Author Topic: seeking rental property evaluation advice  (Read 11190 times)

sol

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seeking rental property evaluation advice
« on: April 14, 2014, 09:18:45 PM »
My family is moving and planning on renting out our current house.  I was hoping a more seasoned pro could offer me some feedback on my rental property estimates, below.
 
Approximate home value today: 300k.
Remaining loan balance: 226k.
Extractable equity in home after 10% transaction costs: 44k.
 
Our monthly payment for PITI: 1712.
Monthly rent we expect to collect: 1900.
 
If I assume the property will stay rented for 11 months per year, then each year we can expect to pocket (1900-1712)*11=2048 in rent minus payments, and I'm very conservatively expecting all of that to go towards continued maintenance costs.  My first thought was this was going to make this a terrible deal as a rental property, about cash flow neutral.
 
But then the details get complicated.  Each year the renters will be paying in 4400 in equity for me.  Total deductions for property taxes, repairs, insurance, and depreciation on the building over 27.5 years work out to about 15k/year, and since we already qualify to itemize all of that is effectively saving us from paying our MFJ marginal tax rate of 25%.
 
25% of 15k in deductions: 3750 in reduced taxes paid
Annual equity paid by renter: 4400
Total annual "profit": 8150.
 
A return of 8150 on extractable equity of 44k is 18.5% ROE.  Suddenly not such a bad deal.
 
I realize that the equity paid by the renter is only realized if we sell eventually, but even if I don't count it the place is still going to return 8% just due to the 3750 in tax deductions, which is better than what I would hope for from my investment portfolio for the next year.  I think I might be foolish to give up a guaranteed 8% return.
 
And none of this has yet accounted for potential property appreciation.  If the house appreciates 3% next year I would see a 9k paper gain on only 44k in equity, due to the leverage of the mortgage, or an additional 20% ROE.  18.5% + 20% is like fantasy level returns, I wish I could buy investments like that every day.
 
I'll re-evaluate periodically as our equity increases and taxes change and such, but for now the mortgage leverage and tax deductions seem to make renting it a better option than selling in the immediate future and paying the capital gains on our $44k in extractable equity, even though the rent barely covers the payment.
 
Have I totally botched this analysis?
 

MDM

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Re: seeking rental property evaluation advice
« Reply #1 on: April 14, 2014, 09:34:03 PM »
A few warm-up questions before the real estate pros weigh in:
  - It seems ''If...the property will stay rented for 11 months per year, then each year [you get] (1900-1712)*11 - 1712 = 336 in rent minus payments" is more correct...?
  - Yes "the equity paid by the renter is only realized if we sell eventually", but when you do sell you will likely pay tax at ordinary income rates on all the depreciation you claimed while renting.  Is that included in your figures?
  - If you simply sold now, why would you be "paying the capital gains on our $44k in extractable equity"?  E.g. see http://www.irs.gov/taxtopics/tc701.html.

Despite all the nitpicking above, rental property can be a good deal - but again there are others here much more versed in the subject so they may have more to say.

arebelspy

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Re: seeking rental property evaluation advice
« Reply #2 on: April 14, 2014, 09:51:27 PM »
If I assume the property will stay rented for 11 months per year, then each year we can expect to pocket (1900-1712)*11=2048

Man, I want a mortgage with your bank, which apparently lets you not pay your mortgage when the property isn't rented!  ;)
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arebelspy

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Re: seeking rental property evaluation advice
« Reply #3 on: April 14, 2014, 10:11:11 PM »
Are you going to be managing it yourself?

The IRS doesn't care that you had to pay a mortgage - they'll tax you on Gross Rents - Expenses (including interest on the loan, but not principal).  Meaning you will probably see negative cash flow (after paying that principal part of the loan) but be taxed on positive cash flow.  It's not that big of a deal with the numbers you're dealing with though.

In other words, say you see gross rents of 1900*11 = 20900

Minus Taxes/Interest/Insurance (total of 16144 - I calculate from 1712*12 total payments minus 4400 principal paydown number you mentioned )

Maintenance (say, 3k/yr - it'll probably be more long term - the actual repair costs will only be a few hundred, but many multiples of that if and when tenants move and you have to pay for paint, carpet, etc. - turnover costs suck -- and when you count long term capital repairs like a roof, water heater, HVAC, etc.. it very well could average quite a bit more).

That gives you a positive cash flow of 1756 that you'll pay taxes on, though you'll have an actual cash flow of -2644 (negative 2644: 1900*11 - 1712*12 - 3000 repairs/maintenance).

So you pay 439 in tax (1756 * .25), and -2644 cash flow leaves you out of pocket 3083.

You won't get deductions for property taxes, repairs, insurance, as those are already counted as expenses, above.

So just depreciation, which is maybe 7500ish? (You'd know this number better than I, but the purchase price you got it at, minus land value, divided by 27.5) * .25 tax rate = $1875

So you'll gain tax benefits of 1875 + 4400 equity paydown minus the 3083 out of pocket = 3192 of gain.  HOWEVER the depreciation will eventually be recaptured when you sell, as will any other gains.  So it's more of a temporary offset that you'll repay later.  You're also giving up the "lived in it the past few years = can exclude up to 500k of the cap gains" benefit, unless you move back into it.  So that will cause a larger tax bite at the end.

A gain of 3192 on 44k equity is a 7% return.  And it's actually lower, since not all of that 3192 is actually gains, but depreciation that will be recaptured.

And all of that doesn't even address the question I started with.  If you pay management, that'll be another ~2k that you'll have to pay out of pocket (that will, of course, deduct from your "profit" when you pay taxes on it).  If you don't, you're dealing with the hassle of landlording yourself for a gain that is less than the stock market's long term average.

