Return On Equity – On Becoming a Rentier

Recently I took the time to read Thomas Piketty’s Capital in the Twenty-First Century cover to cover.1  One of the key concepts that it covers is the historical rising and falling of the “rentier” – namely a person who derives some or all of their income from rents on property that they own.  This topic is closely related to what would in modern economic parlance be referred to as “return on equity” (ROE) – in other words, the net income divided by the net investment (which can also be characterized as “assets minus liabilities”.)

One of Piketty’s theses is that ROE must “mean-revert.”  In less obscure terms, he suggests that there is some overall rate of return which is sustainable, and if the rate is higher than this or lower than this, it will eventually have to come back to this average rate.  High rates of return are only possible when there are significant structural changes to society (think “industrial revolution”) where those who start out with great resources will be the greatest beneficiaries, and will do much better than this sustainable rate.  In contrast, when the rates are too high, revolutions occur and those with the most to lose are, in fact, the ones who lose the most, while those with the least to lose are the beneficiaries.  Between these extremes, there is some stable mid-point which doesn’t greatly enrich the few or impoverish the many, and this is where society will eventually return.

Which is all really a long way of introducing the topic of whether building this house is a good idea, in both financial and ethical terms.  Let’s consider some of the relevant factors.

Income: I expect to be able to rent for something around $1300/month.  Single-room rentals near the two colleges are typically going for a lot more than $650, but they have convenience on their side; furnished two-bedroom homes can rent for as much as $1800/mo, but I’m not planning on offering this furnished.  On the other hand, the green features might command a premium with the right renters.  I could also consider trade-offs like charging a higher rent but throwing in utilities (on the assumption that utility bills will be very low) or offering some minimal furnishings (Craiglist, anyone?) but this seemed like a good starting point.

Expenses: I will minimally need to pay the current monthly maintenance fees (about $125) and property taxes (about $225).  Because the house is only legally a 2-bedroom home with a small footprint, the taxes should be considerably lower than for some of the other homes in this community.  There will be added maintenance expenses over time, but hopefully nothing major for the first few years, so I’ll allocate $50/mo for that, plus another $50/mo for homeowners insurance.

Assets: Assuming I’m on budget(ish), the home including the land and various extras such as solar panels, batteries, and water storage/treatment may cost $140k.

Liabilities: I intend to build this home with funds that I otherwise would have invested in more traditional retirement assets.  In other words, my intention is to pay cash and not take out a mortgage or construction loan to build it.  Thus,  no significant liabilities.  Ironically, the way ROE is calculated, this is considered to be to my disadvantage… but I’m much happier (and run a lot lower risks) living a debt free life.

Thus, estimated ROE is ($1300-$450)x12/($140000-$0) = 7.2% per annum.

Now, where else am I likely to find 7.2% ROE?  Mostly in things that are fairly high risk – corporate junk bonds, sovereign debt of nations in dubious straits, or real estate investment trusts.  One difference here, of course, is that I’m looking at something where I own the capital itself.  If I decide there’s another, better option, I could certainly consider selling the house instead of renting it, and get back my principal – with the possibility of additional appreciation on principal as well.  But the reality is that over my main portfolio of investments (mostly in retirement accounts), I’m only earning about 2.75% right now, because of a lot of relatively conservative and principled investments.  (Funds like LOWC, a low-carbon ETF, or ORG, an organics ETF do not return a high dividend; I do own a few stocks like PEGI, a renewable energy company, which has a >6% yield, but these are high risk and not something I want to invest $140k in.)

This was the argument I made to my financial advisor regarding the investment, and she pretty much concurred that it was a sound way to diversify.  Plus, if the economy falls apart and I lose my job or my retirement investments, the hope is that at least I’ll still have a valuable asset that I could either get income from or sell.

But is it ethical to be a rentier?  Well, I’m not really sure how to evaluate that.  I do know that the Ithaca area seems to have a continual shortage of housing, which I’ll be helping in my small way.  Furthermore, at least a few of the landlords have been reported in the news as rather unscrupulous – apartments with no heat in the winter and such things – and I certainly intend to do better by my renters than that!  What I hope to offer is something that is fair value for the area we live in, with a number of amenities that show people how to live a good life with a smaller ecological footprint.  And while I expect to make money doing this, I will certainly have put a lot of labor into making it happen.  I feel okay about this, and hopefully you, my dear reader, will not rise up in revolt against me for owning a rental property!

  1. Okay, I’ll admit I only skimmed the endnotes.  What happened to footnotes, people?  If the notes are on the same page, I’ll pretty much always read them.  If I have to keep two bookmarks just to find the corresponding endnote… less so.

