Author Topic: seeking RE advice; considering never selling a property again  (Read 7416 times)

sol

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seeking RE advice; considering never selling a property again
« on: September 05, 2013, 10:57:44 PM »
My family will be moving in the next year or two.  We're considering whether to sell our current house or rent it out.  Ultimately, this is a decision about whether our capital tied up in the house is better left where it is or withdrawn and invested elsewhere.

It would make a terrible rental property.  I expect it would rent for $150 less than our monthly payment, and then any maintenance or vacancy costs would just make it worse.

But selling seems like an even worse idea.  We have about 50k in equity on an expected sale value of 280k, due to bad timing during the collapse.  Subtracting off 3% RE agent fee and 1.78% RE excise tax eats like 13k of our 50k in equity, leaving us with 37k in pocket.

Option 1: cash out our 37k and invest it in a whole market index fund.  Assuming 5% ROI after taxes, it's pretty easy to predict the future value of that 37k: about 60k in 10 years or 100k in 20 years.

Option 2: rent the place out at an initial monthly loss.  Assuming an additional 12% of the monthly rent lost to maintenance costs, we still slightly break even due to the principal contributions the renter would be paying.  I'm assuming $50/yr increase in rent (and associated increase in maintenance costs), 2.5%/year price appreciation (the historic RE average, about at inflation), rising equity contributions from advancing the amortization schedule, and depreciating the structure value over 27.5 years at our marginal tax rate.  Adding it all up, the total value of our current equity is over 150k in 10 years and over 400k in 20 years, about half of which is appreciation on the property.

This analysis seems to strongly favor keeping the house as a rental, even though it's a really terrible rental right now.  The numbers get even more ridiculous after the mortgage is paid off.  My market investments would have to return something like 13% every year for 20 years (after taxes!) to be as good as this really crappy rental property.

Am I doing this wrong?  It's late and I might be confused, but this is making me feel like selling a house is NEVER a good idea if you're interested in building long term wealth.

arebelspy

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Re: seeking RE advice; considering never selling a property again
« Reply #1 on: September 05, 2013, 11:13:53 PM »
You are vastly underestimating expenses.

It looks to me like you've calculated taxes, insurance, and 12% (where'd you come up with that?) for maintenance.

How about vacancy? Property management (even if you do it as a side gig, you should subtract that from the earnings, as it's return on labor, not return on investment)?  Turnover costs?  Legal costs (evictions, mostly)?  Long term capital repairs?  Utilities (for the one month or whatever while vacant, it does add up)?  Marketing/Leasing Costs? 

What are your actual numbers (expected rent, P&I payment, taxes, insurance)?

Here's the other thing if you like the idea of a rental: sell and put that 37k as a down payment on a rental that actually is cash flow positive.  Now run the numbers on THAT investment versus keeping this rental.  There's your comparison.

I'm betting you're realizing either:
1) You're missing something, or
2) You should only be buying rental properties, cause apparently even cash flow negative ones are a much better return, and holy cow, what about cash flow positive ones?
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sol

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Re: seeking RE advice; considering never selling a property again
« Reply #2 on: September 05, 2013, 11:51:24 PM »
You are vastly underestimating expenses.

I was hoping someone could point out where I'm underestimating expenses.

Quote
It looks to me like you've calculated taxes, insurance, and 12% (where'd you come up with that?) for maintenance. 

How about vacancy? Property management

12% of rent came from some rental property website as an average cost of owning a rental property, for management and repairs and vacancies and such.  We also have another rental property that is costing us significantly less than that, more like 3%.

My spreadsheet is easy to adjust if you have alternative suggestions for me.

I hadn't accounted for eviction costs either.  Is there a general rule for figuring total costs of a rental, either as a percent of the rent or a percent of the purchase price?

Quote
What are your actual numbers (expected rent, P&I payment, taxes, insurance)?

Expected rent 1550/mo.  Total payment 1712/mo, of which 378 is taxes and insurance.  The rest is currently 400 principal and 930 interest, but those will change in the future, which I have accounted for.

Quote
Here's the other thing if you like the idea of a rental: sell and put that 37k as a down payment on a rental that actually is cash flow positive.  Now run the numbers on THAT investment versus keeping this rental.  There's your comparison.

I don't like the idea of a rental.  I dislike the idea of a rental less than I dislike paying 13k in up front transaction costs to sell the place. 

I'm well aware that returns would be better on a fourplex in town, but I have no desire seek out and manage such properties.  Dealing with high turnover on low-rent units isn't my idea of fun.  This is a family home in a nice neighborhood, and I expect it would be less stressful to manage than a fourplex.

Running the numbers just made me realize that over long enough time horizons, being cashflow negative vs positive almost doesn't matter.  Eventually it will be paid off and will spout free dollars, plus it confers tax benefits while appreciating in value.  That's hard to beat with stock market returns.
« Last Edit: September 05, 2013, 11:55:29 PM by sol »

arebelspy

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Re: seeking RE advice; considering never selling a property again
« Reply #3 on: September 06, 2013, 12:20:14 AM »
Is there a general rule for figuring total costs of a rental, either as a percent of the rent or a percent of the purchase price?

The general rule of thumb is 50% of gross rent to expenses.  Several studies have shown that over an extended period of time, approximately 50% of gross rents will go to expenses.  This is mostly done with multifamily, since SFR data is hard to come by, but since multifamily actually has several advantages in terms of expenses (in house management, discount due to scale, only one roof, etc.), it's not unreasonable to think SFR would be similar.

One might be able to get that down to 40% over the shorter term on a newer SFR (heck, some years I have under 20% expenses on an individual property, just taxes and insurance and property management fee paid to myself, no maintenance or vacancy - but wait for the times when the A/C goes out), so one can run numbers on their own property, but 50% is the rule of thumb.

Running the numbers just made me realize that over long enough time horizons, being cashflow negative vs positive almost doesn't matter.

I donno about that.

If you use the standard metric of 1% of property purchase price in gross monthly rent, and the 50% rule above (and assume no debt service), your annual cash flow will be 6% of the fair market value, whereas the appreciation will be 2.5-3% (both rising with inflation).