(And I also think I underestimated some things in here, such as the benefit of that 44k equity right now being tax free versus paying it in the future, lower than likely long term expenses, etc... but who knows.  Hard to predict that stuff.)

Yes, it may appreciate.  You may want to speculate on that, or not.

Double check all my numbers.  Easy to make a mistake.  :)
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Chiron

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Re: seeking rental property evaluation advice
« Reply #4 on: April 15, 2014, 09:01:27 AM »
If I were in your shoes, I would definitely sell.  The only reason to keep the house would be to speculate on capital appreciation. There are easier ways to do that (REITs) than being a landlord with a cash flow negative property. 

One thing that hasn't been mentioned is that there are phase-outs for the deductibility of passive real estate losses for owners that may or may not apply to you (see here: http://www.irs.gov/pub/irs-pdf/i8582.pdf).  If you can't deduct the losses, you'd have to carry them forward, and your cash flow would be further negatively affected.

tryan

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Re: seeking rental property evaluation advice
« Reply #5 on: April 15, 2014, 12:55:29 PM »
Love the wishful thinking ... "well it doesn't cash flow now, so let me look into the future via my crystal ball so I can cram this square peg in a round hole."  The only thing you forgot was future rent increases ... now it looks GREAT doesn't it!

Fact is if it doesn't cashflow now, you need to figure it will NEVER cashflow.  Counting future equity is useless since it might never be realized (for example - I imagine - you're renting because it can't be sold today).  Tax breaks like depreciation are returned to the government upon sale ... silly to count those chickens.

This one is a major repair (roof, heating system .... ) or BAD tenant (3+ months no rent) away from being a real stinker.

arebelspy

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Re: seeking rental property evaluation advice
« Reply #6 on: April 15, 2014, 01:31:39 PM »
(for example - I imagine - you're renting because it can't be sold today).

I don't think this is the case, sol is just exploring the option of renting instead of selling.
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arebelspy

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Re: seeking rental property evaluation advice
« Reply #7 on: April 15, 2014, 02:07:08 PM »
Also you should compare what else you could do with the money.

If you want it in real estate and you want to be a landlord you could always buy a property free and clear for 44k that rents for ~1k/mo, no mortgage.

Or put it as a 25% down payment on a house that rents for 2500ish.

Either seem like a better option than what you have now, especially since you can cash it out tax free.

There will be transaction costs, of course, but even with those factored in, I think moving the money to a better investment you'll come out ahead (just like those people who have whole life and have to take a big hit to get the cash out value and move it to low cost index funds will often come out ahead by doing so).
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DoubleDown

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Re: seeking rental property evaluation advice
« Reply #8 on: April 15, 2014, 03:23:40 PM »
Wow ARS, way to do all the math!

Sol, I agree with all of the above. For me, this would come down to how much you want to bet on future appreciation, if any, and whether you want to keep this property as a way to diversify your total assets. And also if there are better alternatives available, such as transferring your equity into a property with better cash flow. If you feel confident that your home is in a desirable, stable area, that is expected to thrive in the future and go up in value, then I'd keep it and re-evaluate every year (assuming you can't just buy a better rental property instead). If not, I would sell.

Just 3% compounding appreciation would bring you at least an additional $100k in about ten years, plus paying down your mortgage significantly, and likely higher rents along the way. In a desirable area, you could do substantially better than 3%. Of course you know that betting on appreciation is a bet that could possibly fail, though probably unlikely.

FWIW, I'm hanging onto a home that used to be my primary residence, with a similar barely-break-even cash flow situation as you describe. Here in Northern Virginia, real estate remains expensive and this area continues to thrive and attract people, so I am confident it will continue to go up in value. Even small increases in appreciation result in gains that far outweigh gains I could make elsewhere, and each year I just re-evaluate how things look going forward. So far it's paid off -- I would really be kicking myself if I had sold it when I moved out, even though it was clearly not a winner from a cash flow perspective. I also like having this property for diversification of assets.

One last thing: If you are planning to buy your next house instead of rent, just keep in the back of your mind that lenders will include your rental home mortgage in your total debts, so you'll want to be able to demonstrate solid rental income to help offset that. It can make getting a new loan a little more difficult though, depending on your total debt to income ratio.

Johnny Aloha

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Re: seeking rental property evaluation advice
« Reply #9 on: April 15, 2014, 03:27:14 PM »
Be careful on assuming you can deduct the rental losses from earned income.  There are income limits, currently I think $150k for married filing jointly.  So if your income is over the limit, you will still carry the losses forward, but will not be able to actually use them until your income is below the limit.

arebelspy

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Re: seeking rental property evaluation advice
« Reply #10 on: April 15, 2014, 03:53:04 PM »
Just 3% compounding appreciation would bring you at least an additional $100k in about ten years, plus paying down your mortgage significantly, and likely higher rents along the way.

That may be true, but I probably wouldn't count on the first or third one.

Also something to keep in mind:  If the only reason to hold is speculation in appreciation, think about the appreciation.

In all likelihood, your house should appreciate around inflation rates.  I'm hoping you can find an investment where you don't have negative cash flow just to match inflation (i.e. 0% real return).  Now, you may do better than that, but one reason you might would be because of the leverage - you're seeing appreciation on the whole property even only having 44k equity.  But you can leverage other investments as well, including better real estate.

So don't confuse the appreciation for a good investment just because it's leveraged.
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sol

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Re: seeking rental property evaluation advice
« Reply #11 on: April 15, 2014, 11:57:02 PM »
Hilarity.  I can always count on you folks to explain to me why the apparent fantasy real estate deal is really a money pit.

Are you going to be managing it yourself?

That's the plan, yes.  We already manage one rental property, with minimal hassle.  We had three or four calls in the first six months, then nothing for the next three years.  Same tenant, pays on time, no vacancies.

