Reader Case Studay: Sell or Rent?

[Mr. Green]

The specific angle that I'm interested in is the comparison of selling with the intent of investing our equity in the house vs. renting and using the house as a source of passive income in FIRE.


Market Value: $230,000
Original Purchase price: $260,000
Original Mortgage Amount:$176,000
Interest Rate: 2.875%
Mortgage Term: 15 years
Term remaining: 12 years
Amount remaining on mortgage: $155,000
Gross Rents:$1,500/month ($18,000/year)
Principal and Interest: $1,205/month ($14,460/year)
Taxes and Insurance (the T&I of your PITI): $232/month ($2,784/year)
HOA costs: $70/month
Deferred maintenance notes: None
Anything else special or unique in regards to the numbers of the property (not the property itself; things such as city assessments, back taxes, special costs due to unique features of the property, etc. etc.):  None

If we kept the property and rented it, the mortgage would be paid off in 2028, with positive cash flow after that. I would be a long distance landlord (out of state) but both my wife and I have parents 30 minutes from the property so frequent visits to the area will occur anyway. I've seen the number "50% of gross rents" tossed around on here as expected income. I'm not buying that in this case. It's a townhouse, and I could replace the entire roof, and every appliance in the house, every year for $9,000. I also do most work myself.

What I'm really interested in is the argument comparing selling and investing my equity vs. renting for passive income. By my calculations, it seems like the equity invested over time (I'm 31, long time to compound) is comparable to the "stash equivalent" that would provide, say, $12-15k a year in income that this rental would generate. I'm down with all the tax implications on renting. I've done spreadsheets on the depreciation, possible maintenance costs over time, etc. Essentially, I'm pursuing whichever option will ultimately result in the largest benefit to my stash. Maybe I haven't overlooked anything and it just comes down to choice but I've already learned so much on this forum that it's silly not to ask.

[Another Reader]

You forgot the big ones - vacancy and collection loss:  8-10 percent of gross is typical for single family, property management:  about the same.  How easy is it to evict where this property is located?  What happens if a tenant files BK - how long to get them out? 

Maintenance/replacement schedule:
New carpet every 5 to 7 years.  Clean after every tenant.
Paint every 5 years, major touch up anytime a tenant moves.
New water heater every 8-10 years.
Appliances as needed.  Appliance life is shorter because tenants do not treat them well.  5-10 years
Full clean after every tenant.
Miscellaneous clogged toilets, lock changes, broken window seals, garbage disposal replacements, sink back ups, broken pipes, and so on.  The sink won't clog when you are visiting parents, I can guarantee.

HOA:
Will go up every year, expect special assessments for common improvements.

Taxes and insurance are part of the 50 percent rule of thumb.  $2,784/$18,000 x 100= 15.5 percent.  Add 8 percent vacancy and collection loss and 8 percent property management and you are already over 31 percent expenses.  Amortize the capital improvements and special assessments and then add on something for repairs and maintenance and you will see how we get to 50 percent.  And 50 percent does NOT include the HOA fee.

Based on my experience, over time you will be significantly cash flow negative on this property even if you choose to self manage and do the work you can when you are around.  I would not want that kind of alligator nipping at my heels while I waited to pay off the mortgage. 

You can't isolate equity.  You have to look at the present worth of all the anticipated net cash flows over your holding period and compare it to the present worth of the net cash flows if you sold and invested the proceeds over the same period.  Lots of complicated arithmetic with assumptions that may not pan out anyway.

[waltworks]

1: We really need a "what is the 50% rule" sticky. It gets tedious having the same argument about it over and over.
2: Self-managing does not improve your investment returns. Self managing is having a job. If you like to do that kind of job for free, cool - I have some rentals you can manage for me. If not, you need to consider that as a part-time paid job that you *could* hire out, and in fact for the purposes of investment analysis, you should assume you'll hire it out.
3: I see so many of these threads now that it makes me even more certain I need to sell off my remaining properties as the greater fools are apparently excited about ones that rent for 1/2% of their market value.

-W

[Mr. Green]

You forgot the big ones - vacancy and collection loss:  8-10 percent of gross is typical for single family, property management:  about the same.  How easy is it to evict where this property is located?  What happens if a tenant files BK - how long to get them out? 

Maintenance/replacement schedule:
New carpet every 5 to 7 years.  Clean after every tenant.
Paint every 5 years, major touch up anytime a tenant moves.
New water heater every 8-10 years.
Appliances as needed.  Appliance life is shorter because tenants do not treat them well.  5-10 years
Full clean after every tenant.
Miscellaneous clogged toilets, lock changes, broken window seals, garbage disposal replacements, sink back ups, broken pipes, and so on.  The sink won't clog when you are visiting parents, I can guarantee.

