jankythoughts2

Foreword

I’ve received, over time, numerous requests from various people inquiring about real estate syndication. Here is a quick summary of the space, and the things I look out for when evaluating a new deal.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Real Estate Syndication

As way of a quick introduction, real estate syndication is a fancy way of saying a “real estate fund”, or, in some cases, “real estate private equity fund”. The former (real estate fund) is more general, and encompasses various real estate strategies (explained below), while “real estate private equity fund” refers specifically to funds which buy properties, improve them somehow, and then sell them again — Similar to how generic private equity funds buy companies, improve their operations, and then sell the companies again either on the private or public markets.

Terminologies

Before we dive in, here are some common terms which will come up over and over again in this space.

Sponsor, General Partner, GP	The people who found the deal and are marketing it are generally called the sponsor. The people who actually run the day to day operations as well as make major decisions on behalf of all the other investors are called the general partner (or GP for short). In general, the sponsor will usually be the GP, so the terms are used interchangeably in most cases.
Broker	The people/entity which is purely marketing the deal on behalf of the sponsor. The broker typically takes a cut of the profits, either in the form of a front load (a fee up front as a percentage of committed dollars they bring in) and/or an equity stake (usually a percentage of the profits). While brokers are common for really large deals (hundreds of millions to billions of dollars), they are uncommon for smaller deals (under $100m). Personally, if a smaller deal has a broker (or worse, many brokers), I would consider it a sign that the sponsor is new to the game and simply doesn’t have a large enough rolodex of investors to call upon. Some common brokers are FundRise, CrowdStreet, YieldStreet, etc.
Investor, limited partner, LP	The people who actually put money into the deal. While the GP earns their profits from sweat labor, the LP earns their profits from equity labor, i.e. actual return on actual cash put into the deal. In particular, the LP is also limited in that they have no say in the day to day running of the deal. This is important! A key determination of who has limited liability (and thus can walk away from a failed deal by “only” losing their investment) vs who has unlimited liability (and thus may be personally liable for any losses/debts) is who is responsible for making decisions and who actually made decisions. Before you take part in any deal, make sure that you are joining as an LP, unless you are comfortable making decisions for the deal, and taking responsibilities for the consequences of your decisions.
Capitalization rate, cap rate	The capitalization rate of the deal. At the start of the deal, this is obviously estimated, but when a deal exits (sells of its assets), the “exit cap rate” is also of interest and is typically actual (instead of estimated). Cap rate is simply the “net operating income” divided by the value of the asset. In a hand-wavy sort of way, you can think of it as the inverse of the P/E ratio that is so common for stocks.
Internal rate of return, IRR	The imputed return of the deal (either estimated or actual, depending on context) over a period of time, annualized to one year. The IRR is more complicated than simply the return of the deal divided by the amount invested — the timing of the return of capital and profits is important! A deal that takes in $100, and then immediately returns $100 the next day, while also returning another $100 over the next year, is a much better deal than one that takes in $100 and returns $200 at the end of the next year. Both deals return $200 over a one year period, but the former returns your capital almost immediately, letting you put that capital to further use. Think of it this way — assuming you can and do put all cash thrown off by the deal back into the deal and compounding at the same rate, then 2 deals with the same IRR and same period of compounding will return exactly the same amount of money at the end of both deals.
Levered returns, levered IRR	Almost all real estate funds use leverage, because without leverage (and the associated risks!), most real estate deals simply do not make sense — you can get much better returns with much lower risks by just investing in the stock markets passively. Levered returns or levered IRR is simply the actual (or estimated, depending on context) return or IRR after including the multiplicative effects of leverage and taking out the costs of leverage (i.e. interest fees).
Gross return, gross IRR, fund level return, fund level IRR	“Gross” basically just means “fund level” in this context, which means whatever number listed, is for the fund before the GP takes their cut, but after all other applicable fees, such as property management, expenses reimbursements, legal fees, etc. While these numbers are interesting, the more important numbers are the “net” ones. Always be sure to ask the GP for the net numbers, and if you have both net and gross numbers, then you can get a sense of how much the GP is getting paid.
Net return, net IRR, investor level return, LP level return, investor level IRR, LP level IRR	“Net” basically just means “LP level” in this context, so the number listed is the actual (or estimated, depending on the context) return that you, as the LP, will get. These are the numbers you want to use when comparing two otherwise equal deals.