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Maintenance (say, 3k/yr - it'll probably be more long term - the actual repair costs will only be a few hundred, but many multiples of that if and when tenants move and you have to pay for paint, carpet, etc. - turnover costs suck -- and when you count long term capital repairs like a roof, water heater, HVAC, etc.. it very well could average quite a bit more).

You always tell me that these maintenance costs are sky high but I'm just not seeing it.  This has been my personal family residence for the past five years and we haven't spent anywhere near that much money on it averaged over that time, even accounting for a bunch of ridiculous upgrades.  It will need a new roof eventually, for a few thousand dollars.  I can put in a delux new water heater for $500. 

Having lived here I feel like I have a pretty good feel for the condition of the place and its expected maintenance costs over the coming years.  I think $2k/year is more than enough.  You really think a well kept SFR will cost $10k for upkeep every five years?  Roofs and water heaters and furnaces should all last at least 15, and I think I could replace all three of those for $10k.

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A gain of 3192 on 44k equity is a 7% return.

If that's the worst case scenario using your doomy assumptions, I'll gladly take it.  My worst case scenario on my stock portfolio is minus 50%.

Here's an alternative scenario using my rose colored glasses:

The couple that just signed a 12 month least is active duty military and they want to stay for the next three years, the duration of their assignment here.  So best case scenario is that for the next three years I collect (12*(1900-1712)) 2256/year in up front positive cashflow and spend maybe 1k in maintenance while they contribute 4800/year in to my equity and I take tax deductions on the depreciation.  At the end of my three year least, I've collected 3768 in positive cashflow minus repairs, they've paid 14k into my equity, I've temporarily banked a few grand in tax deductions on the depreciation, and the market price of the house has appreciated 30k.  I then sell and realize approximately 100% return over 3 years on the 44k in equity I could get out today.

Hooray!  The unicorns won!

Reality is probably somewhere in between the two.  I'm fine with that too.

Oh, and the renters I just signed?  They want me to put in new carpet, at their expense.  I didn't argue. 

If I were in your shoes, I would definitely sell.  The only reason to keep the house would be to speculate on capital appreciation.

44k is not exactly an enormous chunk of our stash to be speculating with, and I think the value of this home in three years will be notably higher than it is today.

Tell you what, if I'm still here in three years I'll report back to this thread to let you know how it played out.

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One thing that hasn't been mentioned is that there are phase-outs for the deductibility of passive real estate losses for owners

Are those phase outs based on gross income including rents?  On MAGI?  We press our taxable income down pretty low by taking advantage of every form of tax deferral we can find.

Even if we have to carry the losses forward, that woudn't be the end of the world.  We're not hurting for cashflow so we can opt for the mathematically optimal long term play.  If it means losing money every month to make more money in the future, I'm down with that.

Love the wishful thinking ... "well it doesn't cash flow now, so let me look into the future via my crystal ball

Except it does cashflow now, technically.  Every property is cashflow negative if you assume 50% vacancy and crazy maintenance costs.   This is not one of those properties.

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I imagine - you're renting because it can't be sold today).

I think every property can be sold today, for the right price.  This one could comfortably be sold for 300k today, but I paid more than that for it five years ago and I expect it to be worth more than that next year.


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Tax breaks like depreciation are returned to the government upon sale ... silly to count those chickens.

Can someone explain to me how that works?  Are the taxes you pay upon sale independent of your other income?  How are RE capital gains taxed?  Is there an advantage to selling after we retire and have zero earned income?  Can I get me some of that juicy 0% LTCG rate action?

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This one is a major repair (roof, heating system .... ) or BAD tenant (3+ months no rent) away from being a real stinker.

A fair point from another pessimist.  But I do live here, and I'm pretty confident in the roof and heating system and such. 

Either seem like a better option than what you have now, especially since you can cash it out tax free.

My understanding of the 2 in 5 rule is that I can still sell the place without being taxed on the gains as long as I've lived in it 24 months in the past five years.  So I could sell it 2 years and 11 months from now and still qualify?

One last thing: If you are planning to buy your next house instead of rent, just keep in the back of your mind that lenders will include your rental home mortgage in your total debts

We were worried about that too, since we technically have mortgages on two homes already and are getting a third to buy the new place.  As it turns out, we managed a 15 year fixed term and still didn't have to include our rental income to meet the debt ratio requirements.  Score one for buying in moderation.

Thanks for the feedback, everyone.  We're renting it out for at least a year, then we'll see what's what at that point.  Even if we end up deeply in the red, it won't significantly affect our plans for early retirement.

arebelspy

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Re: seeking rental property evaluation advice
« Reply #12 on: April 16, 2014, 12:31:57 AM »
I can always count on you folks to explain to me why the apparent fantasy real estate deal is really a money pit.

This is your fantasy real estate deal?  You really need to look at some actual good rentals.

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Maintenance (say, 3k/yr - it'll probably be more long term - the actual repair costs will only be a few hundred, but many multiples of that if and when tenants move and you have to pay for paint, carpet, etc. - turnover costs suck -- and when you count long term capital repairs like a roof, water heater, HVAC, etc.. it very well could average quite a bit more).

You always tell me that these maintenance costs are sky high but I'm just not seeing it.  This has been my personal family residence for the past five years and we haven't spent anywhere near that much money on it averaged over that time, even accounting for a bunch of ridiculous upgrades.

That's because you live there, and weren't having to constantly touch it up when you moved out every year or two.  When tenants wreck your carpet, you have to pain the whole place, etc., you'll see those costs show up.

Now they may not for you.  One property over a short term can easily beat the average.  But long term it would catch up with you.


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A gain of 3192 on 44k equity is a 7% return.

