Keep the rental or sell?

[Credaholic]

We moved out of our pre-Mustachian home 3 years ago and started renting it out. We have an interest only mortgage that reset 2 years ago, and thanks to Libor being so low our rents are now higher than the mortgage, but the question remains - keep or sell?

Market Value: $575,000+ (I had my sister in law at Bank of America lending run a quick valuation, and this is what it came up with. Their valuation tool tends to be a little conservative - it's the tool they use to grant HELOCs without actually doing a full appraisal on a home. I think that $600-$650K is realistic in today's market.)

Original Purchase Price:
$500,000 in 2006

Mortgage Terms:
We refinanced 80/20 loans into one mortgage back in 2008. Yes, we needed a good throat punch back in the day. Interest only, 5 year ARM, switches to principal and interest after 10 years. Started at 6.5%, but we're now in our 2nd year of an adjusted rate. In 2013 it was 3% even. This year it is 2.75%. Current balance is $505,000.

Monthly Payment: $1658.47 (this is interest, insurance & taxes - NO PRINCIPAL)

Gross Rents: $2500/month

Depending on what rates do in the future (and clearly there's only one direction for them to go at this point!) and then taking into account the fact that in 2018 the loan will amortize to include principal paid in full over 20 years, the payment is going to skyrocket in 2018. So we either have to sell by then, or need to refinance the property (which would require putting some cash into it to pay down principal.)

It became a rental in April 2011, so we no longer qualify for having lived in it for 2 out of the past 5 years. We have never had any vacancy. There are small maintenance issues, but nothing serious. We'll probably put a new roof on it before we sell it, but that's the only biggie. Our current lease is up August 1st, but our current tenants want to renew. Our basis (we remodeled this house when we were living there) is approximately $600,000. Our depreciation is approximately $18,000 per year.

[Icecreamarsenal]

I am in a similar situation, and am not really qualified as yet, but if your monthly payment is PI + TI, it seems you should sell from a purely mathematical standpoint, as I believe there is an off the cuff calculation of using 50% of gross rents for maintenance.
That's not even including the fact that the principal is not being touched.
Can you better explain the 2 out of 5 years thing? Is that for when you sell you don't have to pay capital gains taxes?
My brother in law tells me that keeping a utility bill under your name at your first place can override this. Is this true or completely shady?



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[TheDude]

I think if i were in your shoes I would sell. If you can pull 100k out of it then you are coming out ahead. Your only other real option is to put a bunch of money into to to qualify for a fixed rate loan. Since you are only getting 2500 for rent it not really a good investment once you refi. Sell Sell Sell

[waltworks]

Sell it yesterday. As a rental it is costing you money in the long run.

-W

[Another Reader]

ICA:

If you are renting the property out, you presumably report the income and expense, including depreciation, on your income tax return.  The IRS is aware that the property is a rental by your own declaration.  It makes no difference if the utilities are in your name.

[Icecreamarsenal]

ICA:

If you are renting the property out, you presumably report the income and expense, including depreciation, on your income tax return.  The IRS is aware that the property is a rental by your own declaration.  It makes no difference if the utilities are in your name.

Hmm, thanks for the info.  I'll have to disabuse him of this notion.

[Credaholic]

Okay, spent some more time looking at recent sales, and I think over $600K is a little too optimistic. I'm in a coveted neighborhood, but no one has listed so far this year, so it's hard to say for sure.

So let's say there's a $600K sales price, about $35K in closing costs, and at least $10K in lost rents, staging, and spruce up costs. Possibly another $5K for inspection items. That takes it down to walking away with $45K in cash. Can somebody help me with the taxes on this? My understanding is that it's basically sales price minus selling costs, subtract the basis, and then add depreciation. So in this case taxable proceeds would be almost washed out, is that right?

The alternative would be to put about $50K into the principal of the property, refinance around 4.5% in a 30 year fixed, making the mortgage about $300 over the current rents. This will decrease over time as rents increase, which over 30 years would wipe this out while the principal balance is paid down. If we actually kept it until it was paid off, it would likely be worth $1M+ 30 years from now. Of course there would be maintenance costs during that time, and then a huge chunk towards taxes.

If we took the $45K out of the sale of the house and the $50K we would have otherwise paid down principal with and purchased a $100K house free and clear, we'd probably rent it for around $750/month. Over 30 years, even with appreciation and rising rents, we wouldn't get anywhere near the proceeds we could get out of keeping the bigger house. So why sell sell sell? Maybe I'm skewing the math somewhere or neglecting some obvious thing.

[waltworks]

You are ignoring maintenance costs (though you did mention them, at least). Figure between 1 and 3 percent annually, depending on the condition of the property and how it's built (ie metal roof? Not much maintenance. 1980s cedar shingles? Doh!)

I know, you are saying, "that's crazy! I have never spent that much!" That's because you probably haven't had to do a big item like a new driveway or roof or whatever.