HOA:
Will go up every year, expect special assessments for common improvements.

Taxes and insurance are part of the 50 percent rule of thumb.  $2,784/$18,000 x 100= 15.5 percent.  Add 8 percent vacancy and collection loss and 8 percent property management and you are already over 31 percent expenses.  Amortize the capital improvements and special assessments and then add on something for repairs and maintenance and you will see how we get to 50 percent.  And 50 percent does NOT include the HOA fee.

Based on my experience, over time you will be significantly cash flow negative on this property even if you choose to self manage and do the work you can when you are around.  I would not want that kind of alligator nipping at my heels while I waited to pay off the mortgage. 

You can't isolate equity.  You have to look at the present worth of all the anticipated net cash flows over your holding period and compare it to the present worth of the net cash flows if you sold and invested the proceeds over the same period.  Lots of complicated arithmetic with assumptions that may not pan out anyway.

I may be low-balling the rent a little. I think the range is $1450-1650 for our area currently. I'm a conservative guy though.

I'm a little shocked at your clogged toilet and sink comment. How is that not the tenant's responsibility?  I've lived in this house for 10 years so I have a pretty good handle on maintenance costs but I get what you mean about life expectancies being shorter because tenants are harder on things.

Maryland is more pro-tenant but a lot of that depends on how strict you are as a landlord. If rent is due on the 1st, late on the 3rd, and eviction paperwork is filed with the Sheriff on the 10th then it's not bad. But if you play Mr. Nice guy, landlords can really be worked over in Maryland. We could refinance to make the property cashflow positive but that would be counter to the endgame goal. Really we just considered it due to it's desirability for tenants, the proximity to our parents, and the good rate we have on a 15 year note. However, knowing that the market returns will outpace gains in home equity, for the purposes of increasing our stash, it sounds like it would be best to let the place go.

[Another Reader]

My guess is you have never had tenants.  If you were ever a tenant yourself, you must have been the ideal tenant. 

On paper, these things may be the tenant's responsibility.  In reality, often you end up fixing the problem, if only to protect your property, and then billing the tenant.  It often takes a while to collect.

[Mr. Green]

My guess is you have never had tenants.  If you were ever a tenant yourself, you must have been the ideal tenant. 

On paper, these things may be the tenant's responsibility.  In reality, often you end up fixing the problem, if only to protect your property, and then billing the tenant.  It often takes a while to collect.

You are correct. I have never been a landlord before. Sounds like I'm not missing out on much based on all the stuff you've mentioned. I'm kinda  wondering now why anyone post-FIRE would want  to be a landlord, unless you really enjoyed the work or considered the income a pivotal part of FIRE.

[waltworks]

http://forum.mrmoneymustache.com/real-estate-and-landlording/examples-of-rentals-you-own-that-perform-well-financially/

That's why. Most of those opportunities are gone now, though. 2009-2012 or so was basically a giant RE fire sale. I'm sorry I didn't buy more.

-W

My guess is you have never had tenants.  If you were ever a tenant yourself, you must have been the ideal tenant. 

On paper, these things may be the tenant's responsibility.  In reality, often you end up fixing the problem, if only to protect your property, and then billing the tenant.  It often takes a while to collect.

You are correct. I have never been a landlord before. Sounds like I'm not missing out on much based on all the stuff you've mentioned. I'm kinda  wondering now why anyone post-FIRE would want  to be a landlord, unless you really enjoyed the work or considered the income a pivotal part of FIRE.

[Mr. Green]

http://forum.mrmoneymustache.com/real-estate-and-landlording/examples-of-rentals-you-own-that-perform-well-financially/

That's why. Most of those opportunities are gone now, though. 2009-2012 or so was basically a giant RE fire sale. I'm sorry I didn't buy more.

-W

My guess is you have never had tenants.  If you were ever a tenant yourself, you must have been the ideal tenant. 

On paper, these things may be the tenant's responsibility.  In reality, often you end up fixing the problem, if only to protect your property, and then billing the tenant.  It often takes a while to collect.

You are correct. I have never been a landlord before. Sounds like I'm not missing out on much based on all the stuff you've mentioned. I'm kinda  wondering now why anyone post-FIRE would want  to be a landlord, unless you really enjoyed the work or considered the income a pivotal part of FIRE.

That's the only other thing I was going to say where it might be worth it, if you picked it up at a steep discount.