If that's the worst case scenario using your doomy assumptions, I'll gladly take it.  My worst case scenario on my stock portfolio is minus 50%.

Here's an alternative scenario using my rose colored glasses:

The couple that just signed a 12 month least is active duty military and they want to stay for the next three years, the duration of their assignment here.  So best case scenario is that for the next three years I collect (12*(1900-1712)) 2256/year in up front positive cashflow and spend maybe 1k in maintenance while they contribute 4800/year in to my equity and I take tax deductions on the depreciation.  At the end of my three year least, I've collected 3768 in positive cashflow minus repairs, they've paid 14k into my equity, I've temporarily banked a few grand in tax deductions on the depreciation, and the market price of the house has appreciated 30k.  I then sell and realize approximately 100% return over 3 years on the 44k in equity I could get out today.

Hooray!  The unicorns won!

Reality is probably somewhere in between the two.  I'm fine with that too.

Yeah, that's not a worst case scenario.  I use realistic numbers, and (if anything) erred on the side of not including realistic expenses because I know you hate that.  I can imagine some much worse scenarios with tenants trashing the place.  Again, not likely, but possible.  The most likely scenario is much closer to what I posted than any perfect or doomsday scenario.

What flaws do you see in the numbers I posted?  You think you might get by with a little less maintenance?


Either seem like a better option than what you have now, especially since you can cash it out tax free.

My understanding of the 2 in 5 rule is that I can still sell the place without being taxed on the gains as long as I've lived in it 24 months in the past five years.  So I could sell it 2 years and 11 months from now and still qualify?

Your understanding is wrong.  It's prorated based on the amount of time you lived in it out of the past 5 years.  So if you sell in a year, you'll pay on 20% of the gains (1 out of the 5 years).. sell in 2 years, 11 months and you'll pay on 58% of the gains.

It seems to me that you're taking on a job that earns you a quite mediocre return which is based on speculation and leverage.  If you actually bothered to sell and redeploy that capital into better rentals you could make quite a bit more money.  I don't think you'll do terrible at this, but I think you could do much better, and I say that for the same reason I wouldn't advise someone to be in a fund with an ER of 2%.  They may well do fine in it, but they could do better.
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tryan

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Re: seeking rental property evaluation advice
« Reply #13 on: April 16, 2014, 07:40:32 AM »
Quote


Quote
I imagine - you're renting because it can't be sold today).

I think every property can be sold today, for the right price.  This one could comfortably be sold for 300k today, but I paid more than that for it five years ago and I expect it to be worth more than that next year.


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Tax breaks like depreciation are returned to the government upon sale ... silly to count those chickens.

Can someone explain to me how that works?  Are the taxes you pay upon sale independent of your other income?  How are RE capital gains taxed?  Is there an advantage to selling after we retire and have zero earned income?  Can I get me some of that juicy 0% LTCG rate action?

Obviously if you're facing a lost upon sale ... renting makes sense.  Just need to figure you might bleed slowly - some months - rather than bleeding alot all at once.

Depreciation is nothing more than an "interest free loan" ... you return it upon sale.  The 2 in 5 rule changed too (as stated above).

tryan

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Re: seeking rental property evaluation advice
« Reply #14 on: April 16, 2014, 08:03:41 AM »
Here's the IRS rules for selling your home:

http://www.irs.gov/taxtopics/tc701.html

Chiron

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Re: seeking rental property evaluation advice
« Reply #15 on: April 16, 2014, 08:33:19 AM »
44k is not exactly an enormous chunk of our stash to be speculating with, and I think the value of this home in three years will be notably higher than it is today.

Tell you what, if I'm still here in three years I'll report back to this thread to let you know how it played out.

If that's the case, then as I said, go for it, and recognize that you're taking $44k and gambling with it.  People here aren't trying to be pessimistic about it, but to bring some of your assumptions back to reality and point out some analytical flaws in your thinking. The numbers you gave on this rental fail basic rules of thumb for real estate investing.  That doesn't mean it shouldn't be done, but it does mean it requires closer scrutiny.

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Are those phase outs based on gross income including rents?  On MAGI?  We press our taxable income down pretty low by taking advantage of every form of tax deferral we can find.

Even if we have to carry the losses forward, that woudn't be the end of the world.  We're not hurting for cashflow so we can opt for the mathematically optimal long term play.  If it means losing money every month to make more money in the future, I'm down with that.

It's based on MAGI, which includes the NOI from the property.  See IRS Pub. 925 (http://www.irs.gov/pub/irs-pdf/p925.pdf).  Of course it may not be the "end of the world" if you have to carry forward losses.  But it does have an immediate negative impact on your cash flow by preventing you from taking losses against your income now, so it's a factor to account for.

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Can someone explain to me how that works?  Are the taxes you pay upon sale independent of your other income?  How are RE capital gains taxed?  Is there an advantage to selling after we retire and have zero earned income?  Can I get me some of that juicy 0% LTCG rate action?

In very general terms, any depreciation you take on a depreciable asset (like a building) must be recaptured when you sell that asset for an amount greater than your adjusted basis in the asset. 

The taxes you pay are capital gains.

sol

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Re: seeking rental property evaluation advice
« Reply #16 on: April 16, 2014, 04:18:27 PM »
In very general terms, any depreciation you take on a depreciable asset (like a building) must be recaptured when you sell that asset for an amount greater than your adjusted basis in the asset. 

The taxes you pay are capital gains.

Oh, I have so many questions...

Did you mean to say that the seller's profit is capital gains, and you'll pay capital gains taxes on them?

Are real estate capital gains taxed in the same way that stock capital gains are?  If so, I'd love to pay the currently applicable 0% LTCG rate on the appreciated value of a property after we retire and have zero income when selling a home.
 