Strategies

There are 4 main strategies for real estate funds:

Development	This is where the fund takes in capital to build a new property. There are two exits: a) The property is sold to buy/hold investors. b) The property is converted into a buy/hold investment for long term holding. In some cases, a fund may even opt for both — the property is sold to an affiliated buy/hold fund, and existing investors can opt to collect cash of the proceeds, or to roll over their investment into the new buy/hold fund. If too many investors opt to collect cash, then investors rolling over may be given the opportunity of putting in more cash, or the GP may find new investors or even put in their own money to make up the shortfall. In general, development funds are the most risky, as a lot of things can go wrong during construction, and delays, additional costs, etc. are common. Also, during the period of construction, there is no cash flow — the property is not in a rentable state! As a result, a successful development deal tends to have the highest returns.
BRRR(R)R – Buy, Rehab, Rent, (Refinance), Repeat	This is a strategy popularized by some influencers, such as the founder of BiggerPockets.com. The basic idea is to a) Buy a piece of property that is somehow mismanaged, either because management has let it fall into disrepair, the property isn’t positioning it properly for the local market, etc., b) Rehab the property by fixing the issues identified, either by fixing whatever’s broken, or renovating the property to position it as more upscale, etc., c) Rent out the property with the fixes in place for higher than what it was previously rented for, d) (Optionally) Refinance the property at the new, higher, valuation to take cash out of the deal, e) Repeat the entire process. Generally speaking, if the goal is to sell off the property to recapture capital invested, then the refinance step may be skipped and instead the property is sold off. This is the “real estate private equity” strategy. If the goal is to keep the property as a long term profit generating asset, then refinancing may be a good way to get some (or in some cases all) of the invested capital back so that it can be put to use in a new deal. In general, this strategy is less risky than development, but more risky than buy/hold. As a result, it tends to have returns in between the other 2 strategies.
Buy/hold	This is the simplest strategy where the deal is to simply buy some property at some perceived fair price, and the GP is in charge of handling the day to day operations of the property, while returning a portion of the rental income to LPs as dividends. In general, this strategy is the least risky of the 3, but as a result, also has the lowest returns.
Opportunistic	This is a catch all phrase for “everything else”. In these types of funds, the sponsor has a lot more leeway to do whatever they deem is appropriate, which can be good (if the sponsor is good) or bad (if the sponsor is not). Be sure to read the incorporation documents to know exactly what the sponsor is allowed or not allowed to do, and make sure you are comfortable with everything listed before you sign your name!

Evaluating a deal

When I evaluate a deal, I look at 2 main things:

• The sponsor
• The deal itself

Sponsor

In the case of the sponsor, the things I look out for are:

Is the sponsor trustworthy?

Anyone can put up a website and ask for money. Anyone can claim 10, 20, 30% IRR.

Doesn’t mean they mean it or that they can do it.

There are lots of unscrupulous sponsors who put up misleading and/or outright faked information to get investors, and I’m not particularly interested in investing with them.

Does the sponsor have the experience to bring the deal full cycle?

Even if the sponsor is acting in good faith, they may simply be too inexperienced to handle the deal and the stresses involved. If everything goes well, this may not matter, but if something breaks, I’d like to know that the sponsor has seen similar situations before, and/or at least have a vague idea how to handle the setback, instead of just throwing their hands up in the air and possibly sobbing in the corner.

