professional money get into the buy-to-rent space. Investment giant BlackRock (NYSE:BLK) bought Home Partners of America for $6 billion. Other major investment firms have raised money to purchase rentals. 

For institutional money managers, this strategy is quite attractive because they earn rental yields on the properties, deduct depreciation (which can reduce taxes), and benefit from home price appreciation. I recently wrote a piece on single-family rental real estate investment trust (REIT) American Homes 4 Rent (NYSE:AMH), where I discussed how much home price appreciation has added to the company's intrinsic value. 

Interestingly, institutional investors have had a leg up over more traditional mom-and-pop landlords in the first half of 2021. The FHFA ordered the government-sponsored entities Fannie Mae and Freddie Mac to limit their loans secured by investment properties.

Mom-and-pop investors are heavily reliant on loans from Fannie and Freddie to finance property purchases. These limits made these mortgages on investment properties scarce and expensive. Big institutions like BlackRock or American Homes 4 Rent have many more avenues to raise investment capital. Eventually, Fannie and Freddie reversed the caps and leveled the playing field between institutions and individuals. 

The math of rental property investing

While home price appreciation has risen by high-teen percentage growth rates, rents have been following along, with some estimates that one- and two-bedroom apartments are rising at a 21% and 17% year-over-year clip, respectively.

So from an investment standpoint, rental properties have a cap rate of around 7% per year, which has been the average for the past 10 years.  So, the property is throwing off income of about 7% per year, and that income is growing at a 19% rate, as is the underlying property. If it were a stock, a one-bedroom apartment might have a 7% earnings yield (in other words, a price-to-earnings ratio of 14 times) and would be growing earnings at 21% per year.

Famed investor Peter Lynch looked at a stock's earnings growth and P/E and combined them in the PEG ratio (or price-to-earnings to growth ratio). That rental property would have 14 P/E and a 21% growth rate, or a PEG ratio of 14 divided by 21 or 0.67. Lynch targeted stocks with PEG ratios below 1, so that 0.67 ratio would be a screaming buy.

Home hacking, flipping, and passive income

The rental property space is still dominated by mom-and-pop investors who intend to rely on this passive income to supplement Social Security in retirement. Another great strategy is house hacking, where an investor buys a multi-unit property, occupies one unit, and collects rent from the other units, which can greatly reduce the investor's cost of living.

Finally, we are seeing many fix-and-flip investors, but the rising price of materials and labor is making this strategy a risky one for investors who don't have six to 12 months of reserve cash to rely upon until the property gets sold. 

As long as the stock market remains expensive and bonds pay paltry yields, residential real estate will remain a popular vehicle for investors looking for growth and income.