Foundational Beliefs

As I so often seem to do, I’m leading off with a pun.  I want to write about the principles that are guiding the Little Rental House project, and the principles that I’m hoping to apply in writing about it.  At the same time, I’m in the process of getting quotations for the foundation, so I intend to update you on that as well.

Principles

Transparency

My wife Raederle has observed that as we have become more open about sexuality, money has remained one of our greatest taboos.  In writing about this house construction project, I’d like to work on breaking down that barrier and start talking about some of the relevant financial issues, including:

To this end, I intend to post my a priori budget, along with an explanation of what it is based on, so that we can look at a before-and-after comparison and talk about where the estimates were out of line, and why.

I will also be posting about the economics of rental homes and how this is part of a transitional strategy toward retirement.

Passive-Level Energy Use

The community that I live in refers to itself as an “eco-village,” and accordingly all of the homes here have been built to extremely high standards in terms of both lifetime energy efficiency and the use of local materials and non-toxic materials to the greatest extent practical.

I want to go a step beyond this and build a house that as closely approaches a passive level of energy use as possible – a “passive house“.  This means among other things that sufficient heat is captured and retained from normal daily activities (body heat, plus cooking, electronics, etc.) that active heating is never required, even during the coldest part of the year.  I will talk in detail about the choices that support this and why I think it matters.

Grid Flexibility

Related to, but separate from the passive house considerations is the idea of a house that can operate flexibly either on or off the grid.  Every existing home in our community has at least some “grid” requirement, either in the form of electric (grid-tied solar) or natural gas, or both.  Furthermore, the existing homes all rely on a community water supply that comes from a local aquifer before treatment.

With this house, I will be building in grid flexibility.  Essentially all day-to-day activities will be possible using only the solar panels provided on the house.  While some activities (such as drawing a 50 gallon bath of pure hot water) may be limited when off grid, in most cases normal practical activities (such as a 10 minute shower) will be possible.  I’ll talk about what activities are supported and curtailed, and how the passive house choices play into this.

Progress

This week, I’m scheduled to have the surveyors out.  Although they charge quite a bit to “mobilize” (mainly for travelling here and getting all their equipment set up, I think), I’m coordinating this effort with several other interested parties so that we can get more measurements (a total of about 20 survey stakes) for an estimated $850.  This doesn’t actually have a line item, so I have to decide whether to count it as “site prep” or just take it out of the contingency budget.  It seems logical that putting the stakes in at the corners of the site and the house is a form of site prep, so we’ll go with that.

Separately, I’ve received price quotes on excavation and foundation.  The first excavation quote came in at $21,000 which puts it 162% over budget!  Part of this is the lack of a budget for utilities (my fault) but they attributed part of it to a junior employee making the estimate and not recognizing potential places to economize (such as, putting both water lines and basement drains into a shared trench).  I’m working with them to get a more definitive estimate, but I’m also looking to get a second quote – if I want to keep things on budget, I need to not just go with the first price I get, even if the contractor in question has been very affordable in the past.

My first foundation quote was based on the use of insulated concrete forms (ICFs).  However, as I was considering things, I realized that given that the basement is going to be purely mechanicals, there isn’t any good reason to insulate it.  So I also requested a quote based on formed and poured walls – slightly thicker (8″) walls to compensate for the lack of other structural elements.  (It turns out this saves money in another area, because the ICFs are required by code to be covered with a fire-resistant surface – drywall – even though it’s not living space.)  The quotes broke out the slab from the footers and walls, so the total is $14,200 for footers+ICFs or $10,300 for footers+formed and poured walls, another $3,000 for the slab, and then on the order of $700 for waterproofing.  Add in another $1,000 if a pump truck is needed for any of the three operations.  (I should be able to avoid this by making sure that a regular truck can back directly up to the site.)

I am strongly leaning toward the formed and poured solution for pure cost reasons; this would give a total of about $14,000 which is still 35% over my budget.  Part of this can be explained by the addition of a “bump out” to install basement stairs.  Although I could use pre-fabricated concrete stairs (quoted at $1,800 delivered and installed) I could not use the prefab solution and still have the stairs be the width I wanted (48″, to handle large water storage tanks) or come out the distance that I need (72″) to keep the house within the appropriate envelope of the lot.  So some of that cost overage is compensated by the fact that I’ll be putting in wooden stairs instead.  (None of the comparable designs I used for budgeting had exterior basement-access stairs, so this was an oversight.)