Evaluating the sponsor

One of the best ways to evaluate if the sponsor meets both criteria, is to see what their track record is — if they have been running the company behind the fund for at least 8-10 years (roughly the time it takes to bring a fund full cycle, or at least 4-5 individual deals), and they’ve done so without changing their name (personal and company), then that’s a good sign that:

• They have been successful enough that they aren’t sleeping on the streets.
• They have built up enough of a reputation/goodwill that they are unlikely to throw it all away just to scam lil’ ol’ me.
• They have been doing this for a while, so they are at least somewhat experienced and are not flying in the dark.

Now, this isn’t a hard and fast rule — some sponsors worked for other funds, and are just starting out on their own.  If they were reasonably successful before, and they are just starting out because of ambitions (as opposed to, say, embezzling from the prior fund), then that’s a good sign too — while the fund itself doesn’t carry much reputation/goodwill, the sponsor themselves might.

I’m also not entirely opposed to working with new teams, as long as they show they know what they are doing — I’ll have to talk to them more.  But the point is that new teams tend to make mistakes, and I’m not particularly inclined to foot their tuition bill.

The absolute worst case is the “serial founder”, who creates new companies (not deals) every 5-6 years, and completely leaving out mentions of their prior endeavors.  This suggests that their prior attempts were less than stellar, and I’m not a fan of the deception, even if by omission.

There are other ways for sponsors to prove their mettle, such as being able to conduct a Q&A with ease and confidence, having a large social media presence for a long time (reputational risk if they mess up, also, if they did mess up, someone would have probably pointed it out, so you should look for those bad reviews), etc.

Another thing about sponsors — it’s usually about the team.  The more things that the sponsor does inhouse, the more likely they have control over their own destinies (and thus your investment).

If a sponsor is just a broker (i.e.: they seek investors, put the money in the fund, take a cut, then give the rest to another sponsor to do the actual deal), then understand that you are paying fees twice.  Once to the broker, and another time to the actual sponsor doing the work, whom you may never meet — because if you’ve met them, you may get the crazy idea that maybe, just maybe, you should cut out the middleman and make more for yourself.

Now, there are benefits to this arrangement — if you are deploying huge sums of money (say O($10m+)), then maybe it’s too much work to find all the deals yourself, and a broker is useful.  But if not…

BTW, and I may be wrong on this, but I believe that all such brokers need to be licensed (For example, https://dos.ny.gov/real-estate-broker for single deals. For funds, see SEC/FINRA rules).  If someone is clearly brokering a deal, and does not clearly list their licenses, then you should worry.

Deal

As for the fund, usually just understanding what the fund is doing will give you a good idea of what to expect. As discussed above there are generally a few types of funds:

• Buy/hold, sometimes called core/core+
• Buy and flip, sometimes called value add, or BRRR(R)R
• Build new, sometimes called development
• Whatever crazy scheme the sponsor can dream of, sometimes called opportunistic

Note: All numbers below are approximate for the period just before Covid19. For the 2 years after Covid19, real estate generally returned significantly higher numbers (a few multiples of the below in some cases) due to all the upheaval as people moved around. We’ll have to wait and see what post-Covid19 brings…

Now, if a fund is a buy/hold, then you’d expect levered net IRR to be in the 6-10% range, with cash flow generally steady from day 1.

For a buy/flip, you should generally see net IRR in the 12-15% range, though I’ve seen as high as 20-25% when the fund gets lucky. Cash flow in the first year is probably close to 0.  Cash flow in the 2nd year may be half of preferred (~4%), and then 8% in 3rd year, before 8-12% in the next 2-3 years.

Development funds can see net levered IRR be as high as 15-20%. Cash flow in the first 2-3 years will be 0.  No renter’s gonna pay you rent for an apartment that does not exist yet. So, if you come across a development fund, that promises 6% cash flow starting from the first year, you’ve gotta ask yourself this:

Where the hell are they getting the money in the first 1-3 years, while the property is being built, to pay me?