In 30 years you will need a roof, you will need multiple water heaters and furnaces, you'll need to paint the inside and outside multiple times, you'll probably have to replace the floors, pipes will burst, etc, etc, etc. Every part of your house is depreciating (both for tax purposes and literally) as the years pass, and if you do zero maintenance (assuming you can keep tenants in) you will have a free and clear absolute dump/unlivable hellhole in 30 years. Property taxes and insurance costs will rise steadily. Tenants will trash something and skip town.

You also should not be comparing this to a $100k house that brings in $750/mo (also a bad rental, albeit not *as* bad). Compare with putting $100k in the stock market in some boring index fund (or pick another investment that you can estimate returns on). Historically that's going to do something like 7%. That would put you at around $700k in 30 years with *basically* zero overhead or costs (or tenants calling you at midnight).

Look, this isn't a good rental property at all. The 1% rule exists for a reason - if you can't hit that (or in your case even come close) you will be negative cash flowing over the long run. Do some more reading and you can easily convince yourself of this.

-W

Okay, spent some more time looking at recent sales, and I think over $600K is a little too optimistic. I'm in a coveted neighborhood, but no one has listed so far this year, so it's hard to say for sure.

So let's say there's a $600K sales price, about $35K in closing costs, and at least $10K in lost rents, staging, and spruce up costs. Possibly another $5K for inspection items. That takes it down to walking away with $45K in cash. Can somebody help me with the taxes on this? My understanding is that it's basically sales price minus selling costs, subtract the basis, and then add depreciation. So in this case taxable proceeds would be almost washed out, is that right?

The alternative would be to put about $50K into the principal of the property, refinance around 4.5% in a 30 year fixed, making the mortgage about $300 over the current rents. This will decrease over time as rents increase, which over 30 years would wipe this out while the principal balance is paid down. If we actually kept it until it was paid off, it would likely be worth $1M+ 30 years from now. Of course there would be maintenance costs during that time, and then a huge chunk towards taxes.

If we took the $45K out of the sale of the house and the $50K we would have otherwise paid down principal with and purchased a $100K house free and clear, we'd probably rent it for around $750/month. Over 30 years, even with appreciation and rising rents, we wouldn't get anywhere near the proceeds we could get out of keeping the bigger house. So why sell sell sell? Maybe I'm skewing the math somewhere or neglecting some obvious thing.

[Credaholic]

Well, I didn't think I was ignoring maintenance costs by mentioning them...

I could see spending *maybe* $100K on this property over the next 30 years. Maybe that's because my husband is a contractor and so our maintenance costs are cheaper, but for that amount I'd have a very well cared for home (albeit outdated). Maybe it's because if this house was located an hour and a half north or south it would be worth at least half of what it is, but being near the Microsoft campus in a high priced area doesn't make maintenance on it more expensive than an hour and a half away. In fact, I'd argue that my maintenance will probably be less BECAUSE we are in this area renting to very reliable and stable tenants.

I appreciate the logic behind the 1% rule, but in my area it's not very realistic. I could get closer to that by buying further out (my $100K, $750/mo example), but then I've added to my own stress in managing a property hours away, and would be renting to far less reliable tenants with increased maintenance costs. That doesn't make me want to skip having rentals. I think that rentals are a good way to diversify your investments, even in an area where the 1% rule can't realistically be achieved.

All that being said, I'm not trying to argue that this is a good investment property. I would never spend $600K expecting $2500 in rents on an intended rental. But I already own this property, so the question now is mathematically will I be better off keeping it or freeing up a small amount of cash and buying a different rental? My actual course of action if we did sell would probably be to buy a $200K rental with $50K down and PITI payment of ~$1K and rents ~$1500/mo which I could achieve in a decent enough area about 30-45 minutes from city center, so I'd still feel comfortable with it.

[brandino29]

All that being said, I'm not trying to argue that this is a good investment property. I would never spend $600K expecting $2500 in rents on an intended rental. But I already own this property, so the question now is mathematically will I be better off keeping it or freeing up a small amount of cash and buying a different rental? My actual course of action if we did sell would probably be to buy a $200K rental with $50K down and PITI payment of ~$1K and rents ~$1500/mo which I could achieve in a decent enough area about 30-45 minutes from city center, so I'd still feel comfortable with it.

We own one SFH rental worth about 1/10th of yours but the only thing that made it a worthwhile investment in my mind was that we were able to get it at a price significantly below market value and put a 20% payment down on it.  The day we closed we already had 35% equity (conservative estimate) in the house, plus it met all of the other rules of thumb.  My big concern about your situation is that not only does it not meet the general rules of thumb for rental property, which is obviously heavily dependent on location, but you have invested $0 in principal paydown on top of falling well short of the 50/50 rule. 

I'm with the others saying sell, if you have equity due to appreciation, I'd say get out while you can definitely come out ahead.  If the monthly rent were able to go toward at least some principal, it might be a different story. 