What are the tax implications of consolidating real estate liabilities?  If I sell a property and realize a 100k gain, but then sink that 100k into paying off another mortgage, am I still taxed on the gain?

waltworks

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Re: seeking rental property evaluation advice
« Reply #17 on: April 16, 2014, 10:08:33 PM »
I think the way to think about the maintenance costs is this: NOTHING lasts forever. Not the floor, not the HVAC, not the roof, not even the foundation. Every bit of the house has a lifespan (some long, some short) and so while every house is a little different, 2 or 3% a year is reasonable - this is basically saying that if you did NOTHING for 50 years, you'd be left with a near-wreck of a structure with basically zero value - which is probably the case.

It's also a little different if you don't live there - when you're the occupant, that sticky lock on the back door or finnicky garbage disposal is no big deal and you can just live with it or fix at your leisure. Your tenants won't deal with those things and will make you fix them, if you are renting a nice place to high end tenants. Which means either arranging a time to get in, traveling to the house and fixing the problem yourself, or hiring a pro to do it - all more expensive than doing the equivalent work when you're bored with the tools you have 20 feet away in the garage.

The 1% and 50% rules exist because people who have lots of experience with rentals have settled on them. It's possible to make some money from appreciation, of course, but as others have already said, that's just gambling. The way to look at it is this: would you buy the house for the price you can sell it for to use as a rental? If the answer is no, you should sell.

-W

Chiron

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Re: seeking rental property evaluation advice
« Reply #18 on: April 17, 2014, 08:06:30 AM »
In very general terms, any depreciation you take on a depreciable asset (like a building) must be recaptured when you sell that asset for an amount greater than your adjusted basis in the asset. 

The taxes you pay are capital gains.

Oh, I have so many questions...

Did you mean to say that the seller's profit is capital gains, and you'll pay capital gains taxes on them?

Are real estate capital gains taxed in the same way that stock capital gains are?  If so, I'd love to pay the currently applicable 0% LTCG rate on the appreciated value of a property after we retire and have zero income when selling a home.
 
What are the tax implications of consolidating real estate liabilities?  If I sell a property and realize a 100k gain, but then sink that 100k into paying off another mortgage, am I still taxed on the gain?

The seller's "profit" is capital gains, if you mean that the profit is the sales price minus the original cost basis.  However, it gets complicated by depreciation and capital improvements.  That's why you have to keep track of all those things while you hold the property to determine your adjusted basis when you sell.  When you sell, you'll have an adjusted basis, and any gain over that adjusted basis will be taxed.  Some will be taxed at the LTCG rate if you held the property for over 1 year.  The portion that is depreciation recapture is subject to a different tax rate, which is currently 25%.

If you sold a property for a $100k gain, your tax treatment on that property would be subject to the analysis above.  If you sink $100k into the principal of another mortgage, that has no effect on the treatment of your sale.  However, if you take the gain and BUY a new property with it, it's possible you could qualify for a 1031 like-kind exchange, which allows you to further defer the gain.

PathtoFIRE

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Re: seeking rental property evaluation advice
« Reply #19 on: April 17, 2014, 08:15:27 AM »
Let me qualify what I'm about to say, and point out I am neither an expert nor someone who has ever sold a home that had nonqualified uses, and that before reading this thread, like Sol, I thought it didn't matter what you did with the house during up to 3 of the last 5 years as long as you lived in it for at least 2 years during that time. I see I was wrong, but went to the IRS publications to confirm and understand, and I found this:

http://www.irs.gov/publications/p523/ar02.html#en_US_2013_publink1000240774
"Nonqualified Use
Gain from the sale or exchange of the main home is not excludable from income if it is allocable to periods of nonqualified use. Nonqualified use means any period after 2008 where neither you nor your spouse (or your former spouse) used the property as a main home, with certain exceptions (see next).
Exceptions.   A period of nonqualified use does not include:
Any portion of the 5-year period ending on the date of the sale or exchange after the last date you (or your spouse) use the property as a main home;
"


Then 2 examples are given, one in which the owner moves back into the home after renting, and receives a prorated exclusion, and one in which the owner qualifies for owning and use, then rents it out, sells it without moving back in, and receives the entire exclusion (minus claimed depreciation). So as long as Sol sold the house before 3 years after starting to rent it without moving back, he would get the full exclusion (minus claimed depreciation). If it's been longer than 3 years or he moves back in after a year or two of renting, then he would need to "restart" the 5 year clock from that date to qualify for the full exclusion apparently.

Am I understanding this right?

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Re: seeking rental property evaluation advice
« Reply #20 on: April 17, 2014, 09:48:09 AM »
Wow, that does indeed appear to be right.  Maybe to not penalize those who were forced to rent out their (underwater) homes over the last few years?

EDIT: That's a really good find Jason.  That's exactly how I read it.  Don't move back in, and as long as you lived in it two and rented it less than 3, you can exclude the gain like normal, except you'll pay on the depreciation you took (or were supposed to take) during those years you rented it.  Thanks for the info!
« Last Edit: April 17, 2014, 09:52:03 AM by arebelspy »
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Re: seeking rental property evaluation advice
« Reply #21 on: April 19, 2014, 08:56:53 PM »
This is really helpful. Unlike sol, I am renting my condo not to make money but to pay down the underwater mortgage. Moved in with my now-husband in 2012. Condo mortgage is $150k, purchased in 2006 for $175k. Value in 2012 when I put it "in service" as a rental was $70k, and I have taken depreciation based on that value. Value has since risen to about $85k. If I rent for longer than 3 years, do I pay capital gains on any increase above $70k? Or just pay back the depreciation? Since it's below the purchase price, is there any other way around this?