And the answer is, probably, they just took in more money than they really need, and are paying you with your own money. Which generally means:

• It’s a marketing gimmick.
• Actual net IRR is likely to suffer, since this additional money is non-productive, and just a paperwork transfer.

Location, location, location

Finally, for a deal to make sense, the strategy must fit the location.

• It doesn’t make sense to build class A+ buildings in a depressed neighborhood with median income in the $30k’s.
• It doesn’t make sense to do heavy renovations on a fund with many single family homes.
• It doesn’t make sense to build large apartment complexes in a city with heavy net outflow of households.
• It doesn’t make sense to value add a property that just recently underwent renovations.
• Etc.

Also, note that there are some states which are just extremely hostile for real estate investments, and a fund that tries too hard to make it work there, probably can make substantially more returns by just focusing their attention elsewhere. These states tend to have laws which make it hard to turn a profit on an investment, by severely restricting the landlord’s abilities to manage their property the way they see fit. For a discussion on this, see Affordable Housing.

Foreword

For most people, retirement/financial planning (1) is often thought of as simply how you deal with excess money (disposable income) after paying for living expenses, taxes, etc.

In my opinion, that is a very limited and limiting way of thinking about some of the most consequential decisions you would have to make in your lifetime.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Human net worth

As I’ve discussed in “Net Worth“, net worth and cash flow are related topics, and in general, outside of less common cases like illiquid non-cash flowing assets, they can be thought of as the same thing.

Now, if you subscribe to that view, then it may seem odd that when people talk about net worth, they very rarely talk about their incomes from their jobs. In a hand-wavy, abstract sense, you can think of your knowledge, health and age as assets, and your knowledge + health + age enable you to generate cash flow via using your labor to create value for others, i.e. performing a job and getting paid for it.

So, in that sense, your knowledge + health + age should have some implied “worth”. In a more crude sense, you can imagine (a) someone who’s 26, but terminally ill and bed-bound, (b) someone who’s 80 but healthy for their age and (c) someone who’s 26 and healthy for their age. Clearly, in most cases, (c) will be able to generate much more income from their labor than (a) or (b).

Now, and again, being crude, if we were to put a number on it, how much would we value our knowledge + health + age?

Job incomes tend to be fairly stable and dependable in the short/medium terms(2), but health and age deteriorates with time, while knowledge improves with time, though deteriorate beyond some point due to old age. Unlike most financial assets like bonds, stocks, etc., the value of knowledge + health + age is extremely hard to compute, as there are other factors that muck things up — e.g. you may be a natural genius in the medical field, but were never afforded the chance to attend medical school and thus your genius is entirely trapped as “potential”.

Without going too much into theoretical modeling, I’m just going to use something simple — take your expected retirement age, subtract your current age. This is your number of working years left. Multiple that number by your current pretax salary, and we’ll call it your “human net worth”. This simplistic model assumes your salary increases at the rate of inflation, and doesn’t change other than that. It also assumes that the rate of discount is just the rate of inflation, so we can use current nominal values in place of imputed future discounted values. Feel free to nerd out and use more complex models.

If you’ve done the exercise above, you’ll quickly notice that your “human net worth” is probably pretty significant. If you are below the age of 35, I’m guessing your “human net worth” is probably quite a bit higher than your “financial net worth” (3).

Think like a business person

The one thing that most successful business people know, is how to maximize the value of their assets by focusing on what’s important. For example, it simply doesn’t make sense spending a lot of time trying to save a few thousand dollars by being draconian on office supplies if you are a multi-billion (or even trillion!) dollar software company. The same amount of effort, if directed towards more productive endeavors like improving employee productivity, would yield far greater results.

