The Reverse Rent vs. Buy Question

[Snowboard junkie]

Situation: 33 and single.  Own a small house.  No renters, but I could have (and have had) a roomate paying 700 / month without difficulty, I could fit a third person in but it would be very cramped and I currently have a home office in the 3rd bedroom.

Purchased for 210k in 2003.  Initially mortgage financed.  Now paid off.  Spent between 25-30k renovating in stages.

2 houses nearby for sale presently (asking $319k and $329k respectively)  Mine is slightly smaller, but apparently would sell for the low 300's.

Rental house 3 blocks away - slightly larger than mine, having a very tempting double garage (kidding).  asking 2100/month

So the basic question is: Would you SELL a house for $310k if you could equivalently rent for $25k per year? 

FYI This is not a hypothetical, but it is somewhat neat in that it works out to an 8% effective return on investment, whereas the conventional early retirment formulas (I believe) assume an average 7% return on equity investment before inflation.  Nonetheless, my home clearly does not meet the 1%/month rental property criteria. 

[tooqk4u22]

That is not an 8% effective return as you have not factored in taxes, maintenance, repairs, vacancy, management, etc - it is probably a 4-5% effective return.

[Snowboard junkie]

When calculating this kind of thing over time, do you base your effective yield on your initial investment (in this case 210k) or on current value (lets call that 310k)?

When I had a roomate at 700/month, I would cover my costs (taxes, maintenance, vacancy) easily.  After the mortgage was paid off, I chose to have my own space.  (I have a home office which I work out of frequently and I am self employed, so having someone else around is a bit of a hassle sometimes)

If this was strictly a rental property I would ask $2100/month, and (1%) and the costs (taxes, maintenance, vacancy) would be covered out of this 1% (as I understand the rule - but please clarify if I am misinterpreting this)

The question is essentially whether to capitalize on a local market runup before interest rates go up and nobody wants to buy anymore.  The math to purchase was made very simply in 2003 in that rents were around 1800 for an equivalent property at the time and I sublet 2 rooms for 600 each.  (I did not know about the 1% rule at the time).  At this point I probably would not buy if I was entering the market for the first time since property values have risen 3 times faster than rent. 

The broader question then is: If all real estate is an investment (including one's primary residence), what are your criteria for determining when it is time to sell profitably? 

[Mike]

Just look at it in terms of cash flow and account for the expenses via the 50% rule.  In your case, you're really just deciding what you want to do with $300,000 - keep it tied up in a house that pays you interest via rent or cash out and invest it elsewhere.  Since half of that $25k will go to expenses of owning the property as a rental, your real cash flow will be around $12,500 per year - right around 4% of that $300,000 selling price.

You can do much better than that in the stock market.  On average, you can probably match or exceed that in the bond market as well.  And of course, you can do better than that simply by buying a different rental property.

[tooqk4u22]

When calculating this kind of thing over time, do you base your effective yield on your initial investment (in this case 210k) or on current value (lets call that 310k)?

The broader question then is: If all real estate is an investment (including one's primary residence), what are your criteria for determining when it is time to sell profitably?

I think these two questions go together.  Lets say you have a 7% return on you the $210k cost but that would only be a 4.7% return on value but have an imbedded $100k gain or 47%.  Every time you don't sell you are making a decision to buy and whether or not you are satisfied with the investment vs alternatives. Although taxes need to be factored too. 

[arebelspy]

I'd sell and rent.  Assuming the future is like the past, you'll come out ahead renting and redeploying that equity into better investments.

That is the logical, mathematical answer.

The actual answer then gets clouded with emotion (the feeling of owning is very different than renting, for most people).  How you feel about it will dictate what is best for you, none of us here can say what that is.

[Daleth]

Just look at it in terms of cash flow and account for the expenses via the 50% rule.  In your case, you're really just deciding what you want to do with $300,000 - keep it tied up in a house that pays you interest via rent or cash out and invest it elsewhere. 

And the options here are not just "keep or sell." If the house is paid off, Snowboard could, assuming he has good credit, VERY EASILY get a low-interest (<4%), low or no closing cost home equity line of credit and use that as the down payment on an investment property (Snowboard will need 20% of the investment property's purchase price as a down payment, and will also need another several grand for closing costs). Since Snowboard has no mortgage payment, assuming he has a decent job or good self-employment income, he should have no problem whatsoever meeting the lender's debt-to-income ratio in order to get a mortgage for the new house.

Then use the rent payments to pay down the new house's mortgage and, if the interest starts going up, the HELOC that he took out for the down payment.