I'll definitely take 10% cash on cash returns, and ignore the principal paydown and appreciation as future safety nets, rather than taking 0% return (or negative) in the short term after the principal paydown and hoping for appreciation.
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arebelspy

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Re: seeking RE advice; considering never selling a property again
« Reply #4 on: September 06, 2013, 12:23:03 AM »
12% of rent came from some rental property website as an average cost of owning a rental property, for management and repairs and vacancies and such.  We also have another rental property that is costing us significantly less than that, more like 3%.

3%??  I'm assuming that's not counting insurance*, taxes*, and management.

It also though seems to assume no maintenance, that's only 11 days of vacancy, with 0 turnover costs.

I think you may be miscalculating something.

*Insurance and taxes should be separated from the debt service, P&I, as they are an expense unrelated to it, even if your bank ties them together to protect their loan.
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englyn

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Re: seeking RE advice; considering never selling a property again
« Reply #5 on: September 06, 2013, 01:34:22 AM »
I'm not sure about using 5% after taxes for shares, but then my tax system may be different. You don't pay taxes on shares until you sell them, here, by which point many people will be on a lower marginal tax rate.
Don't forget selling costs (agent, excise, any other taxes) of the house after the 10 or 20 year period.
Consider also the illiquidity of the house - you can't sell 4% of it to support a year's expenses, so odds are you will have to sell it sometime.
Your income in a year of selling the whole house may affect the tax rate you pay that year too.

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Re: seeking RE advice; considering never selling a property again
« Reply #6 on: September 06, 2013, 05:40:21 AM »
If you sold this property, I do not see how you would end up with $37k.  Unless you think you can sell this yourself and only pay the buyer's agent 3 percent, you have underestimated the commission.  In a full service transaction here in California, I would expect to see commission of 6 percent,. unless you negotiate a discount.  Does your state assess an excise tax on real estate transactions?  Here, we have a transfer tax assessed at the County level that is much less than that.  Also, you have not included closing costs.  The custom here is the seller pays the buyer's title insurance plus half of the escrow fees.  Overall, I would expect to pay between 9 and 10 percent of the sales price to sell this property, or between $25,000 and $28,000.  That means you will end up with $22-$25,000 from this sale.  And that's if you get a cash or conventional offer.  If your buyer pool is FHA/VA buyers, you can expect to pay some of the buyer's closing costs as well.

As someone that has owned lots of rental properties over a long period of time, I agree with Arebelspy on the 40 to 50 percent expense rule.  That includes capital improvements averaged out over time.  New houses will have lower expenses over the first 10 years or so.  You might get away with 30 percent, including vacancy and collection loss and property management over that period.  However, even in an area with low property taxes like Arizona, once you start in on the cycle of roofs, HVAC units, water heaters, etc., the operating expenses go way up.  As I understand your climate, roofs and siding are replaced more frequently than in a drier, warmer climate.

Using the $1,550 rent and the very conservative 40 percent in vacancy and operating expense, the first year net income would on average be $11,160.  If you owned the $280,000 house free and clear, your return would be 4 percent if your expenses were as predicted.  Add the inflation rate and you are looking at an overall return of 6.5 to 7 percent, based on this first year cash flow.  Leverage the property with low cost money, and the yield on paper would increase.  However, the risk increases as well.  You might have to come out of pocket to pay some or all of the mortgage if you have a particularly bad year.

One of the reasons house prices on the West Coast are so high is the high percentage of Asian investors in our markets.  A lot of these folks think about real estate investments in terms of multiple generations.  Their philosophy is to buy today, pay off the property, and never sell.  The children and grandchildren will benefit from the income from the paid off investment.  If you take that approach, you should look at the long term optimization of the financial structure.  Could you refinance today as an owner-occupant and improve your leverage? 

Personally, I'm not interested in buying and managing properties at that rate of return when I can dump money into equities and do as well or better.  That's why I use the 1 percent rule when I buy.  In your shoes, I would not get caught up in the sunk costs dilemma for this house.  Yes, you are going to have selling expenses.  Yes, you are going to get very little out of this property and it's painful.  Look past that and make the decision that maximizes your long term financial success.  Maybe if the house is newer and your leverage benefits you, it would make sense to hold the property for a few years, until the value goes up and/or the expenses get out of hand.  Maybe you can make the numbers work.  If not, sell and move on.



ioseftavi

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Re: seeking RE advice; considering never selling a property again
« Reply #7 on: September 06, 2013, 07:03:22 AM »
Seems to me like you're being unrealistically optimistic with regards to your potential rental property.  As others have pointed out, many of the numbers you've submitted are on the "favorable" side of common ranges, and you haven't included some key costs like vacancy, turnover, long-term capital improvements, etc.

I would also mention that it sounds like you're being unduly pessimistic on your potential long-term after-tax returns from stocks.  Assuming you use index funds and you aren't selling everything Dec 31st only to rebuy the index on Jan 1st...your tax drag should not be bringing your long-term returns down to 5%.  5.5% or 6.0% is probably a more realistic number, especially if you can adjust your asset allocation so that most of your taxable bonds are in tax-deferred accounts. 

Through this combination of over-estimating your real estate returns and under-estimating your long-term portfolio returns, you're probably making the gap between your two options look much closer than it is.  I suspect if you make the tweaks that I and others have suggested, you're probably going to find that the rental house isn't worth hanging on to.

Based on what you're saying, I'd suggest selling the place.  If the numbers don't work well with reasonable assumptions, then you can come to the conclusion that the property isn't worth owning.  Turning down the opportunity to own a sub-par investment doesn't make you a bad investor because you can't "make it work".  It makes you a better one because you can go take your capital somewhere else where you can realize better returns.  Keep those 'green employees' working as best you know how.  It's never fun to sell underperforming investments, but it's certainly necessary if you want to keep your money working for you.
« Last Edit: September 06, 2013, 07:17:02 AM by ioseftavi »

totoro

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Re: seeking RE advice; considering never selling a property again
« Reply #8 on: September 06, 2013, 08:05:52 AM »
Sol - I do see your point, I really do. I own and rent out a number of properties in high cost areas.  My bottom line is that the properties must be cash flow positive with a 10 year mortgage.  I know that eventually the principal pay down will provide a good lump sum but I don't count it and won't until I sell.  Appreciation does not travel in a straight line and holding to time the market has worked for many if they stay in for the longer term. That said, the other posters have loads of experience in the us market and some good advice. I personally plan to hold my properties and sell only one when market conditions merit it. I do all the mAnaging myself though and don't mind it and am a lawyer so can handle disputes and evictions (done one - cost $65). I don't account for my time and  I will post more on costs later.

arebelspy

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Re: seeking RE advice; considering never selling a property again
« Reply #9 on: September 06, 2013, 08:20:59 AM »
My bottom line is that the properties must be cash flow positive with a 10 year mortgage.