Sol - sorry to add to the doom and gloom but I have found expenses have gone up from when I lived there. I hope it works out better for you.

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Re: seeking rental property evaluation advice
« Reply #22 on: April 20, 2014, 10:54:46 AM »
Hilarity.  I can always count on you folks to explain to me why the apparent fantasy real estate deal is really a money pit.


Hey I didn't quote any doom and gloom, I said if you think your property will increase in value to hang onto it!

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Re: seeking rental property evaluation advice
« Reply #23 on: April 20, 2014, 01:43:06 PM »
None of us did, Sol just has his own way to do things.  That's okay.  :)
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sol

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Re: seeking rental property evaluation advice
« Reply #24 on: April 20, 2014, 05:12:26 PM »
This is your fantasy real estate deal?  You really need to look at some actual good rentals.

I meant fantasy in the sense of "too good to be true" rather than "what I wet dream about" but I see your point.  I think I'm in the wrong market to find good rentals locally.

Quote
I can imagine some much worse scenarios with tenants trashing the place.  Again, not likely, but possible. 

I can imagine a worse case scenario on almost any investment where I lose my shirt.  The market could crash or my rental could burn down.  I'd rather have a few eggs in each basket, I think.

Quote
What flaws do you see in the numbers I posted?  You think you might get by with a little less maintenance?

I think maintenance will be closer to the ~2k/year average I'll be collecting in positive cashflow if it stays rented.  Given how much interest we got on this place, I'm guessing we could turn it around in less than two weeks even if had to recarpet and repaint.

We just signed a one year lease to people who told us they want to stay for three years, so I expect to be rented for more than an average of 11 months per year.

Even if the property doesn't appreciate at ALL, if it stays rented for duration of the one year lease then the renters will have paid in 4800 to our equity, that's over a 10% return all by itself without even getting into the taxes.  And I expect it will appreciate at the inflation rate or better, around here.  If it goes up 3% we make another 9k in equity, if it goes up by (the zillow forecasted 5.5%) then we make another 16.5k.  That's all just gravy.  Speculative gravy.

If you actually bothered to sell and redeploy that capital into better rentals you could make quite a bit more money.  I don't think you'll do terrible at this, but I think you could do much better

Isn't the process of selling and then finding another rental investment also kind of a job?  Part of the attraction here is that I'm looking at very mediocre returns for very little work, since we already own it.  And paying $30k in transactions costs to unload it doesn't really sound appealing right now.

Obviously if you're facing a lost upon sale ... renting makes sense.

Is it really obvious?  Part of the reason I was doing this math on 44k of equity was becasue that's what we could cash out of it after costs.  Hell, I put $63k down on the day I bought it, and I've been making payments for for five years now so I've got WAY more than 44k in sunk costs.  Does that past loss really have any bearing on the rent vs sell decision today?

I'm trying to think of it like a losing stock.  After it has lost value on paper, do you sell and lock in those losses, or hold and hope for recovery?  In some cases, selling the losers is the best thing to do.

The numbers you gave on this rental fail basic rules of thumb for real estate investing.  That doesn't mean it shouldn't be done, but it does mean it requires closer scrutiny.

Yea, I get that.  I don't think anyone chooses 300k homes in nice neighborhoods as ideal rental investment properties.  Very few places command 3k/mo or more in rent for 3br/2ba homes.

I think the way to think about the maintenance costs is this: NOTHING lasts forever. Not the floor, not the HVAC, not the roof, not even the foundation. Every bit of the house has a lifespan (some long, some short)

This helps, thanks.  Looking at it this way, it seems like regular ongoing maintenance is minimal, but major repairs are to be expected every decade or so.  It's still hard for me to see spending more than 90k on repairs every decade (3% of 300k time ten).  3% is probably a lot more reasonable on cheaper properties.  90k would just about pay to remodel this house from the studs out, and it shouldn't need that every 10 years.

Hey I didn't quote any doom and gloom, I said if you think your property will increase in value to hang onto it!

Yes, and I appreciate your singular ray of light and bask in the warm confirmation bias it provides.  Thanks.

Chiron

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Re: seeking rental property evaluation advice
« Reply #25 on: April 20, 2014, 08:35:06 PM »
This is really helpful. Unlike sol, I am renting my condo not to make money but to pay down the underwater mortgage. Moved in with my now-husband in 2012. Condo mortgage is $150k, purchased in 2006 for $175k. Value in 2012 when I put it "in service" as a rental was $70k, and I have taken depreciation based on that value. Value has since risen to about $85k. If I rent for longer than 3 years, do I pay capital gains on any increase above $70k? Or just pay back the depreciation? Since it's below the purchase price, is there any other way around this?

Sol - sorry to add to the doom and gloom but I have found expenses have gone up from when I lived there. I hope it works out better for you.

I don't think you will pay any capital gains.  The depreciation will get recaptured, but without a large appreciation in value, you will still be at a loss over your original basis.  You will most likely have a capital loss.

minougray

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Re: seeking rental property evaluation advice
« Reply #26 on: April 21, 2014, 07:50:50 PM »
This is really helpful. Unlike sol, I am renting my condo not to make money but to pay down the underwater mortgage. Moved in with my now-husband in 2012. Condo mortgage is $150k, purchased in 2006 for $175k. Value in 2012 when I put it "in service" as a rental was $70k, and I have taken depreciation based on that value. Value has since risen to about $85k. If I rent for longer than 3 years, do I pay capital gains on any increase above $70k? Or just pay back the depreciation? Since it's below the purchase price, is there any other way around this?

Sol - sorry to add to the doom and gloom but I have found expenses have gone up from when I lived there. I hope it works out better for you.