As long as there's a house for sale that meets the 1% rule (could rent it for 1% or more of the purchase price), and he gets a fixed-interest mortgage on the investment property, Snowboard is then golden: he's got a house in which he can rent a room for $700, and a rental property that he can rent for (insert number here, but given today's low interest rates it will be noticeably more than the mortgage payment on that rental property), so someone else--namely, his renters--can buy him a house. Now he has two houses, one of which ends up being effectively free, since the renters buy it for him.

[zinethstache]

Since the home has no mortgage, the HELOC could be used for multiple investments. If you is a handy DIY type person, then a couple of rentals at the 1% rule could be a great income (not so passive if you're doing all the work) However not wanting all eggs in one basket, you could buy a multi-unit rental, perhaps a duplex. Then perhaps invest the difference, if/for as long as the interest rates make sense. You could even consider hard money lending with some of that HELOC? I would even say because of being self employed (you mention the annoyance of renting a room there), perhaps with the multi unit, you could get more by renting the SFH out, move into 1/2 of a duplex and rent the other half out. Heck, then you could still decide to rent a room if its a 3 bedroom. There's of course some balance needed in all this, lots of great options in your position:)

[Snowboard junkie]

Thanks for the input everyone.  I worked it out, felt it was best to sell mathematically, and then despite that stayed where I am.  Rebel Spy, you are a wise man.

Ironically, I came back to a series of posts about downsizing to a smaller home which I will definitely have to consider.

To address the ideas raised:

I would love to find a real estate investment that follows the 1% rule, but in my local market I have not seen any for years.  I have looked for duplexes and multi-unit properties but if and when they came on the market they were snapped up before I even heard about them, or were ridiculously priced and my "lowball" offers got refused. 

Where do you find these properties?  I just read the recent post about how to buy a house and I have also felt the pain of losing out on a great deal by a few hours.  Perhaps one day I will find one of these mythical underpriced properties that pay for themselves and when I do I will keep my unicorn there in the backyard...

re: fixing up a rental place myself

Perhaps the younger me could have managed it, but right now one business keeps me fully occupied.  I would never get things done in a reasonable timeframe on my own, so I would have to pay someone for every little thing, which is not likely to be worthwhile.  A multi-unit rental would be more worthwhile, because I could then use my existing staff or hire additional staff to deal with those problems.  (Oversimplifying and setting aside potential issues about getting into unfamiliar business territory)

Definitely an option for those that are working jobs or working on a consulting basis though, and probably an option for after I "retire". 

re: financing of real estate purchases

I find it a bit difficult to amortize big ticket investments such as real estate or major equipment because in my experience business profits are volatile.  In the last 5 years, my corporate self has ranged between +400k & -160k annually.  The best approach I have is to control my personal expenses in good times and bad, hence the reason I check out this blog.  So practically speaking for real estate I now pay cash or don't buy.

I have used the HELOC to cover salaries and overhead in down years, and I can state that it will probably never be used again because:
a. I value sound sleep.
b. Using your HELOC to fund your business while you're losing money is a hair on fire kind of emergency.

Specifically regarding using mortgage or HELOC financing:

I don't think I would qualify for a useful mortgage, because I draw a minimal salary from the business and therefore on paper I look like I can't afford much.  I can borrow at 3.59%, but I max out on the total amount at just under 120k based on debt service ratios and my official income.  Ironically, I am better positioned to pay back a mortgage now than when I first bought the house.  This may be an issue for others on this site that decide to move or want to finance an investment property though.

I could issue myself a dividend whenever I need money, but:
a. it pulls capital from the business.
b. taxation issues arise.
c. there is no point since thanks to MMM I don't need a huge salary to live well.

as an aside/FYI: Unsecured business credit is tighter than ever right now.  I can currently borrow up to 700k at 8.59% on the corporate account which would be utterly ridiculous if I actually used it.   (This is one reason why people use lending tree, prosper, etc., or even hard money lenders)

[arebelspy]

Thanks for the input everyone.  I worked it out, felt it was best to sell mathematically, and then despite that stayed where I am. 

Perfect.  That's the ideal way to do it: work it through logically, decide what will make you happiest/let you sleep at night, and make your decision.  It has to be something you can live with, without regrets.

Too many people go one way or the other (logic - and then regret it emotionally - or emotional - and never even work out the logic/numbers and do an inferior plan for lack of reflection), glad you were able to find a balance.

As far as finding properties that fit a 1% rule (or hopefully better) - first target a market (and not necessarily a market where there are a ton of those, but a market you'd like to invest in, based on the criteria that you decide).  Starting with a property is doing it backwards.