That's an interesting metric.  I'm going to have to dig more into the numbers on that (what it translates to in terms of the other rules of thumb, gross rents versus purchase price, cap rate, cash on cash return at various interest rates, etc.)

Another popular rule I've seen used is that the property must always be able to pay for itself using the 50% rule for expenses and assuming 100% financing (not that you'll necessarily leverage 100%, but it should be able to support itself, your down payment shouldn't be forcing the cash flow).
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DoubleDown

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Re: seeking RE advice; considering never selling a property again
« Reply #10 on: September 06, 2013, 09:05:24 AM »
I'll buck the trend maybe a LITTLE, while giving all the weaselly caveats that I mostly agree with all of the above. I think there could be a case to be made that if Sol is willing to bet on future appreciation in his neighborhood outpacing all the expected costs, then it could make sense to hold and rent for a while - say, 1-3 years, keeping an eye on how the housing market is going along the way. This is trying to time the market, I fully acknowledge that. But it's usually easier to do this in your own neighborhood than trying to time the stock market, which is completely impossible (at least for us regular, mortal folks if not everyone).

If Sol thinks his neighborhood is up and coming based on everything he knows about it, and sees a bright future for at least the next couple of years, then just the leverage he has in the house could make it much more profitable to hold it and sell later than, say, putting the little equity he is left with and investing it in stocks or another much less expensive, but positive cash flow, rental.

I've been in a similar situation several times in the past. For example, marrying and combining two households with each person having their own home previously, neither of which was suitable for the combined, bigger family. Both our individual houses made terrible investment properties: one was  seriously cash flow negative, one barely breaks even on PITI alone.

We kept both because our area has a very strong (and expensive) real estate market -- lots of jobs, excellent schools, blah blah. I expect appreciation here to outpace any losses we take in the short run, we get all the significant tax breaks writing off the expenses and losses, and so on. Since the houses are so expensive and pretty fairly leveraged, even tiny percentage gains in the market translates to large $$$ that dwarf the carrying costs along the way. We just sold one of them last month, and it was definitely the right call vs. selling it earlier, even though it lost money each month. The other one will also definitely be the right call, Lord willing, barring some unexpected giant downturn in the next year.

It's a gamble, but not an outrageous one IMO if you know your local market and have a reasonable expectation of healthy growth in your area.

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tl;dr -- Do the math on keeping the house with expected appreciation in 1-3 years, and realistic expenses as described above. Then determine if the expected gains outpace what you could get selling now and investing the net equity elsewhere.

totoro

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Re: seeking RE advice; considering never selling a property again
« Reply #11 on: September 06, 2013, 09:33:41 AM »
I'll buck the trend maybe a LITTLE, while giving all the weaselly caveats that I mostly agree with all of the above. I think there could be a case to be made that if Sol is willing to bet on future appreciation in his neighborhood outpacing all the expected costs, then it could make sense to hold and rent for a while - say, 1-3 years, keeping an eye on how the housing market is going along the way. This is trying to time the market, I fully acknowledge that. But it's usually easier to do this in your own neighborhood than trying to time the stock market, which is completely impossible (at least for us regular, mortal folks if not everyone).

If Sol thinks his neighborhood is up and coming based on everything he knows about it, and sees a bright future for at least the next couple of years, then just the leverage he has in the house could make it much more profitable to hold it and sell later than, say, putting the little equity he is left with and investing it in stocks or another much less expensive, but positive cash flow, rental.

I've been in a similar situation several times in the past. For example, marrying and combining two households with each person having their own home previously, neither of which was suitable for the combined, bigger family. Both our individual houses made terrible investment properties: one was  seriously cash flow negative, one barely breaks even on PITI alone.

We kept both because our area has a very strong (and expensive) real estate market -- lots of jobs, excellent schools, blah blah. I expect appreciation here to outpace any losses we take in the short run, we get all the significant tax breaks writing off the expenses and losses, and so on. Since the houses are so expensive and pretty fairly leveraged, even tiny percentage gains in the market translates to large $$$ that dwarf the carrying costs along the way. We just sold one of them last month, and it was definitely the right call vs. selling it earlier, even though it lost money each month. The other one will also definitely be the right call, Lord willing, barring some unexpected giant downturn in the next year.

It's a gamble, but not an outrageous one IMO if you know your local market and have a reasonable expectation of healthy growth in your area.

----------------------------------------

tl;dr -- Do the math on keeping the house with expected appreciation in 1-3 years, and realistic expenses as described above. Then determine if the expected gains outpace what you could get selling now and investing the net equity elsewhere.
I'll buck the trend maybe a LITTLE, while giving all the weaselly caveats that I mostly agree with all of the above. I think there could be a case to be made that if Sol is willing to bet on future appreciation in his neighborhood outpacing all the expected costs, then it could make sense to hold and rent for a while - say, 1-3 years, keeping an eye on how the housing market is going along the way. This is trying to time the market, I fully acknowledge that. But it's usually easier to do this in your own neighborhood than trying to time the stock market, which is completely impossible (at least for us regular, mortal folks if not everyone).

If Sol thinks his neighborhood is up and coming based on everything he knows about it, and sees a bright future for at least the next couple of years, then just the leverage he has in the house could make it much more profitable to hold it and sell later than, say, putting the little equity he is left with and investing it in stocks or another much less expensive, but positive cash flow, rental.

I've been in a similar situation several times in the past. For example, marrying and combining two households with each person having their own home previously, neither of which was suitable for the combined, bigger family. Both our individual houses made terrible investment properties: one was  seriously cash flow negative, one barely breaks even on PITI alone.

