Rental Housing Types: Risk vs Reward

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For some reason the other day I started thinking about the risks and rewards of different types of purpose-built rental housing. Risk is a complex thing and varies from project to project and developer to developer, but, at least from a high-level perspective, it’s probably best defined as absorption risk (how fast will available rentals be leased?) and to a lesser extent price acceptance risk (how willing are prospective renters to accept asking rents?). Reward is less complex and is focused mainly on rents; at a basic level, it could be defined simply by using gross rents, net rents (net of expenses), or rents per square foot.

The chart below is my first try at comparing relative risks and rewards for the most common types of purpose-built rental housing.

Rentals with low risk and low reward are affordable housing and family-sized units. Risks are low for both of these types of rentals because the demand for low-priced rentals and units capable of housing a family with a bunch of children always outstrip supply. Rewards are low because asking rents are low in affordable housing, while in family-sized units large square footages mean that even higher priced 3 bed and 4 bed units earn a low rent-per-square-foot ratio. Older low-quality rentals (C and D grade) are low reward because they can’t command high rents because of their low quality, but on the other hand their risk is low because many renters can’t afford higher priced rentals and have few other options. Operating costs tend to be high in old buildings, further suppressing rewards.

Rentals with low risk and high reward are rental housing types which (a) can ask higher rents and (b) are in high demand. Demand is high thanks to high quality (there are limited amounts of old high-quality rentals and new or recently constructed rentals) and because for some of these housing types there exists ongoing, annually replenished demand (seniors and students). High demand enables high asking rents. Low risk and high reward is obviously the ideal combination.

Rentals with high risk and low reward are furnished rentals. Furnished rentals often achieve high rents but are usually short-term stays or have shorter leases with a greater chance of sitting vacant between tenants (or visitors). This means less predictable revenues, more frequent turnover, and more property management.

Rentals with high risk and high reward are micro rentals, student rentals in small markets, and oversized new and recently constructed rentals. Micro rentals, thanks to their small sizes (usually around 250 to 350 square feet), can often achieve a high rent-per-square-foot (high reward), but because of their small size they aren’t practical or appealing for most renters (high risk)—rentals targeting niche renters are always riskier than rentals targeting ‘mass’ renters. New and recently constructed rentals with large square footages often command extremely high rents (high reward), especially in central Toronto where detached houses are in short supply, but the pool of renters who can afford extremely high rents is shallow (high risk).

Hopefully this first attempt to summarize risks and rewards for different types of purpose-built rental housing is helpful to readers. I think some sort of scatter chart might work better at visualizing the risk/reward relationship but that will require coming up with ratings or a ranking system. I’ll give it further thought and if I can make it make sense I’ll tackle it in a future post.