I don't think you will pay any capital gains.  The depreciation will get recaptured, but without a large appreciation in value, you will still be at a loss over your original basis.  You will most likely have a capital loss.

Thanks! That's one less worry about this rental. And if by some miracle I get back to my original basis, I'd be thrilled!

sol

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Re: seeking rental property evaluation advice
« Reply #27 on: May 02, 2014, 10:04:08 AM »
Tell you what, if I'm still here in three years I'll report back to this thread to let you know how it played out.

Checking back in ahead of schedule to say that I checked the zillow estimates on this property yesterday.  They think it has appreciated $18k in the past 30 days.

First reaction:  wahoo, we're rich!  Holding on to that place was totally the right choice, look at that appreciation!

Second reaction:  there's no way in hell, this zillow value estimate thing is totally bogus.

Third reaction:  if that WERE right, then we just made a 40% ROE in 30 days and should sell immediately.  Maybe renting it out was the wrong choice?

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Re: seeking rental property evaluation advice
« Reply #28 on: May 02, 2014, 10:13:34 AM »
Tell you what, if I'm still here in three years I'll report back to this thread to let you know how it played out.

Checking back in ahead of schedule to say that I checked the zillow estimates on this property yesterday.  They think it has appreciated $18k in the past 30 days.

First reaction:  wahoo, we're rich!  Holding on to that place was totally the right choice, look at that appreciation!

Second reaction:  there's no way in hell, this zillow value estimate thing is totally bogus.

Third reaction:  if that WERE right, then we just made a 40% ROE in 30 days and should sell immediately.  Maybe renting it out was the wrong choice?

Zillow is often bogus. but that's quite a jump.

Do assessments on your homes value periodically based on:

1) similar homes sale prices in the area (only SOLD deals!!!)
2) similar capitalization rates for homes rented in the area (10k in net income on a home that's worth 100k would be a 10% cap rate) make buddies with some land lords in the area to find out? See if your cap rate for the value of your home is coming in lower or higher, or get a feeling for what your home is "worth" in a renter's market
3) What the house is worth to you SOLD VS generating cash flow (opportunity cost)

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Re: seeking rental property evaluation advice
« Reply #29 on: May 02, 2014, 10:38:42 AM »
It's quite common for Zillow to have huge jumps up or down for an individual property - because the algorithm relies entirely on publicly available (ie square footage, location, $ sold, year built, etc) information. Zillow does not have information about the condition of the property or the desireability of a specific lot/house and it can't distinguish arms-length deals from parents selling their old house to their kid - so if a totally trashed house in your neighborhood with similar square footage sells, it'll drop the "value" of your nicely appointed place, and likewise if a super pimped out small house sells, it'll bump up you up.

The problem is exacerbated by (in most US markets) the current low inventory environment where the outliers aren't canceling each other out as well.

Our house went from $580k to $520k and back in ~30 days on Zillow once. Funny stuff since it had to be appraised (long story) twice during that time period and was $565k both times.

-W

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Re: seeking rental property evaluation advice
« Reply #30 on: May 07, 2014, 10:44:40 AM »
From Arebelspy:
"There will be transaction costs, of course, but even with those factored in, I think moving the money to a better investment you'll come out ahead (just like those people who have whole life and have to take a big hit to get the cash out value and move it to low cost index funds will often come out ahead by doing so)."
Thanks Arebelspy for the kick in the pants. I have a whole life policy that I need to cash out despite the large hit I'll take. The expenses are just too high, and though the penalty to close the account will disappear after 8 years, I'm not sure that it would be a good idea to wait that long.

arebelspy

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Re: seeking rental property evaluation advice
« Reply #31 on: May 07, 2014, 10:53:01 AM »
From Arebelspy:
"There will be transaction costs, of course, but even with those factored in, I think moving the money to a better investment you'll come out ahead (just like those people who have whole life and have to take a big hit to get the cash out value and move it to low cost index funds will often come out ahead by doing so)."
Thanks Arebelspy for the kick in the pants. I have a whole life policy that I need to cash out despite the large hit I'll take. The expenses are just too high, and though the penalty to close the account will disappear after 8 years, I'm not sure that it would be a good idea to wait that long.

Sure!  Start a thread with details if you'd like people's advice/thoughts to be sure.  It is not always the case, but often all those fees you've paid are sunk costs, and going forward 8 more years puts you even more behind.
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Re: seeking rental property evaluation advice
« Reply #32 on: May 10, 2014, 09:58:42 AM »
Thanks for the advice Arebelspy. I gathered all the information and started a thread in the investing sub forum. Sometimes I think there should be a section for "stupid things to avoid-learn from others mistakes, you can't make them all in one lifetime".

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Re: seeking rental property evaluation advice
« Reply #33 on: May 12, 2014, 10:52:33 AM »

The way to look at it is this: would you buy the house for the price you can sell it for to use as a rental? If the answer is no, you should sell.


Perfectly said. To me, the evaluation of whether to keep a primary residence as a rental after you move is nothing more than a sunk-cost analysis. Would you re-purchase the property for the prospective selling price to use as a rental? If not, sell the house. If so, and you have the stomach/desire to be a landlord, then keep it.  The fact that the house is already in your possession should have no bearing on your decision.

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Re: seeking rental property evaluation advice
« Reply #34 on: May 12, 2014, 11:10:07 AM »

The way to look at it is this: would you buy the house for the price you can sell it for to use as a rental? If the answer is no, you should sell.


Perfectly said. To me, the evaluation of whether to keep a primary residence as a rental after you move is nothing more than a sunk-cost analysis. Would you re-purchase the property for the prospective selling price to use as a rental? If not, sell the house. If so, and you have the stomach/desire to be a landlord, then keep it.  The fact that the house is already in your possession should have no bearing on your decision.