We kept both because our area has a very strong (and expensive) real estate market -- lots of jobs, excellent schools, blah blah. I expect appreciation here to outpace any losses we take in the short run, we get all the significant tax breaks writing off the expenses and losses, and so on. Since the houses are so expensive and pretty fairly leveraged, even tiny percentage gains in the market translates to large $$$ that dwarf the carrying costs along the way. We just sold one of them last month, and it was definitely the right call vs. selling it earlier, even though it lost money each month. The other one will also definitely be the right call, Lord willing, barring some unexpected giant downturn in the next year.

It's a gamble, but not an outrageous one IMO if you know your local market and have a reasonable expectation of healthy growth in your area.

----------------------------------------

tl;dr -- Do the math on keeping the house with expected appreciation in 1-3 years, and realistic expenses as described above. Then determine if the expected gains outpace what you could get selling now and investing the net equity elsewhere.

Completely agree. This has worked for me as we'll. The issue is risk and ability to continue to hold through high interest rates/vacancies. 

Also the 50 percent rule makes no sense to me given the wildly varying costs of real estate and rental rates.  My duplex grosses 36 000 per year. There is no way expenses will approach 50 percent. This same duplex would gross 12 000 in another market. How can expenses vary by 12 000 per year for the same asset in the same condition? They can't and don't. 

Also, I buy used appliances and Manage myself - I can control costs. I have found good inexpensive handymen. I don't have the same ability to increase returns on stocks using my own efforts.  I don't account for my time as some will insist I must because I view it As a privilege and opportunity to be a le to do this.

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Re: seeking RE advice; considering never selling a property again
« Reply #12 on: September 06, 2013, 01:34:08 PM »
Running the numbers just made me realize that over long enough time horizons, being cashflow negative vs positive almost doesn't matter.  Eventually it will be paid off and will spout free dollars, plus it confers tax benefits while appreciating in value.  That's hard to beat with stock market returns.
Heh-- so the more you spend and the more you lose, the bigger your gains?  Yeah, maybe that's a stock-market analogy. 

And speaking of "long enough time horizons", that would also explain why the most popular landlord exit strategy is "probate".  Talk about "just one more year" syndrome.

Perhaps your realization could also mean that your running numbers are not realistic.  And considering how you feel about the whole project, maybe you'd be wise to have a realtor market the property and get the first set of tenants in there.  It's one more expense, but you'd rather pay up front for a realtor (or property manager) to do it in one month than to try to DIY for six months.

It might be interesting to take your posts to another forum like Early-Retirement.org or BiggerPockets to see if you get the same feedback you're getting here.
« Last Edit: September 06, 2013, 01:35:51 PM by Nords »

sol

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Re: seeking RE advice; considering never selling a property again
« Reply #13 on: September 06, 2013, 06:35:42 PM »
The general rule of thumb is 50% of gross rent to expenses.

I can see that, iff you're counting your taxes and insurance and "paying" yourself to manage the property a few hours per month as expenses.  We're paying 378 in taxes and insurance and I was figuring another $200/mo in costs associated with upkeep, that's already 37% of monthly rent lost to expenses.  Throw in a month of vacancy every year or two, and I can see maybe hitting 50%

How do you decide how much to pay yourself to manage the property?  Are you actually taking a salary as your own property manager, and thus paying income tax on it, or is this just another accounting trick to pad the costs?

As totoro pointed out, the costs of managing a well kept single family home in a nice neighborhood are probably a lower percentage of rent than the costs of managing a shitty duplex.  Repairs don't cost much more, but rent is much higher, so the percent cost drops. 

If you sold this property, I do not see how you would end up with $37k.  Unless you think you can sell this yourself and only pay the buyer's agent 3 percent, you have underestimated the commission.

If you're right and I pay even more in transaction costs, this pushes the calculus much more strongly towards retaining the property as a rental. 
If I can only clear 25k in pocketable equity, it's hard to envision a scenario in which renting it out doesn't provide better value.  I get an immediate 100% ROI by leaving it in the house.

Quote
you are looking at an overall return of 6.5 to 7 percent, based on this first year cash flow.  Leverage the property with low cost money, and the yield on paper would increase.  However, the risk increases as well.  You might have to come out of pocket to pay some or all of the mortgage if you have a particularly bad year.

Right, except I don't own the house outright.  It's mortgaged to provide significant leverage.  We have more than enough income to carry the cost of another house indefinitely with no renter, so I'm not worried about having to pay out of pocket for a month or three.

Quote
you are going to get very little out of this property and it's painful.  Look past that and make the decision that maximizes your long term financial success.

The longer I look into this, the more I lean towards renting.  50k in equity in a house worth 280k would return 14% ROI due to a 2.5% annual price appreciation all alone, not counting principal contributions by a renter or the tax deduction for depreciating the structure.  I've already taken the equity hit, the neighborhood is only going up from here.

Seems to me like you're being unrealistically optimistic with regards to your potential rental property.

By contrast, I feel like some people here are being unrealistically pessimistic about rental property.  How can you call house price appreciation a negligible safety net?  How can you ignore the tax benefits of the rental in your financial calculations?  Why would you only look at first year immediate cash flow and not rising rents, or advancing amortization schedules?

I get that being so conservative only improves your margins.  And I get that highlighting the difficulties diminishes the pools of competing property owners. 

I have no illusions that this is a great rental property.  I know I could do better if I got serious about becoming a real estate investor.  But I think that my extractable 25k wouldn't do as well in the market as my leveraged 50k in the house would do while almost breaking even on cashflow while providing a tax shelter while appreciating in value while someone else pays off the mortgage.

Despite all the dire warnings here, I'm leaning toward renting.  It's already technically net worth positive on a per month basis when counting equity, and it will be cashflow positive in a few years.  The amount of cashflow I'd lose between now and then is smaller than the up front transaction costs of selling, and is dwarfed by the expected asset appreciation over the same period.

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Re: seeking RE advice; considering never selling a property again
« Reply #14 on: September 06, 2013, 07:00:44 PM »
What's the financing structure on this property?  Can it be refinanced on more favorable terms?  Where is it located - what's the historic appreciation?  Is it a standard family-oriented tract home or an unusual floor plan that appeals to a limited market? 

