From Alexander Weis and Gerd Kommer
Almost 60% of the 24 million rented apartments in Germany belong to private individuals or “small landlords”, as the Federal Statistical Office calls those landlords who only operate the residential property rental business on a modest scale - by renting out just one or a few residential units as a non-full-time job. The other ten million or so rental apartments are owned by professional commercial providers, including the largest, Vonovia SE, based in Düsseldorf. Vonovia is a listed real estate company, a member of the DAX index and manages around 500,000 rental apartments, most of which it owns.
Given the high proportion of private landlords in Germany, one could assume that the rental of residential properties by private individuals, i.e. small landlords, is a lucrative business. After all, around four million private real estate investors can't be wrong. Or maybe it is?
No one will doubt that the purpose of a rented property from the landlord's perspective is to generate a satisfactory return that is reasonably proportionate to the risk of the investment. However, there are doubts as to whether small private landlords actually achieve this satisfactory return on average. The advice books on the topic of “getting rich with real estate”, which have been uncountable since the residential real estate euphoria began in Germany around 2013, do not change this assessment. What is particularly noticeable in how-to books and websites on the residential rental business is the complete absence of serious data on historical returns and risks. Many of these publications fall into the “investment pornography” category, such as “Richer than the Geissens: Become a real estate millionaire in five years with zero starting capital,” “The basics of real estate investing: Why real estate is so phenomenally lucrative” or “Become a real estate professional in 180 days.”
Such I-make-you-rich messages and books flood the investor market after a particular asset class has experienced a few years of above-average success in a row. At the beginning of the 90s it was tax-driven “builder models” in the new federal states, at the end of the 90s it was technology and internet stocks, from 2008 to 2012 it was gold and today it is (again) residential real estate. These get-rich-quick publications and the underlying investments are mainly consumed after most of the boom has already passed and entry takes place at a more expensive and therefore higher risk and lower return level. For late entrants, this risk materialized badly in the first three examples mentioned from the mid-90s (builder models), from the beginning of 2000 (technology stocks) and from the beginning of 2013 (gold).
Back to rented residential properties: When it comes to apartments and single-family homes, there is always a property that is actually unique and therefore outside the competition. However, the vast majority of properties compete against dozens, hundreds, sometimes thousands of other properties and are therefore traded in a highly competitive market. Economics students learn in their undergraduate studies: The price of a good in a functioning market tends towards the price of the cost leader, i.e. the cheapest price on the market. All more expensive providers have to follow the cheapest provider downwards in price, otherwise their goods will not be purchased or will not be purchased in full - this is no different in the housing market. The cost leader dictates the market price and in the rental housing market these are the commercial landlords - not the private ones. Why?
Quite simply, commercial landlords have enormous cost advantages due to the much larger volume of their property purchases and property management compared to small private landlords. [1] Therefore, they are the ones who tend to determine the market price (the rent level), which everyone has to orientate themselves towards. Since markets are constantly changing and cannot be influenced by any small market participant, private landlords can only keep up in this rabbit-hedgehog race if they are satisfied with a lower return compared to commercial landlords.
Large commercial landlords have considerable economic advantages over small landlords when it comes to all of the following influencing factors that affect the acquisition costs and ongoing costs of rental properties. Specifically, this concerns:
- Purchase price/construction price
- Brokerage fees
- maintenance
- Insurance
- Interest rate (in case of debt financing)
- Legal advice (if there are problems)
- Steer [2]
In the book “Buy or rent”, section “How useful are rental properties for private households” by Kommer, it is explained in detail why and to what extent these cost advantages exist for large landlords compared to small landlords. They are likely to average around 30% for both acquisition costs and current expenses. Even naive ideas about personal contributions, “managing yourself” and regularly overestimated tax advantages do not change this. (Tax advantages or disadvantages that are already known at a given point in time are already priced into a functioning market and no longer have a net return effect for investments after the introduction of the tax regulations compared to relevant investment alternatives.)
A trite-sounding but true business rule is: “There is profit in purchasing”. This applies even more to financial investments such as stocks, real estate and bonds than to consumer or industrial goods. Those who procure and operate significantly more expensively than their most cost-effective competitors will earn less or nothing at all. In the long term, this applies to the majority of private landlords. If so, one would assume that small landlords would largely disappear from the market over the years. But, as we saw at the beginning, this is neither the case in Germany nor in other countries. This phenomenon is probably also due to the fact that private landlords rarely have meaningful accounting for their rental business. Without such accounting, you will never know how poorly your equity actually returns in the long term. As a result, they stay in this business for decades, true to the motto: "The main thing is that the rent collected essentially covers the ongoing expenses and I don't have to add cash every year. The real thing anyway is the increase in value."
However, even if a private landlord realizes that the economic viability of his rental property and the equity risk taken do not correspond to his original or market-standard objectives, he will in many cases hold on to his property for decades because he lives from two hopes: Firstly, that he will be able to sell the property - from which he earns little or nothing "currently", measured in terms of the equity invested in it - at a profit "in the next few years" due to increases in value. Secondly, that the “tax advantage” will somehow, at some point, heal its balance of payments, which is in deficit in most years.