In a similar vein, if you are a software engineer with a portfolio of, say, $300k, and an annual salary of $184k, it simply doesn’t make sense spending a lot of time trying to optimize your portfolio. Even if you manage to outperform the market by 10% (assuming market returns is 10%, this would be a 20% return) (4), you will only make about $30k more. If you spend your effort concentrating on your career, getting promoted just once can easily yield more than double the benefits:

Clearly, the exact numbers depend a lot on your personal situation, but the point is that in many cases, especially for those who are below the age of ~40, where you simply haven’t had enough time to accumulate a significant portfolio, your best financial/retirement planning move is very likely to just be throw your money into something simple to manage and not too risky, and then concentrate your efforts on developing your career.

Always do the math

Many people dive headlong into finance and investing, others take up side hustles, thinking that they can supplement their main sources of incomes. In many cases, they completely ignore the one thing that is most likely to benefit their financial situations the most profoundly — simply doing better at their day job (and getting recognized for it via higher commissions or promotions), or finding another line of work with more advancement opportunities.

Before diving headlong into any new endeavor, it probably makes sense to just spend a week or two figuring out if the effort is even worth it, or if you could get more out of your efforts if you just redirect your focus elsewhere.

Personal experience

Some random notes based on personal experience and talking to people:

• Many people think real estate investments are passive (6). They are not.
  • If you are owning the property outright, then you have to deal with managing the property (or paying someone to manage it, and then managing the property manager). If you only have 1 or 2 properties, this is probably not a big deal, but does take quite a bit of time. If you have more than 5 or 6 properties, this easily becomes a full time job.
  • If you are investing via a fund or syndication, then you’ll have to spend a lot of time sourcing deals and vetting sponsors, reading their periodic reports to make sure everything is on track and deciding how to deploy your future dollars. In some ways, this is very similar to the pros/cons of investing in stocks.
  • In both cases, you’ll have to understand the economics/finance of real estate investing, and how macroeconomics affect it and thus you. Keeping up with these generally involve a lot of reading, attending conferences/webinars/seminars, etc., which again take up a lot of time.
• Many people think trading stocks can be passive — once you’ve figured out a winning strategy, just make a bot and watch the money roll in. It doesn’t work this way.
  • As someone who has written and ran multiple trading bots before for personal trading, and who has worked in a quant hedge fund, I can assure you that it is not so simple.
  • All strategies eventually lose their edge. It may be 1 week after you find the strategy, or it may be 1 year. But it eventually happens. And the tricky part is trying to figure out if your current losses are due to a change in the regime (i.e. your strategy losing its edge) or just an expected drawdown. Deciding wrongly will be punishingly expensive.
  • The trading space is unbelievably crowded. Outside of large funds, millions of personal traders trade either as a full time job or with bots. Thus, you’ll need to be nimble, and be able to change and adapt depending on financial/economic forces, so that you can stay one step ahead of the competition.
  • Again, all the above means that a long term successful trading operation is almost always a full time job.
• If you are a software engineer (7), then unless you have $10m+ in your portfolio, your best path to financial security is almost definitely to improve yourself so that you can perform your day job better, and get to your “terminal level” (8) as quickly as possible. As shown by surveyed salaries of Facebook software engineers (5), each promotion comes with a pretty hefty and permanent (9) salary increase, each of which would easily equal a double digits return on most common portfolio sizes for people of those income levels.
  • Of course, if you are personally interested in finance, and are doing it as a hobby, then by all means go ahead. All work and no play makes Jordan a dull kid. But be sure to understand the limitations of this, and do not fool yourself into thinking it is something beyond what it really is.