I understand what you are saying, but without more information, I can't tell you exactly what I would do in your shoes.

sol

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Re: seeking RE advice; considering never selling a property again
« Reply #15 on: September 06, 2013, 07:29:55 PM »
What's the financing structure on this property?  Can it be refinanced on more favorable terms?  Where is it located - what's the historic appreciation?  Is it a standard family-oriented tract home or an unusual floor plan that appeals to a limited market? 

The house has a 30 year mortgage financed at 4.875% with 230k left.  I think it has 24 years left, because I have paid more than the minimums when I had spare cash laying about.

I could refinance but it but the really killer rates are gone.  Had I done it six months ago when I first looked into it, I could have scored some serious savings.  Doing it now probably isn't worth the loan costs.

The house has appreciated at an average of 2.2% per year over the past decade, but that includes some crazy fluctuations in value of almost 50% up and down.  Zillow is predicting 7% appreciation over the next year.  My model assumes 2.5% appreciation every year going forward.

If zillow is right and the house goes up 7.2%, the equity increase would just about cover my whole carrying costs for the year.  It could sit empty all year and I'd about break even.

It's a 3br/2ba family home with a modern floorplan in a nice neighborhood within walking distance to downtown.  I'm pretty confident we could get 280k for it pretty quick, given how fast comparable homes are selling in this neighborhood.  Three houses on my block have sold this summer.

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Re: seeking RE advice; considering never selling a property again
« Reply #16 on: September 06, 2013, 07:48:12 PM »
How do you decide how much to pay yourself to manage the property?  Are you actually taking a salary as your own property manager, and thus paying income tax on it, or is this just another accounting trick to pad the costs?

Standard property management fees are 8-10% of the gross rents.  I don't take a salary, but when I run the numbers to find out my ROI I always take this out.  I shouldn't be working for free, and even if I am, that shouldn't up my ROI by counting that labor as part of the return on my money.

And, if and when I turn it over to property management so I can travel overseas for extended lengths of time, the property better be able to carry that cost.

As totoro pointed out, the costs of managing a well kept single family home in a nice neighborhood are probably a lower percentage of rent than the costs of managing a shitty duplex.  Repairs don't cost much more, but rent is much higher, so the percent cost drops. 

Sure, so you might be able to beat the 50% rule for awhile, like we said.  Managers generally take a flat percentage, even if your property takes less of their time.  Definitely a reason to self-manage as a side gig while you're so inclined.

If you're right and I pay even more in transaction costs, this pushes the calculus much more strongly towards retaining the property as a rental. 
If I can only clear 25k in pocketable equity, it's hard to envision a scenario in which renting it out doesn't provide better value.  I get an immediate 100% ROI by leaving it in the house.

I generally estimate about 8% selling costs, though they can be as high as 10, depending on circumstances.

The last sentence is ridiculous to say, if I'm understanding it correctly.  You'll pay the costs at some point.  That's like saying "if I sell these stocks, I pay 15% capital gains.. so by not selling I have an immediate 15% ROI!"  But again, maybe I'm misinterpreting that.

We have more than enough income to carry the cost of another house indefinitely with no renter, so I'm not worried about having to pay out of pocket for a month or three...

That's certainly good (otherwise this conversation would be a nonstarter), but how long will paying out of pocket slow your path to FIRE?  And how much more of a stache will you need to support an alligator if you ER?

The longer I look into this, the more I lean towards renting.  50k in equity in a house worth 280k would return 14% ROI due to a 2.5% annual price appreciation all alone, not counting principal contributions by a renter or the tax deduction for depreciating the structure.  I've already taken the equity hit, the neighborhood is only going up from here.

Keep in mind the equity is what you'd have from cashing out, not the fair market value minus mortgage.  Further, I still feel that you're comparing the wrong thing.  If you are considering a rental, what type of property could you get that

What if you could get a 280k property that appreciated like yours, but was cash flow positive by several hundred per month (after the 50% rule and paying the mortgage)?  If you're considering keeping it as a rental versus selling it, and you decide that you're okay being a landlord, why the heck wouldn't you consider what you could do with that equity in terms of a rental, and compare a decent investment to cashing it out for index funds or whatever?


By contrast, I feel like some people here are being unrealistically pessimistic about rental property.  How can you call house price appreciation a negligible safety net?  How can you ignore the tax benefits of the rental in your financial calculations?  Why would you only look at first year immediate cash flow and not rising rents, or advancing amortization schedules?

Equity and appreciation don't pay the bills, and may not be there when times are tight.   Sure, maybe the house appreciated 7% this year and that covers the carrying costs, but how do you access that 7% gain?

Paper equity is great, but how fast can you tap that?  Maybe a HELOC, but what if lending standards are tightened?  How fast can you sell?  If you are cash flow negative, how long can you keep that up when TSHTF?  Appreciation is great, but you can't rely on it short term.  Think of this analogy: someone will need money in a year.  Should they go all in on equities?  Probably not.  Counting on appreciation over the short term is the same thing.  Over 20, 30 years, yes, that house will appreciate, no doubt.  But counting on the appreciation (and speculating - by paying negative cash flow) is not generally a great idea.  The fact of the matter is, if you can get cash flow positive rental property that ALSO appreciates.. why not go for the one that makes sense right away from day 1, AND has the gravy appreciation in 20 years?

And I get that highlighting the difficulties diminishes the pools of competing property owners.

...really?  You think fellow Mustachian community members would purposefully try and decive others here just to limit our competition (in a locale that none of us - AFAIK - actually invest in, on a property that is already purchased/off the market)?  That's rather insulting.   Maybe you didn't mean it the way that came off.

Or do you think it's plausible that we've seen too many people jump in and make mistakes while underestimating the risks and get burned, and we'd rather people go in with open eyes?

Despite all the dire warnings here, I'm leaning toward renting.  It's already technically net worth positive on a per month basis when counting equity, and it will be cashflow positive in a few years.  The amount of cashflow I'd lose between now and then is smaller than the up front transaction costs of selling, and is dwarfed by the expected asset appreciation over the same period.

Right-o, sounds like you've made up your mind then.  It's not a terrible investment since you can carry it, I just think there are much, much better ones.  But yes, you may be seeing why rental property is such a great wealth builder - leverage, equity gain via principal paydown and appreciation, tax benefits (depreciation), and cash flow (though you're skipping that one).

