As you might recall from our Q1 financial update, we are under contract on a new house. While we are still early in the process, we now have the inspection results back and learned that the house appraised for the total value on our offer. While nothing is guaranteed until closing, these two pieces of information make the transaction more likely to occur. As such, it is time to seriously consider what to do with the house we currently live in. Should I sell it or should I rent it out?
We bought this house in the fall of 2016. I have written extensively about purchasing this home, and did a review after living here for 2 years. You can get a lot of details in both of those posts. Otherwise here is the TLDR:
- Bought the house for $174,000 in 2016.
- Have put about $4,000 into it. $3,000 for replacing the upstairs carpet with luxury vinyl plank flooring, and the rest for smaller repairs and improvements.
- Maintenance costs have been lower than expected since this is a relatively new (2007) townhome and I estimated conservatively.
- The house has appreciated a lot more than we expected. When I wrote the 2-year update in February 2019, the estimated value was $213,000. Now in June of 2021, it’s somewhere around $275,000.
How Would Our Current House Perform as a Rental?
One of the best metrics to evaluate a rental for its potential is to calculate the property’s capitalization rate (AKA cap rate). The cap rate measures the net operating income of the property compared to the property’s cost. The cap rate ignores financing and appreciation so it’s a good measure of a property’s unlevered cashflow. In other words, it is analogous to a stock’s dividend. Here are the base, best case, and worst case cap rates I calculated for our current house.
As you can see, the expected “dividend” from renting out our house is 4.89%. To put this in context, we can look to seasoned landlords who usually aim for a 6% cap rate of higher when looking at properties. Like most things in finance, you have to consider risk when evaluating cap rates. I could buy a property for $30-50K in a very rough neighborhood and possibly get double-digit cap rates. Given that our current house is in a good neighborhood, it’s relatively new (built 2007), and in pretty good condition, the expected cap rate seems very reasonable.
Cashflow and Cash on Cash Return
Another way to evaluate a rental property is through its cashflow. Like most financial metrics, cashflow alone can be misleading. I could easily refinance this property into a 30-year mortgage and get it to be cashflow positive. This is one of the things I like about cap rate. It gives no room for talking yourself into a mediocre rental by making it look OK via leverage. Also, cashflow is only one of the 4 ways in which rental real estate could give you economic benefits. The other three are: mortgage principal paydown, appreciation, and tax advantages. With that, let’s look our expected cashflow and cash on cash returns for our current house.
As you can see, cashflow on the base scenario is slightly negative. Basically, cashflow is expected to be neutral on most months and then negative on months on which there are repairs on capital expenditures. From this metric alone, this house looks like a terrible rental. But as mentioned above, looking at only one metric alone can be misleading. Cashflow is not great for this house because we have a 15-year mortgage, and therefore, a higher monthly payment than we would if we had a 30-year mortgage. This is OK because:
- When the mortgage is paid off (in about 6 years assuming minimum payments only) the house will cashflow around $725 per month (net operating income from cap rate table).
- We can make the negative cashflow work since we have a high savings rate. While cashflow may not be a good metric by itself it is an important one to be aware of. If we lived paycheck to paycheck, this negative cashflow could get us into financial trouble.
- Since this is a 15-year mortgage on which we have made additional payments every month, most of our mortgage payments go towards principal at this point. So even if cashflow is neutral or negative, we are ultimately getting a significant economic benefit with each mortgage payment. This is a good segue onto the next metric.
Return on Investment (ROI)
Return on investment (ROI) does a better job accounting for overall economic benefit since it accounts for leverage (something cap rate doesn’t do), and for other return drivers such as appreciation and mortgage principal paydown (something cash-on-cash doesn’t do).
As you can see the main differences from cash-to-cash to ROI is that here we have mortgage principal paydown and appreciation contributing to the overall return. From every $901 mortgage payment, $760 goes towards the principal (aka home equity), and the remaining $141 goes towards interest. Only the interest piece is a true economic expense.