No, you forgot about effort, risk and transaction costs. 

Every time you buy you need to spend a lot of time searching for and evaluating deals.

Every time you buy and sell it costs money whether in property transfer taxes or real estate fees.

Here Sol has a known quantity.  His repair/maintenance costs are likely accurate as he lived in the house previously. 

His returns and overall value on the home could likely be improved if he could suite it and rent the suite as well, but maybe the deal is good enough to hang on to given that it is cash flow positive and minimal effort with a good chance of appreciation on leveraged capital.

There are other places that could be better deals, but knowing a market and area really well brings some peace of mind too.

arebelspy

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Re: seeking rental property evaluation advice
« Reply #35 on: May 12, 2014, 01:06:24 PM »

The way to look at it is this: would you buy the house for the price you can sell it for to use as a rental? If the answer is no, you should sell.


Perfectly said. To me, the evaluation of whether to keep a primary residence as a rental after you move is nothing more than a sunk-cost analysis. Would you re-purchase the property for the prospective selling price to use as a rental? If not, sell the house. If so, and you have the stomach/desire to be a landlord, then keep it.  The fact that the house is already in your possession should have no bearing on your decision.

No, you forgot about effort, risk and transaction costs. 

Right.  And why wouldn't someone take those into account when doing the calculation of "would you buy it as a rental?"

I don't think anyone forgot those.

There are other places that could be better deals, but knowing a market and area really well brings some peace of mind too.

Sure.  Yet the question remains: in this market and area you know well, with this known quantity of a rental, would you buy it?

In other words, let's say it was taken from you, forcibly sold, and you were given the proceeds (which takes into account transaction costs).  You then have the opportunity to buy it just by saying "yes" (no effort, same as holding). Would you do it?
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ibleedirish

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Re: seeking rental property evaluation advice
« Reply #36 on: May 12, 2014, 02:49:25 PM »
Uh, no, I didn't forget those things at all. Clearly those need to be considered when contemplating the purchase of a rental property. Thats precisely the point of doing the sunk cost analysis in the first place. Knowing all expenses involved, including time, would you re-purchase the property for the sole purpose of renting it out? If not, cut bait, take your profits and find a deal that works.

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Re: seeking rental property evaluation advice
« Reply #37 on: May 12, 2014, 10:17:58 PM »

In other words, let's say it was taken from you, forcibly sold, and you were given the proceeds (which takes into account transaction costs).  You then have the opportunity to buy it just by saying "yes" (no effort, same as holding). Would you do it?

Maybe we are talking about the same thing overall, but it is not clear to me. 

The critical question for me is not whether you would buy the property for the sole purpose of renting it out if you were forced to sell today and had to pay the transaction costs. 

The question for me is whether the doubling of the transaction costs and efforts makes financial and life energy sense under all the circumstances.

Where I live, transaction costs average $30,000 when you factor home inspection, real estate fees and property transfer taxes.  This is not a sunk cost, but a potentially unnecessary and costly repeating of transaction costs that needs to be a line item when analyzing the expected ROI with keeping or selling - along with other factors like any mortgage rate differences or other mortgage consequences.  In Canada there is a fairly hefty penalty for breaking a fixed mortgage.

I would tend to keep a property that was cash flow positive, was in excellent condition and that I knew had a good prospect of appreciation even if I could get somewhat higher ROI on another property. 

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Re: seeking rental property evaluation advice
« Reply #38 on: May 18, 2014, 06:23:24 PM »
 Tad late to this but I agree with the rebel spy above. Passive losses on RE phase out at AGI of $165,000. I would most likely sell before you lose the personal residence gain exclusion. Also, watch the recapture of depreciation. If that will slaughter you when holding long term, sell on a 1031 exchange, roll the gain into your next rental.

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Re: seeking rental property evaluation advice
« Reply #39 on: February 12, 2015, 12:45:06 PM »
Hey Sol, any updates on this? Is this still working well for you as an investment?

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Re: seeking rental property evaluation advice
« Reply #40 on: February 12, 2015, 08:13:03 PM »
Hey Sol, any updates on this? Is this still working well for you as an investment?

I haven't reviewed the numbers recently, but we haven't had any problems.

We easily rented it for the targeted $1900/mo to two military professionals who make more than we do, and they claim they want to stay for the duration of their 3 year posting here so I may end up with no vacancy until then.  They pay by automated bank transfer every month.  We manage it ourselves but there haven't been any maintenance issues in the 9 months it's been rented.

So in 9 months, they've paid me $1692 in cash profit and have paid $3506 towards the principal of my mortgage.  There are additional tax savings but even neglecting those I've already made about 11% on my extractable equity of $44k.  By comparison, if I had sold and bought an index fund last May I'd be up 9.8%.

Capital appreciation is hard to gauge after only 9 months because the market is seasonally cyclical, with winter comps going for less than summer comps.  If it manages to appreciate at the historical average 3%, we'll do well just because of the leverage inherent in the mortgage.  Like a 3% price increase would raise the selling price from 300k to 309k, a 20% annual return on our $44k of extractable equity.

That number is sort of artificially inflated, though, because that 44k number is the result of price declines after I bought eating into my equity.  It's the right value to use for this comparison because that's what I could sell for now, but it's not what I paid originally.

I know the maintenance costs will catch up with me eventually, but so far so good.  I lived there long enough to have a pretty good feel for maintenance status and I don't expect any major expenses before our planned exit date of 2019.

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Re: seeking rental property evaluation advice
« Reply #41 on: February 13, 2015, 01:26:16 PM »
Glad to hear it's going so well!

Long term, good tenants are key to making money - if you avoid vacancy and move in/out get ready costs, you'll avoid a lot of the maintenance stuff. Sounds like you have a good handle on that.
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