I am a big fan of rentals. I just think that if one is willing to do rentals, might as well get good ones, instead of settling for the path of least resistance (oh, I already own this one, so though it's quite mediocre, I don't have to do any work to get a better one, so I'll just couch it as "I'm not a 'serious' real estate investor" and not worry about it.)

/knowing you, the facepunches in this post won't be misinterpreted
//my apologies though if anything is seen as too harsh.
« Last Edit: September 06, 2013, 07:50:18 PM by arebelspy »
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Re: seeking RE advice; considering never selling a property again
« Reply #17 on: September 06, 2013, 08:49:53 PM »
OK, you have a bread and butter property that should appeal to a variety of tenants.  What makes this location desirable?   IIRC, you are a federal employee.  Is there a large federal agency or military base nearby?  Is that facility likely to expand over the next few years?  Who are the other employers in the area?  Are they stable or expanding?  Are there lots of short term transfers in and out that would encourage people to rent rather than buy?  What percentage of the employed population can afford to buy?  Are there other rentals in the neighborhood?

In your shoes, I would scope out the local market for rentals starting today.  I would call all the for rent signs in the area, get the rents, and ask the landlord or property manager on the other end of the line a lot of questions.  How long has the property been vacant?  What have the tenants been like over the past few years?  Who is the typical tenant?  How long do they stay?  Have rents been stable, increasing, or decreasing?  Keep doing this until you are ready to move.

Once I had a good handle on the answers to all these questions, I would sit down with my spreadsheets.  I would ignore Zillow.  I have no idea where their assumptions come from, but I do know they are often 30 percent wrong on their Z-estimates.  That's not much of a track record.  I would use the experience of the other landlords in the area to make estimates.  Over the next year or two, I would track my findings so I had a thorough understanding of the rental market.

In the end, what you are deciding is whether it is better to incur the selling costs when you move and take the net proceeds and run, or incur the selling costs in the future, at what is hopefully a higher value and a smaller mortgage principal thanks to the tenants paying it down.  The good news is you are not selling or renting today.  If you get that 7 percent that Zillow's crystal ball is predicting, you will have a lot more equity to play with when it's time to decide whether to sell or rent.  And if you follow the rental market closely over the same period, you will be a lot more knowledgeable and can make a more informed decision.


sol

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Re: seeking RE advice; considering never selling a property again
« Reply #18 on: September 06, 2013, 09:27:16 PM »
Standard property management fees are 8-10% of the gross rents.

I've been waiting for you to rejoin the thread.  I value your input on these issues.

Taking your advice to heart, I upped my carrying costs from 40 to 50% of gross rents even though we'd be managing ourselves.  It makes a surprisingly small difference.  The extra 150/month in rent works out to such a small percentage of total returns that the graphs aren't significantly different, and any additional profit we make by self-managing will just be gravy.

Quote
The last sentence is ridiculous to say, if I'm understanding it correctly.  You'll pay the costs at some point.  That's like saying "if I sell these stocks, I pay 15% capital gains.. so by not selling I have an immediate 15% ROI!"  But again, maybe I'm misinterpreting that.

My wife made a similar comment, only she was much more harsh about it.  The spreadsheet lists accumulated value from the property over time, but does not account for the eventual sale, which will cost more in the future as the asset value increases.  I'll add a new column.  Yay for spreadsheets on a Friday night!

Quote
how long will paying out of pocket slow your path to FIRE?  And how much more of a stache will you need to support an alligator if you ER?

This is totally a worst case scenario, but if we had to carry the house indefinitely with NO renter, like if we just wanted to live in two houses, it would drop our savings rate about 12%.  Since we're currently saving something like 60% of our income and have no intention of retiring when we reach FI, I'm not too worried about it.  Is that grotesque?

Besides, it's not like deciding to rent it this year is a commitment to rent it forever.  If it turns into an alligator we just unload it and take our little piece of equity elsewhere.  It's still an asset, not a liability.

Quote
Keep in mind the equity is what you'd have from cashing out, not the fair market value minus mortgage.

If I look at it that way, then the returns on the rental are suddenly astronomical.  For example, in year one I would lose 2769 in cashflow, gain 4920 in equity payments by the renter, and get 1545 in tax deduction for a total return of 3696.  If that's on a mere 28k in extractable equity, that's over 13% in year one.

Year two is even better.   If rent and property value both go up 2.5%, then in year two I lose less in cashflow, gain more in equity paydown, get the same tax deduction, plus 2.5% of 280k is another 7k in equity from price appreciation, for a total two year paper gain of 13228.  On my 28k, that's like 23% annually.  Which seems ridiculous.  What am I doing wrong?

I was instead calculating my ROI on the 50k.  The same numbers on 50k are a more reasonable 7.4% in year one, and 13% in year two.  Still not bad.

Quote
What if you could get a 280k property that appreciated like yours, but was cash flow positive by several hundred per month (after the 50% rule and paying the mortgage)?

One alternative way to view this problems is to find what rent I would need to charge to make it worthwhile.  At dinner this evening a friend who just rented her house for 30% above zillow's rent estimate suggested I should be asking much more.  If I can charge 1800, the math changes considerably and my returns almost double.

At what rent would you consider this property a good investment?

Quote
Equity and appreciation don't pay the bills, and may not be there when times are tight.

A valid point and a useful warning for people who live on on the margin.  But we're filthy rich mustachians.  I can't envision a realistic scenario in which times will ever be tight for us.  I sleep well at night.

Quote
Paper equity is great, but how fast can you tap that?

I'm no hurry.  If the sell vs keep-renting calculus changes in a year or two, we'll sell.  Selling now is an irreversible decision.  Renting it out now is not.

Even without the appreciation, which I expect to be substantial, renting it makes us more profit from years 4 through infinity compared to investing the equity at 7% in the stock market.  With appreciation, it makes more money than investing in years 3 through infinity.

Quote
counting on the appreciation (and speculating - by paying negative cash flow) is not generally a great idea.

I would agree, if we were living in the house.  But with a renter, we gain more in mortgage reduction per year than we lose in cashflow per year, so our net worth still goes up.

Quote
...really?  You think fellow Mustachian community members would purposefully try and decive others here

Not others, just you.  You're evil.

Okay, maybe you're not evil but just advising caution and due diligence.  I'm doing that due diligence by berating you and AnotherReader, hoping you experts will poke holes in my math and show my why this is such a bad idea. 