[Mr. Green]

1: We really need a "what is the 50% rule" sticky. It gets tedious having the same argument about it over and over.
2: Self-managing does not improve your investment returns. Self managing is having a job. If you like to do that kind of job for free, cool - I have some rentals you can manage for me. If not, you need to consider that as a part-time paid job that you *could* hire out, and in fact for the purposes of investment analysis, you should assume you'll hire it out.
3: I see so many of these threads now that it makes me even more certain I need to sell off my remaining properties as the greater fools are apparently excited about ones that rent for 1/2% of their market value.

-W

I just realized your point #3 is referring to the 1% rule (of which I was unaware until about 5 minutes ago). I find that interesting because no house purchased at market value is going to meet a 1% rule. At least not in my area.

[waltworks]

Yes, buying rental properties (or holding them) makes zero sense in many places.

-W

1: We really need a "what is the 50% rule" sticky. It gets tedious having the same argument about it over and over.
2: Self-managing does not improve your investment returns. Self managing is having a job. If you like to do that kind of job for free, cool - I have some rentals you can manage for me. If not, you need to consider that as a part-time paid job that you *could* hire out, and in fact for the purposes of investment analysis, you should assume you'll hire it out.
3: I see so many of these threads now that it makes me even more certain I need to sell off my remaining properties as the greater fools are apparently excited about ones that rent for 1/2% of their market value.

-W

I just realized your point #3 is referring to the 1% rule (of which I was unaware until about 5 minutes ago). I find that interesting because no house purchased at market value is going to meet a 1% rule. At least not in my area.

[Gazelle]

This is interesting to me because my situation is almost identical.  House value around $225k, mortgage around $145k, getting ready to move to a new place.  Can probably rent the house for $1,500-1,600.  Obviously fails the 1% rule, as do most properties in my area.  Buying this house for the purpose of renting it out would be a terrible investment.

But once I take into account the fact that it costs me money to unload the house (commisions, fixing inspection findings, etc) the go/no-go marker can't be the same 1% number; mathematically, it's got to be something less.  I've put together a spreadsheet of my options:

1. Sell house
2. Keep 15-yr mortgage and rent (negative cash flow with 50% gross rents)
3. Refinance to 30-yr mortgage with cashout to get to 80% LtV and rent (positive cash flow with 50% gross rents)

And the verdict is pretty clear: #3 is the winner.  Once you are in the house, and forced to make the sell vs. keep decision instead of the buy vs. don't buy decision, the math has to be a little different.

[NumberCruncher]

This is interesting to me because my situation is almost identical.  House value around $225k, mortgage around $145k, getting ready to move to a new place.  Can probably rent the house for $1,500-1,600.  Obviously fails the 1% rule, as do most properties in my area.  Buying this house for the purpose of renting it out would be a terrible investment.

But once I take into account the fact that it costs me money to unload the house (commisions, fixing inspection findings, etc) the go/no-go marker can't be the same 1% number; mathematically, it's got to be something less.  I've put together a spreadsheet of my options:

1. Sell house
2. Keep 15-yr mortgage and rent (negative cash flow with 50% gross rents)
3. Refinance to 30-yr mortgage with cashout to get to 80% LtV and rent (positive cash flow with 50% gross rents)

And the verdict is pretty clear: #3 is the winner.  Once you are in the house, and forced to make the sell vs. keep decision instead of the buy vs. don't buy decision, the math has to be a little different.

It's true the math is different somewhat if you already own the place- but couldn't you use a modification of the "1% rule" as well in this case by subtracting the unloading costs from the market value? Of course going through all the options as you've done is more thorough and accounts for the specifics of a situation, but this seems like an easy way to modify the 1% rule for a quick analysis, unless I'm missing something:

So if you have a $225k house, selling might be something like 4-6% for commissions, maybe another 1-5% for fixing things, meaning a modified price of something like $225k*(0.92) = $207k. So instead of needing at least $2,250 in rent for the 1% rule, you would only need $2,070 in rent per month.

[waltworks]

Subract your costs to sell and collect your equity. That's your basis for the keep/sell calculation, just as you'd include your closing costs and repair costs when considering whether to buy a property.

-W

[Another Reader]

I live in Silicon Valley.  A $1.3MM house rents for $4,200 a month in San Jose.  That's 0.32 percent per month. 

There are reasons not to free your trapped equity and take a low ROI.  For example, if you bought low, have a huge capital gain because you rolled over gains on one or more previous houses when the rules allowed that, have a very low property tax basis because of Prop 13, and you are no spring chicken, it might actually make some sense to rent the house out and let the heirs get a stepped up basis.  The selling costs plus the checks you would have to write to Washington DC and Sacramento add up to a breathtaking number.  A lot of baby boomers in HCOL areas in California are facing that exact scenario, particularly if they are single, widowed or divorced and only get a $250k capital gains exclusion.