Lastly, we have to factor in appreciation as well. While real estate around most of the U.S. has appreciated very rapidly in recent years, over the long term real estate has more or less kept up pace with inflation. That’s why I’m using 3% on the base case.
Accounting for all of this, I can expect a 9.02% return on my investment (initial down payment + initial repairs + mortgage paydown over the last 4.5 years). For context, the U.S. stock market has returned about 10% per year on average over the last century or so. Looking at it from a dollars and cents perspective, we expect that keeping this house as a rental will make us $10,504 wealthier per year.
What About Selling?
The rental numbers above are only meaningful in comparison to something else. In this case, that something else is selling the house and investing the proceeds (most likely in the stock/bond markets). We have been very fortunate to see this house appreciate far beyond our expectations. I guess that’s one nice thing about conservative expectations and some luck with the timing of our purchase 😊.
We currently have a soft offer on our house for $288,000 minus repairs. An inspector is coming in a few days to estimate what those repairs might be, so I’m not totally sure what to expect. For now, I have prepared 3 scenarios. The base and best case both start with the $288,000. And the worst case, in which proceeds are closer to what I thought the value of house was based on recent sales in the neighborhood.
Two of the most important assumptions here are: what rate of return to expect on the invested proceeds, and how much of the proceeds we’ll need for personal stuff. This is highly dependent on how much repairs the seller of the new house is willing to pay for and how much we’ll pay for ourselves. With all of that in mind, it looks like selling the house on the base scenario and investing all but $15K of the proceeds will make us $13,135 wealthier per year. This is $2,630 better than keeping it as a rental.
There are several assumptions on both the rental case and the selling case. I have tried to estimate conservatively on both places, but the end result will highly depend on how things actually play out. While selling looks a little better, it is very close to call definitively. So, it might ultimately come down to qualitative factors. We’ll also have better information to plug into the tables soon as:
- We hear back from the seller of the new house regarding repairs
- We hear from the person that is coming to take a look at our current house.
As seen above, selling the house appears to be a bit better, but too close to make it an easy decision. So let’s look at non-financial factors.
In favor of renting the house:
- Diversification – we already have a substantial portfolio of stocks and bonds. Having a rental property in the mix might provide us with returns that are not totally correlated to the financial markets. Though depending on the particulars of the next crisis, housing and stocks could both get hit at the same time (think 2008-2009).
- Learning something new – I have toyed with the idea of owning rental real estate for some time now. I have research the topic in depth and even made a couple of low-ball offers on rental properties. After the offers didn’t get accepted, I ultimately concluded that it was too much work for not that much extra return (compared to the stock market). While my thoughts are still the same, renting a property you already own and know is a lot less work (and risk) than going through the process of finding and buying a new property. Also, I might learn new things in the process (both about myself and about rental properties).
- Cashflow – the property would currently have a small negative cashflow, but this will dramatically change in 6 years (or sooner if we make extra principal payments) when the mortgage is paid off. While the 4% rule is very robust, it would still be nice to have the rental cashflow in addition to selling off our index funds to fund our retirement.
In favor of selling the house:
- Simplicity – index funds are very much hands off investments. You just buy them and then collect dividends and enjoy appreciation over the long-term. You don’t need to be on top of the index funds to pay you rent, and they certainly won’t call you in the middle of the night asking you to fix the toilet. We still work full time and have 2 small kids, so simplicity is something we definitely appreciate. That being said, when we no longer work full-time maybe looking after a rental property won’t necessarily be a bad thing.
- Risk – any investment carries some level of risk, but the chance of your index funds suing you over some nonsense, or trashing your property is zero. While many of these risks unique to rental investors can be reduced (proper tenant screening, appropriate insurance, setting up an LLC, etc.), they cannot be eliminated.
I was hoping that writing a detail post of what to do with our current home when/if we move would give me a clear answer. Well, it hasn’t 😁.
It has still been a useful exercise and has helped me realize that both options are good and we’ll probably be OK either way. It was also helpful to set up the spreadsheet so that when we get more information over the next couple of weeks we can update our data and see how things change.
What would you you do if you were in our shoes?