Footnotes

1. Many people treat retirement planning and financial planning as different things. They aren’t really — it’s probably more accurate to think of retirement planning as a facet of financial planning, the goal of which is to, naturally, retire by some age.
2. This isn’t true for everyone, but generally true for most people under most economic circumstances.
3. “Financial net worth” is a made up term, here meaning the traditional “net worth” definition — the net value of your assets.
4. It’s pretty damn hard to consistently beat the market by 10%. Many hedge funds get paid millions/billions of dollars just to beat the market by 2-3% every now and then.
5. I am not endorsing the numbers on levels.fyi for Facebook. I do not know if these numbers are accurate at all, though I assume they are close enough to be a reasonable comparison in this case.
6. Here, “real estate investments” mean private real estate investments, not buying publicly traded REITs, etc. Buying publicly traded REITs have all the usual pros and cons of trading stocks, which are touched on later.
7. I’m specifically calling out software engineers here, because I am one, and understand the economics here better. Other professionals may have similar dynamics, I simply do not know.
8. Due to luck, experience, knowledge, life commitments and other factors, most people have a “terminal level” beyond which they find it hard to impossible to get promoted beyond. At Facebook/Google/Uber and most tech companies with a similar level structure, this is generally around levels 5 – 7.
9. OK, fine, it’s technically not permanent. But it’s pretty rare (outside of sign on bonuses and dramatic market events) to see annual total compensation drop at one of the big tech companies.

Foreword

Housing is a touchy subject. On the one hand, nobody likes to hear about homeless children, or elderly retirees forced out of their homes. On the other hand, nobody seems particularly obliged to go out of their way to help those in need obtain and retain housing. So what then?

For full disclosure, I have a fairly large portfolio of real estate investments, of which a majority are residential. Obviously, I am not an impartial observer. At the same time, having been both a tenant and an (indirect) landlord for multiple years and in many different locales, while also keeping constant tabs on the managers who oversee my investments, I feel I can provide a perspective that is often lacking in the media.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Costs of building a home

According to RocketMortgage, the average cost to build a home is about $282,299 in 2022. Granted that a portion of those homes are larger, luxury homes, so the actual cost of building a “starter home” for someone of more modest means is probably lower. On the same article, the average cost to build a 1 bedroom is about $80,000 on the low end — much better!

But let’s dig a little more — according to BusinessInsider, the median American family has a net worth of around $121,700. Suddenly, that $80,000 looks a lot tighter. Also, recall that the $80,000 figure is at the low end of the scale — in most parts of the country, it may not even be a feasible number. At the same time, the $80,000 cost doesn’t even include the cost of the land which, depending on location and size, can easily cost $100,000 or more.

Next, building a home takes time, from a few months to a year or more, depending on the location and scope of the project. During this time, the new owners will need a place to live, likely rented which means monthly rent payments.

Finally, home insurers and mortgage lenders typically do not service new builds. A new build is much more risky for the insurer, as there is active work being done and thus more chances for accidents. At the same time, if the borrower defaults on their mortgage, the lender has no real collateral (i.e. the house) to foreclose on to recoup their money. As a result, both insurance premiums and mortgage rates for a new build tend to be much, much higher than for a regular home.

Why is building so expensive?

A large part of the reason why building new housing is so expensive is because of existing rules and laws. Modern day housing units must fulfil a myriad of rules and laws built over decades of experience. Unfortunately, these necessarily add to the costs of building.

For example, in practically everywhere in the USA, all homes must have proper heating and cooling depending on the local climate, bedrooms must have an exterior wall and have exterior facing windows for safety reasons, wall paint must be lead free for health reasons, bathrooms must have proper plumbing, etc.

For the most part, I personally believe these to be sensible and reasonable — no one should be poisoned by lead paint just because of their financial situation.

Separately, the craftspeople who build our homes deserve to be compensated fairly — theirs is a job involving manual labor and, often, very real risks to their bodies and health. They should also be protected by adequate insurance policies so that them and their families are taken care of if the worst were to happen.

Finally, to ensure that all the proper building rules were adhered to, and that nobody made a mistake that might lead to potential disaster, most counties in the USA have enforced inspections by local engineers and experts, to ensure that buildings are “up to code”. While overall a good thing, these inspections do add to the overhead both in terms of costs (inspections typically are not free) and time (and they take a while to schedule, while any issues found need to be remedied).

And remember, we’ve just discussed the cost of building the home. Maintaining a home incurs another set of expenses such as property taxes, utility bills, etc.