In this context, an argument for the credit-financed purchase of rental properties by private households, which has been propagated by the real estate and banking industry since Tobak, goes like this: "Take out a loan of X; your tenant will actually pay off your loan for you and in the end you will have a debt-free property that will also be worth more than it is today." It is difficult to formulate a simpler logic for purchasing real estate (Camanho/Fernandes 2018). There is almost nothing wrong with this dusty argument, because: (a) The equity contributed to the financing - i.e. usually 15% to 50% of the purchase price - is not “paid off” by the tenant from the outset because equity is not a loan. (b) If the investor had invested this equity in a diversified stock-bond portfolio for 25 to 30 years (the typical loan term in the small landlord business), he would have generated considerable income to offset the property that was ultimately paid off. (c) The landlord and borrower pays interest for 25 to 30 years, i.e. capital rent to the bank and maintenance costs to third parties (craftsmen, hardware stores). (d) When buying and selling the property, the investor must spend between 8% and 14% of the property's current value on transaction costs. By definition, all the expenses for interest, maintenance costs, insurance, property transfer tax, property tax and other transaction costs are not offset by any value-creating effect. Overall, over 25 to 30 years, these expenses can add up to a sum that is equal to or even far exceeds the original loan amount. It is then as if the loan has to be repaid twice. All in all, the argument about the loan that the tenant pays off for the owner is wishful thinking, which endless repetition doesn't make it more correct or realistic. Because this is the case, no one in the commercial real estate financing of large investors comes up with the idea of using this shaggy beard argument.
The fact that a property, especially a loan-financed one, is associated with considerable financial risk (e.g. construction completion risk, maintenance risk, rental loss risk, general market risk, cluster risk, litigation risk, political risk and illiquidity) is also often swept under the table. And in our blog post “The risk of investing in real estateThe fact that fluctuations in the value of equity in a property cannot be observed daily on the Internet, as is the case with securities, does not change the existence of these fluctuations in value.
What does science say about the return on rented properties? Similar to studies on the historical total returns on owner-occupied residential properties, serious academic calculations on historical returns on rental properties from small landlords are in short supply (for returns on owner-occupied properties, see our blog post “The return on investments in real estate”). One of the rare exceptions is a study by the DIW (German Institute for Economic Research) from 2014 (Bach et al. 2014). According to this study for the period from 2002 to 2012, private real estate landlords/investors achieved an average net return after taxes including inflation of 1.5% to 2.0% p.a. a. If you take the inflation rate in this period of 1.7% p.a. from this nominal return. a. This results in a real return of –0.2% to +0.3%. That could easily be exceeded with a portfolio of a global equity and a well-diversified bond ETF, with less risk and a lot less work.
Of course, average returns from the beginning of 2009 to today (the phase of the current real estate boom in German-speaking countries) were probably much higher. Anyone who believes that these ten fat years will continue into the future is falling for one of the oldest investment errors, the so-called recency bias. In this context, it is also often overlooked that the return on the world stock market over the same period was also extraordinarily high, namely 11.0% p.a. adjusted for inflation. a. (nominal 12.4% p.a.) over the ten years from 2009 to 2018 (MSCI World Standard in euros). Even compared to real estate, German government bonds (RexP), which are much lower risk, returned a decent real return of 1.8% p.a. in this decade. a. (nominal 3.1% p.a.).
The real estate industry itself publishes almost nothing about long-term historical returns from private landlords, even though it would be easy for them to do so. An exception to this conspicuous silence was a study in Great Britain that was published in 2014 by the consulting firm Wriglesworth on behalf of the real estate company Paragon on historical buy-to-let returns (rental property returns). The study covers the 18 years from 1996 to 2013 (Paragon/Wriglesworth 2014). Anyone looking for a creative example of how the real estate industry achieved historical returns on equity over an 18-year period of a spectacular 16.3% p.a. a. (real 13.4% p.a.) calculated after costs and taxes, you will find what you are looking for here. “Coincidentally” it was precisely in 1996 (the starting point of the study period) that the recovery of the British housing market began after a brutal crash from 1989 to 1995 (cumulative price collapse at the end of 1995 in real terms over 37%). It is important to remember that in hardly any other European real estate market is the availability of historical data as good as in Great Britain and the data there goes back much further than 1996. Anyone who specifically selects the lowest valuation point in a market in the previous 30 years for the beginning of an observation period will find fantastic returns in every asset class, regardless of whether they are tulip bulbs, real estate, stocks, emerging market bonds, gold or trouser buttons.
Apart from the statistically rather moderate long-term returns on rental properties from small landlords, compared to a simple internationally or globally diversified capital market investment, e.g. B. ETFs on a buy-and-hold basis, there are a number of other disadvantages and risks for small private landlords that are difficult or impossible to quantify. These include cluster risk (too high a proportion of assets in a single asset or asset class), a rather unreliable net cash flow [3] and the further above. Risk types (Sebastian et al. 2012).