Quote
Right-o, sounds like you've made up your mind then.  It's not a terrible investment since you can carry it, I just think there are much, much better ones.  But yes, you may be seeing why rental property is such a great wealth builder - leverage, equity gain via principal paydown and appreciation, tax benefits (depreciation), and cash flow (though you're skipping that one).

I'm not decided, I'm leaning and seeking reasons to be dissuaded from leaning. 

And I'm only skipping the cashflow if it doesn't rent for at least 1712, which it might, and even then I'd only be skipping it for a few years up front.

Quote
I am a big fan of rentals. I just think that if one is willing to do rentals, might as well get good ones, instead of settling for the path of least resistance (oh, I already own this one, so though it's quite mediocre, I don't have to do any work to get a better one, so I'll just couch it as "I'm not a 'serious' real estate investor" and not worry about it.)

I can see your point; if you're going to be a real estate investor, invest wisely.  But in this case there are other considerations, like avoiding any unnecessary transaction costs and retaining the property for eventual reoccupation.  I already know the property is sound and well cared for, so I avoid the risks inherent in buying a new place.  I have a good feel for the neighborhood and future appreciation rates.  It's a familiar investment and feels less risky because of it.

Quote
/knowing you, the facepunches in this post won't be misinterpreted

My ego is FAR to large to be injured by a post containing zero profanity, zero personal attacks, and only vague allusions to alternative suggestions which might yield better results.  Seriously, does anyone really get butthurt about receiving free advice on the internet?

sol

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Re: seeking RE advice; considering never selling a property again
« Reply #19 on: September 07, 2013, 01:07:22 AM »
Thanks everyone for your helpful suggestions.  I've spent my evening geeking out with Excel, trying to determine the financial consequences of the rent vs sell decision based on rental price, rent and house appreciation rates, market rates on invested funds, transaction cost percentages, and the carrying costs.

Rebel's 50% rule seems unbelievably high for a property in this range.  I'm just not sure how to spend an average $400/mo on maintenance costs outside of taxes and insurance on a property that rents for 1600.  Higher carrying costs favor selling sooner, but not now.

Not surprisingly, the spreadsheet says the decision is largely dependent on your assumed stock market returns.  If they'r significantly higher than property appreciation and rent increases, renting the place out always loses out in the long run to compound growth.

The rental amount seems less significant than I thought.  Even if it only rents for 900/mo and is horribly cashflow negative, assuming 7% market growth and 2.5% property/rent increases, I should still hang on to it for at least three more years.  At 1500/mo I should hold it for 9 more years before selling.  At 1800/mo more it's like 15 years.  Or at 1800/month and the market returns 8% instead of 7%, I should hold for 11 years instead of 15.  I like having math make make decisions for me.

But for a wide range of reasonable values, I've decided that renting is the best solution at least for the next few years.  The leveraged appreciation potential is just too great to lock in the recent equity declines and buy into the stock market with so little equity.

spreadsheet is attached for your amusement.

arebelspy

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Re: seeking RE advice; considering never selling a property again
« Reply #20 on: September 07, 2013, 08:38:40 AM »
Rebel's 50% rule seems unbelievably high for a property in this range.  I'm just not sure how to spend an average $400/mo on maintenance costs outside of taxes and insurance on a property that rents for 1600.  Higher carrying costs favor selling sooner, but not now.

Keep in mind it's not just maintenance, it's all the listed things.  One month of vacancy will cover that $400/mo. for 4 months.  Property management is $160 of that 400.  (Meaning the rest is only 240, so one month of vacancy covers that 240 for over 6 months.  Major repair, turnover costs, etc. cover the rest.) But again, yes, you may only have 40% or even 30%.

Looking forward to downloading the spreadsheet and responding more once I'm at a computer instead of mobile device, I was going to ask you to post it.

It seems that leverage + appreciation is your primary way of making this return worth it (otherwise the equity gain via principal paydown basically matches the negative cash flow, meaning essentially no return).

Assuming that's true, and you realize it's true and own it, that's absolutely fine.  Negative cash flow and leverage both add in risk, quite a bit.  Being in the position financially that you are, that risk may be no big deal (seems like it isn't).  But I'm sure you can see why - for most people - investing using the principles of negative cash flow and then appreciation + leverage to get a good return would be a bad idea.

(And why for someone looking to BUY a rental, rather than hold something they already have, they should avoid a property like that and get a better one.)
« Last Edit: September 07, 2013, 09:43:12 AM by arebelspy »
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Re: seeking RE advice; considering never selling a property again
« Reply #21 on: September 07, 2013, 09:46:16 AM »
Ah, the spreadsheet fallacy.  Plenty of folks have gone bankrupt and lost properties by projecting inaccurate compound growth in rent and expenses. 

You have a rental property.  If you have had this property for any length of time, you should have detailed records of rent and expenses.  Your tax returns should be enlightening annual summaries.  You should also have expense records for your own house.  In your shoes, I would review all of the major expenses of both properties to see how much they have grown.  When you call on those for rent signs, ask how much rents and how much each of the major categories of expenses have gone up in the last 10 or 15 years.

I can tell you from 17 plus years of owning rentals in the Phoenix area that operating expenses there, including capital improvements, have grown at a much faster rate than have rents.  In addition, as the properties have aged, they have required more work.  Property values skyrocketed, plunged, and are now recovering. 

The same is true in Silicon Valley.  I bought a home here in 1984.  The value of that property today is 6 times what I paid for it.  In 29 years, the rent has merely tripled.  The house I bought in 1989, 24 years ago, is worth three times what I paid but the rent has only doubled over the 24 years. Despite the restrictions of Prop 13, taxes have more than doubled (think parcel taxes and special assessments).  Other operating expenses have tripled or in many cases have quadrupled since 1989.  The property I inherited in 2007 is worth 15 percent less than it was then.  The market rent has grown in dollars about as much as the HOA fees have increased over the same time frame.  The rent is up 15 percent, the HOA fee has doubled in the six years of my ownership.