Grim reality

When you put together all the requirements a modern home needs, and the costs of building that home, you arrive at a very grim conclusion — for a very large portion of the country, buying a home is simply an expense they cannot afford.

Renting

Given that so many people cannot afford to buy a home, yet still require a roof over their heads, it’s no wonder that many people choose the next option, which is to rent a home from a landlord.

Unfortunately, the facts that renters tend to be less affluent, housing costs are high, and investors (landlords) need to make profits result in some very contentious relationships. In particular, landlords tend to be portrayed in the media as unscrupulous capitalists, out to suck up every last cent from their hapless tenants.

While clearly not every landlord is a saint, it seems unduly combative to assume every landlord is the devil. While there are certain valid criticisms, there’s also a lot of just simple misunderstandings and well poisoning.

Houses are for living, not for investing

On the surface, this seems like a valid complaint, but is it really?

For better or for worse, in the USA, the government has decided that it is incapable of providing housing for the people. As such, this critical role has been outsourced to the private sector, with incentives such as tax advantages for real estate investments, etc. to encourage development.

The private sector, being capitalistic in nature, is incentivized by profits — private individuals and entities simply do not, in general, offer up their resources for free.

Given that the country has a general lack of housing, in order to correct that imbalance, housing prices need to rise, essentially increasing profit margins and incentivizing investment, so that enough housing will be built for everyone who needs it.

Until the government’s stance on the matter is changed (see below), the only real way to ensure enough housing units being built annually to accommodate new household formation is, unfortunately, higher home prices.

Investors push up the price of homes, forcing others to rent

There is some truth to this — real estate investors are driven by the profit motive, and as long as the numbers work, they will willingly bid up the price of homes, sometimes beyond the means of Regular Joe’s.

But that’s just one side of the equation. The investors clearly needed to buy the homes from someone else (in order to push up the prices) — someone who benefitted from the increase in home prices. Someone who, too, maybe a Regular Joe. What then? Are real estate investors now Santa Clauses handing out bags of money?

The fact is that this is a more nuanced issue — investors benefit existing homeowners, while hurting new ones. In more concrete terms, baby boomers and Gen X’ers tend to benefit from real estate investors, while millennials and Gen Z’ers tend to suffer.

Whether this is desirable, then, likely depends a lot on whether you already own your home.

Landlords raising rent is predatory

Tenants tend to complain that landlords seem to raise rents every year, and at rates that tenants generally feel are unfair. So let’s break it down.

As we’ve discussed before, housing is expensive, and maintaining them is also expensive. At the same time, landlords (investors) are capitalists and out to make a profit. Which means that whatever costs the landlord bear, must eventually be passed on to the renter, along with a markup for profits.

Yes, that means renters tend to pay more in rent than the landlord pays in costs. And as we’ve discussed earlier in order for the supply of housing to meet the demands of new households, this must necessarily remain true.

Given that the landlord’s costs increase every year due to inflation, so too must the rent. At the same time, in order to stimulate more housing to be built, areas with a severe lack of housing must necessarily see rents rise faster than inflation — the temporary supernormal profits incentivizes new housing to be built, which then will increase competition amongst landlords, which in turn reduce future rents.

But if renters are paying for the cost of the homes to begin with, what are landlords for? As it turns out, a lot.

Recall that renters tend to be less affluent. As a result, they tend to have trouble getting the necessary financing for building or buying homes. Landlords step in here, as an intermediary between the banks and the renters — the landlord puts up their reputation and assets as collateral to the bank to obtain the financing needed, and they then charge the renter for the “lease” of their balance sheet.

If you’ve worked in finance, you’ll know that while financing rates for the first ~75% of a project is relatively cheap, rates jump dramatically as the loan to value increases — the lender naturally assumes more risk as the equity cushion is reduced.

Similarly, the cost of borrowing 100% of the cost of a home needs to be much higher than borrowing 80% of the cost of the same home — the higher rates compensate for the higher risk assumed by the lender + landlord.