Perhaps the recent political discussions about expropriation of rental properties, tightening of the rent cap, the first “rent cap law” (Berlin), high valuation levels in large cities and the fact that domestic rental properties are likely to be among the riskiest investments in the (however unlikely) event of a German national crisis or a chaotic collapse of the Eurozone will at some point lead to a more realistic perception of these types of risk.
Of course, these disadvantages and question marks do not count for all those landlords who view the real estate boom of the last ten years or so as normal rather than as a positive outlier, who believe that they can cherry-pick even in expensive and difficult market phases and that many hundreds of buying competitors would watch docilely, who assume that the current very low interest rates almost automatically compensate for the high purchase prices and other risks, that the reality dutifully reproduces the credit leverage effect in their Excel file that real estate generates “passive income”, i.e. income without work, stress and risk and that investments in “Tangible assets"are particularly stable in value. These landlords are simply unshakable real estate idealists, even if they silently complain about increasingly senseless government regulations and taxes, rude tenants, months-long gaps between two tenancies, incompetent craftsmen and "once again" a year of subsidies.
However, if you as a private household do not view a rental property as a hobby and passion, but rather purely rationally as an investment and pragmatic retirement provision, you will often come to the conclusion that a residential property is suitable as a home, but less often as an attractive investment or retirement provision property.
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Conclusion
Very little is known about the sustainable returns on equity of private small landlords. For fact-oriented investors, this is cause for skepticism and caution. For private households that can only rent out one to three properties, it is probably not worthwhile ex ante to purchase a residential property and act as a landlord. Private landlords have serious cost and tax disadvantages compared to commercial landlords, which make it difficult for them to achieve an acceptable return on the equity they invest. There are also a number of other, hardly quantifiable disadvantages that a rental property brings with it for a private landlord. Therefore, a normal household that already owns a home should not invest its additional assets in a second or third residential property in the same national jurisdiction for risk reasons.
Endnotes
[1] Commercial real estate investors not only have major cost advantages, but also skills advantages over small landlords. Since a competency advantage is more difficult to measure, we will not go into it further in this article. However, taking it into account would strengthen the argumentative line presented here.
[2] When it comes to ongoing taxation, commercial real estate investors generally have significant advantages over small rental companies (see Gerd Kommer, 2016, page 194 ff.). What is the tax situation with capital gains? Although natural persons who hold a rented property as private assets (unlike commercial landlords) do not pay tax on capital gains provided the property has been held for at least ten years, this advantage compared to commercial landlords is often overestimated. The latter can avoid the tax burden entirely through clever legal design or postpone it for a very long time and therefore effectively reduce it significantly. In addition, many large real estate landlords hold the properties for decades or virtually forever, so that they do not incur any taxes on increases in value for decades.
[3] This can e.g. B. This can become a serious problem for pensioner households that rely on the regular flow of money from a single rental property.
literature
Askola, Jussi (2019): “Rentals Vs. REITs: The Detailed Study Of Pros And Cons For The Average Investor”; (May 4, 2019) Internet reference: https://seekingalpha.com/article/4258212-rentals-vs-reits-detailed-study-pros-cons-average-investor
Bach, Stefan; Popien, Philip; Thiemann, Andreas (2014): “Returns on real estate investments by private investors”; Wertgrund study by DIW Berlin; Research project commissioned by Wertgrund Immobilien AG; Berlin, September 2, 2014
Camanho, Nelson/Fernandes, Daniel (2018): “The Mortgage Illusion”; Internet reference: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=1856325
Kommer, Gerd (2016): "Buy or rent? How to make the right decision for yourself", Campus Verlag, 244 pages
Kommer, Gerd (2017): “Real estate financing for owner-occupiers: save money and avoid mistakes when buying your own four walls”; Campus Publishing; 292 pages
Kommer, Gerd/Schweizer, Jonas (2018): “Better understanding the risk of direct investments in real estate”; blog post; August 2018; https://www.gerd-kommer-invest.de/das-risk-von-direktinvestments-in-immobilien-besser-verstanden/
Kommer, Gerd/Schweizer, Jonas (2018): “Better understanding the returns from direct investments in residential real estate”; blog post; October 2018; https://www.gerd-kommer-invest.de/die-vergleich-von-direktinvestments-in-wohnimmobilien-besser-verstanden/
Kommer, Gerd/Weis, Alexander (2019): “The concept of “real assets”: facts and fantasies”; April 2019; https://www.gerd-kommer-invest.de/konzept-der-sachwertanlage/
Paragon/Wriglesworth (without author) (2014): “Buy-to-let comes of age”. A comparative analysis of returns for a buy-to-let and other major asset classes” (source no longer available)
Sebastian, Steffen/Steininger, Bertram/Wagner-Hauber, Melanie (2012): “Advantages and disadvantages of direct and indirect real estate investments”; IRE|BS International Real Estate Business School at the University of Regensburg; In: Contributions to the real estate industry; Issue 2; 01/23/2012