My point is that spreadsheets with compound growth assumptions are interesting but rarely accurate or even all that helpful by themselves.  Try separating out the expenses and increasing their compound growth to 3.5 percent and see where the wheels come off.  Personally, I would NEVER make a selling decision based on this spreadsheet alone.  It's use to me would be to see how much I could move the assumptions in an unfavorable direction and still come out ahead by keeping the property. 

Investing in real estate is really an art as much as it is a science.  For me, my own experience as a property owner and landlord, the experience of landlords in my local market over the last 10 to 15 years, and what my research shows the likely demand for my property will be over time are much more important in making my decision to sell or rent. 

Finally, I don't see why you are making a decision today about an event that will not occur for 1 to 2 years.  In your shoes, I would start doing the things to the property that will prepare it for sale or rent when I move.  Any upgrades I would do for a sale would not be done until I decided to sell.   While I am waiting, I would track the rental market and research the drivers of future demand.  I would make my decision when I was ready to move.

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Re: seeking RE advice; considering never selling a property again
« Reply #22 on: September 07, 2013, 09:50:14 AM »
Oh, yeah, +1 to everything Arebelspy said.

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Re: seeking RE advice; considering never selling a property again
« Reply #23 on: September 07, 2013, 09:52:21 AM »
Quote
/knowing you, the facepunches in this post won't be misinterpreted

My ego is FAR to large to be injured by a post containing zero profanity, zero personal attacks, and only vague allusions to alternative suggestions which might yield better results.  Seriously, does anyone really get butthurt about receiving free advice on the internet?

If that advice is not what they wanted to hear, yes, yes they do.

Looking at this spreadsheet, I'm not understanding the yellow part, specifically the parts that go "SELL>rent>SELL" -- why would it make sense on the "sell in two years plan" to sell in year 2, sell in year 3, but if you don't, you missed the window and should rent for 20 years, but then back to sell again!

These sell>rent>sell scenarios are making me scratch my head, without me delving into exactly where those calculations are coming from, do you know why the spreadsheet shows that?

Oh, yeah, +1 to everything Arebelspy said.

You must have missed that edit I put in about your mother!
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Re: seeking RE advice; considering never selling a property again
« Reply #24 on: September 07, 2013, 10:28:46 AM »
  I've decided that renting is the best solution at least for the next few years.  The leveraged appreciation potential is just too great to lock in the recent equity declines and buy into the stock market with so little equity.

spreadsheet is attached for your amusement.

sol, have you actually researched the historic appreciation rate for your exact area and property type?  I think your 2.5% is low, although still putting a nice $7,000 and growing every year into the equity bank.  At 2.5% that would mean the property was worth $217,000 in 2003 and $169,000 in 1993.  Does that sound close?  Over time a small 1% difference in appreciation rate means big bucks so I'd make a decision only on an accurate appreciation rate and an educated guess on the future prosperity of your area.

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Re: seeking RE advice; considering never selling a property again
« Reply #25 on: September 07, 2013, 10:39:43 AM »
Parental passings are how I got the 2007 property.  I kick myself every day for not selling it then.  Whatever you said about mom, she's not around to hear it!

sol

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Re: seeking RE advice; considering never selling a property again
« Reply #26 on: September 07, 2013, 10:45:08 AM »
All good advice, I think.  This thread alone has more than paid back my membership fee to this forum.  Thanks to both of you for sticking with it.

NEVER make a selling decision based on this spreadsheet alone.  It's use to me would be to see how much I could move the assumptions in an unfavorable direction and still come out ahead by keeping the property. 

That's exactly how I was using it last night.  What assumptions do I have to make to move the rent/vs sell line for any given date?  I couldn't put together a realistic combination of assumptions that favored selling it in the next three years.

Looking at this spreadsheet, I'm not understanding the yellow part, specifically the parts that go "SELL>rent>SELL" -- why would it make sense on the "sell in two years plan" to sell in year 2, sell in year 3, but if you don't, you missed the window and should rent for 20 years, but then back to sell again!

I thought that might be confusing.  Understanding someone else's spreadsheets is kind of like understanding how they cook, or organize their sock drawer.  Not always obvious.

Those SELL/rent breaks are conditional statements that compare the value of the invested equity every year for selling in the year listed in the column header.

So for many scenarios, selling the property looks like the best choice in the first year or two after the sale because the net value increase of the rental property is less than the extractable equity of the property we'd get by selling, favoring selling now. 

But the property gets more profitable over time as the amortization schedule advances and I get higher equity gains from the renter, and as the property appreciates, which means that after a few years I would have made more total money renting and then than selling at the header date and investing in the stock market at the specified rate.  This middle period is decades long for most parameter sets.

In the VERY long term, investing in the stock market is almost always a more profitable choice because the stock market is modeled as having higher long term returns than property appreciation.  Compound interest in the market at 7% always catches up eventually, over 50 or 100 years, with rent /property increases of 2.5%, regardless of how little equity you start with.

Seeing the flip flop was counterintuitive to me at first, too, but it made sense when I dug into the math.  Because we have so little equity left in the house after the downturn, our potential returns from price appreciation over the next few years are much larger than our expected stock market return on the same amount.  This is essentially the same thing totoro and Double Down said earlier in the thread, except now I've run the numbers to convince myself.


arebelspy

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Re: seeking RE advice; considering never selling a property again
« Reply #27 on: September 07, 2013, 10:58:35 AM »
All good advice, I think.  This thread alone has more than paid back my membership fee to this forum.  Thanks to both of you for sticking with it.

Your membership fee is the amount you have contributed to the forums.  You're still in the green.  ;)

Seeing the flip flop was counterintuitive to me at first, too, but it made sense when I dug into the math.  Because we have so little equity left in the house after the downturn, our potential returns from price appreciation over the next few years are much larger than our expected stock market return on the same amount.  This is essentially the same thing totoro and Double Down said earlier in the thread, except now I've run the numbers to convince myself.

I can see this being the case if you are projecting larger than average appreciation over the next few years due to a "reversion to the mean" type thing (i.e. assuming we overcorrected, and will see greater than inflation like returns for a few years to get back to a normal price level), but if you're just assuming a flat amount now, and in the future, it seems odd to me to go sell>rent>sell, especially on scenarios that are 10 years out, to have that same pattern.
We are two former teachers who accumulated a bunch of real estate, retired at 29, and now travel the world full time with two kids.
If you want to know more about me, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.