Secondly, landlords tend to manage more than 1 home. This often translates into savings in terms of maintenance costs via economies of scale — it is fairly common for landlords to build relationships with local craftspeople in a win-win relationship — the landlord provides the craftsperson a steady stream of jobs and income, while the craftsperson gives the landlord a discount for their services. This discount can then be passed on to the tenant.

Next, the landlord, by virtue of having to deal with constant maintenance issues across their tenants, will naturally build up a rolodex of known and trustworthy craftspeople, saving the tenant time and potential costs of engaging a less skilled or even outright fraudulent contractor.

Finally, the landlord also provides a service — essentially a 24 hours contact for maintenance issues, as well as aggregation of various expenses into a single, tidy monthly rent payment.

Solutions

Personally, I believe strongly that everyone benefits if everyone has proper housing — homelessness tends to bring with it many social problems.

However, and I say this as a beneficiary of the current system (being a real estate investor), the private sector is simply not equipped nor incentivized to achieve that goal. The most profits can be extracted when relative demand is high, since as supply increases marginal profits fall. So given a free market, supply will likely never ever rise enough for everyone to be suitably accommodated.

Given that the benefits of 100% housing is a benefit shared by all, basic economics then suggest that affordable housing, as opposed to luxury housing for those more affluent, should really be provided or subsidized by the government in some way. Forcing the private sector to subsidize housing for the less affluent such as the use of rent control, rent stabilization or other coercive means will just lead to less investment and thus even worse problems in the future.

Section 8 housing

As a start, section 8 housing, I feel, is a pretty good program. Its main issues are 2 fold. First of all, the program is severely underfunded, and really needs to be a much bigger priority of the government’s budget, so that everyone those in need can reliably qualify and get the assistance they need.

Secondly, the stigma associated with it must be eliminated. That can likely be achieved with a bigger budget, so that more graduated assistance can be provided to more people — those who are living in poverty may get, say, 99% of their rents covered, while those much above the poverty line but are still struggling can get, say, 10% of their rents covered.

With an expanded program aimed at everyone from those in dire need up to those in, say, the lower 85 percentile in terms of income, the program can conceivably be seen as just as social benefit, and not “aid for the poor”, and hopefully that will remove the stigma, allowing more people to benefit.

Along with the above, enforcement of the rules to prevent abuse should also be strengthened. Those receiving aid should be required to show actual need, while landlords should be on the hook for providing quality housing at a reasonable price, and not just taking advantage of desperate people who don’t have much of a choice.

Government built housing

Section 8 housing works by engaging with the private sector via subsidies. It is, however, not the only way, and to be honest, the fact that the private sector is involved necessarily means that the overall costs are higher to account for private profits.

As an alternative to section 8 housing, the government can also opt to just do-it-itself so as to save on costs. As we know from examples around the world, large scale public housing programs can work, though like section 8 housing, it needs to be properly funded and managed, while also at a scale large enough to overcome the stigma of receiving government aid.

Not that long ago, the US government used to build and sell subsidized housing to those in need. Technically, remnants of this program and its offshoots still exist around the country, though the scale is at a level that’s much too small to really address actual needs. A dramatic expansion of that program, with adequate funding, proper oversight and management may revitalize the program enough to help address the housing issues faced by those most financially vulnerable.

Altruism?

Ultimately, I think it is important to acknowledge a few basic facts:

• A lot of people, with their own means, simply cannot afford to own a home. Some may not even be able to afford to rent.
• Homelessness is a social problem which affects everyone, even those who are not homeless. As such, everyone benefits if homelessness is reduced or eliminated.
• To a lesser extent, giving everyone a stake in society, via home ownership, has benefits too. People who feel that they have a stake tend to behave better, leading to less social issues.
• To bootstrap these programs will likely involve large public programs and associated large public spending. Yes, that means those who are financially better off necessarily must take on some temporary discomfort. But if we can get it right, the future benefits should outweigh the current costs.