By Lucas Szwarcberg
Even though as many as 8% of taxpayers report rental income, the reasons for which individuals invest directly in this sector rather than exclusively holding diversified stock portfolios remain largely unexplored. My thesis investigates the hypothesis that households invest in individual rental properties because they can take out a mortgage to finance a large fraction of the property’s value, without being subject to margin calls as they would if they borrowed from a margin account to buy stocks.
I develop a theoretical model of households’ portfolio allocation between stocks, cash, and rental properties over their earning years, incorporating labor income uncertainty and allowing for both mortgage and stock-margin leverage. Calibrating the model using historical parameters and solving it numerically, I demonstrate that mortgage-funded rental-property investment is particularly appealing for young investors, as their future labor income justifies greater risk-taking.
The model results also show that initial wealth has a non-monotonic effect on the amount of rental housing purchased, because rental-property ownership is most attractive at medium values of wealth, which are high enough to afford the smallest possible property without taking on too much risk and low enough that future income makes leverage highly desirable. In addition, I analyze how the results change depending on parameters such as the rental yield of the property, the riskiness of labor income, and the correlations between assets and income.
My paper describes several implications for my findings. First, this leverage motive for buying individual rental properties may help explain why the majority of rental housing is supplied by households rather than professionally run businesses, even though the latter can achieve greater diversification and economies of scale. Second, there may be an asset-market distortion from the fact that it is usually only possible to take out mortgages (i.e., loans not subject to margin calls) to buy rental properties and not stock indices, thus leading some investors to prefer rental properties even if their pre-leverage returns are comparable to those of stocks. Third, while the use of stock-margin leverage to take on more risk than with regular stock investment has been recommended for young investors by books such as Lifecycle Investing, a greater number of investors may already be employing a similar leveraging strategy through rental-property investment. Fourth, my model shows that higher-income households can purchase rental properties earlier on average and thereby achieve higher risk-adjusted returns, which aligns with an empirical literature showing that the rich earn higher returns on their investments. My findings thus also contribute to the literature on wealth inequality.
In summary, by describing a leverage motive for households’ rental-property investment, my paper uncovers a theoretical justification for the role of rental-property investment in personal finances.