[waltworks]

Regarding maintenance, I'll just say this: there is a reason the IRS lets you depreciate a structure on a 27.5 year schedule. Your $100k for 30 years is ludicrously low and making your husband do the work doesn't make it cheaper - it means he has a part-time, no-pay job of maintaining your house that doesn't (and probably will never) cash flow.

It's not clear to me that you came here for actual advice but I'll say it one more time: you have a money losing rental *even with a super crazy low no-principal loan*. You have some equity. Any competent real estate investor would ditch your house in a hot second unless they thought prices were about to skyrocket. Nobody in their right mind would buy it as a rental, so the fact that you own it is a *bad* thing, not a good thing.

Honestly, it does not sound to me like you should be investing in real estate at all unless you can step back and look critically at your decisions here.

-W

[Credaholic]

I just have to take advice with a grain of salt when somebody tells me I should expect to spend $450,000 on maintenance costs over the next 30 years (and that's basing it on the purchase price, not the present value which would make it even more based on your rules.) I understand how a rule of thumb can be useful to quickly sort through a multitude of investment options, but when discussing a specific property I think there's a lot more to take into consideration.

For instance, as I said, why should maintenance costs on a $500K home in a high demand area be $15,000 a year but be $6000 per year in a less coveted area an hour or two away for the exact same house? The roof doesn't need replacing any faster, the materials are all being sourced from the same place. So, given that I'm simply in a high priced real estate area, I'd tend to lean closer to 1% than to 3% of your suggested 1-3% maintenance rule of thumb, which takes it to $150K.

I also think it makes sense to use the square footage to estimate maintenance costs at $1 per square foot per year, which would put this house at $60K over 30 years. If we average these two methods to find something in between, I find my $100K estimate to be fairly spot on.

If we take into account that yes, my husband can do a lot of the work and source materials without the markup that hiring out would come with there's even more savings. If he doesn't feel like replacing the roof himself and he gets his subs out there instead, they give him a discounted rate. If he spends a few weekends a year on projects, or if I spend a day in between tenants walking through with a bucket of paint and a brush doing touch ups (or spend a couple of weekends painting the house from top to bottom as I did when we lived there) I don't see this as wasted time or working for free - it's a great return on my time investment vs. hiring a painter.

When I sit down and think how many hot water heaters will we go through, how many furnaces, how many times will the composition roof need to be replaced, how many times will I have to find a deal on a new appliance on Craigslist, etc. I find that $100K seems reasonable as long as we don't neglect regular maintenance.

Again, I know that this still isn't a good rental. I will argue that a $200K rental bringing in $1500/month in rent is not just a better rental but a decent rental in my area, and that just because a rule of thumb (which includes much cheaper to buy areas throughout the US) would cross this off other real estate investor's lists, that it doesn't mean that no one in my area should consider buying rental properties to add diversity to their investments. If you'd rather diversify your investments by buying REITs, consider that the rental described actually does meet REIT buying guidelines for my area.

But I am genuinely asking (and trying to decide for myself) whether it makes more sense in the long run to just keep this property or to put the potential $50K of free equity into a $200K rental. But I'm trying to step back, look critically, and crunch these numbers rather than shotgun pulling the trigger on selling.
 

[GoCubsGo]

I'd sell due to many of the reasons stated above, especially considering the current low rate can't be locked in.   Diversifying just to diversify into a less than ideal investment could cost a lot of missed gains over the long haul. If you do decide to sell, you may want to talk to a Realtor to determine when you should sell.  I'm a Realtor and the early spring market tends to inflate sell prices and lessen market time. Late summer market tends to cool off for buyers who have a family as many want to be settled into school districts/sports/etc.  This year was extra crazy with given the lack of good inventory and had a pronounced effect on both pricing and market time.   Your proximity to Microsoft may negate that, but it couldn't hurt to ask.

Maybe you can extend your current renter until March or April which would allow you to have a bigger pool of buyers to choose from (and they may have more rentals to choose from).  Just a thought.

[Bearded Man]

Sell, too much tied up in one property.

[nodomo]

Since your rent is considerably greater than your mortgage due to the interest only loan, have you considered paying off the loan each month with the excess?

I have some rentals like yours (doesn't meet the 1% rule) and some rentals that do meet the 1% rule. I've elected to keep one of the rentals that doesn't (worth $200k, rents for $1300. it's also on an adjustable mortgage but it is principal + interest loan) because the tenants have been there for 4 years and do almost all of the maintenance themselves. The only thing I have had to pay for is 1 water heater.  In this case, I haven't had to spend much time on it, so I'll keep it as long as this tenant stays there and continues to help me pay down my principal.

The one thing nobody has brought up is your transaction cost if you sell. Selling a house is expensive! Figure on 7% total when you sell (commission + other costs) so selling means you will reduce your reinvestment capital by ~$35k.

I lived in Redmond/Bellevue in the late 90s and think you could consider keeping it as a rental if the tenants are high quality, low maintenance, and you either pay down your loan with the excess from rent or reinvest it.  I would not put more money into it or refinance it if it required more down payment, rather I would use that money to diversify in another investment.