Where Do Landlords Make the Most Money?
Historically, most Americans have sold their homes when they’re ready to move out. However, more homeowners are choosing to rent out their homes instead. This is not only due to a combination of economic trends that make it increasingly attractive to own rental properties, but also attributable to lingering effects of the Great Recession that makes it unattractive for some homeowners to sell.
Homeowners considering renting their current home rather than selling must weigh the costs and benefits. Frequently, homeowners are focused on the short-term gain: whether rental income will cover mortgage payments on a monthly basis. But even if homeowners fall short on a monthly basis, they often come out ahead in the long-term after eventually selling their home. In fact, of the top 50 metros analyzed by Zillow, homeowners in several metro areas—such as San Jose—who choose to rent out their homes pay more in mortgage payments than they receive in rental income. However, they more than recover those short-term losses with the long-term gain from home value appreciation when they eventually sell.
What drives homeowners to become landlords?
In the aftermath of the Great Recession, three interrelated trends have converged to make it increasingly attractive for homeowners to rent out and become landlords rather than sell their homes:
- Rental demand growth. As the homeownership rate has declined, the number of renter households has increased. Over the past half-decade, the share of prime working age adults (25-54) who rent their home has risen rapidly from a two-decade low of 28 percent in 2005 to 36 percent in 2013.[1] Among young adults age 25-35, only about one-third rented in 1980 compared to about half in 2013.
- Declining but persistent negative equity. As home values declined during the Great Recession, large numbers of homeowners discovered that their outstanding mortgage balances were greater than the resale value of their homes, making it impossible (or extremely costly) to sell their homes. At its peak, Zillow estimates that nearly one-third of U.S. homeowners had negative home equity.[2] Although the negative equity rate has declined substantially, to 18.8 percent in 2014 Q1, more than 9.7 million homeowners with a mortgage remain underwater.
- Expected home value appreciation. Home values are expected to continue rising over the next year at a pace of 4.2 percent, which is slower than the pace of growth in recent years, but still attractive relative to other asset classes.[3]
The decision to sell or rent a home is complex. Relatively few homeowners have the luxury of holding onto a home when moving, since accrued home equity may be necessary to fund a down payment on the next residence. In many cases, however, this is feasible when a homeowner is downsizing, such as is common among retirees. Moreover, while casual observers typically assume that it is sufficiently profitable for rental payments to cover mortgage payments, homeowners also accrue substantial gains from long-term asset appreciation. In some cases, these long-term gains may justify initial losses (e.g., if mortgage payments, property taxes and property insurance exceed rental income) where liquidity is not a concern.
Results
The table below shows the results of a simulation of a homeowner who chooses to rent his home after living in it for several years. Under the assumptions described below, homeowners in Oklahoma City ($536), Miami ($515), Tulsa ($396), Cincinnati ($385) and Denver ($355) earn the largest monthly dollar profits from rental income, while homeowners in San Jose (-$1,211), San Francisco (-$789), Los Angeles (-$544), Honolulu (-$379) and Sacramento (-$350) suffer monthly losses in the near-term—meaning that their rental income is insufficient to cover their full mortgage payment after accounting for maintenance, taxes and vacancies.
However, once accumulated home equity is taken into account, landlords in the metro areas that experience losses on rental income fare much better. In monthly dollar terms, homeowners in San Jose ($8,927), San Francisco ($6,078), Los Angeles ($4,328), San Diego ($4,165) and Riverside ($3,659) make large profits if both rental income and home equity are included. The smallest monthly dollar profits after accounting for home equity are in St. Louis ($900), Kansas City ($900), Louisville ($978), Memphis ($978) and Tulsa ($983).
Overall, the data suggest that when it is financially feasible and if landlords are willing to put up with short-term monthly losses, holding onto a property as a rental is often advantageous in the long-term.
Methodology
For the above analysis, we simulated the long-term profits and losses of homeowners turned landlords across the top 50 U.S. metro areas.[4] (For an illustration of how we calculated these numbers using the example of Las Vegas, see the accompanying article.)
- To facilitate this comparison, several assumptions were necessary. In particular, we assumed homeowners purchased the property five years ago, in June 2009, with a 30-year fixed rate mortgage, a 20 percent down payment, and an interest rate of 4.5 percent, roughly the rate that prevailed at the time.
- For tax purposes we assumed that the homeowner is married with a gross annual income equal to the metro-area median for homeowners with a mortgage as reported in the Census Bureau’s 2012 American Community Survey (ACS).
- Property taxes are assumed to grow in line with home values, meaning that the assessed tax value of each home is updated every year—an admittedly strong assumption, but one that yields conservative estimates.
- Finally, we assessed the accumulated home equity and the net monthly rental profit using average vacancy rates to account for vacant months during the first seven years that the property rents.
[1] Zillow analysis of data from the March Supplement to the U.S. Census Bureau’s Current Population Survey (CPS) made available by Miriam King, Steven Ruggles, J. Trent Alexander, Sarah Flood, Katie Genadek, Matthew B. Schroeder, Brandon Trampe and Rebecca Vick, Integrated Public Use Microdata Series, Current Population Survey: Version 3.0, Machine-readable database, Minneapolis: University of Minnesota, 2014.
[2] Svenja Gudell, “Negative Equity Continues to Fall, Concentrated in Bottom Tier,” Zillow Real Estate Research, May 19, 2014.
[3] Svenja Gudell, “The Long and Winding Recovery,” Zillow Real Estate Research, July 20, 2014.
[4] Due to data availability, we drop New Orleans and Buffalo from the top 50 metro areas, and include the next two, Tulsa and Fresno.