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Real estate is inherently an inefficient market. Homeowners in the Washington area, however, are lucky to live in one of the most efficient real estate markets in the country. In other words, a new listing in our area gets a lot of eyeballs.
Good opportunities get snatched up quickly, challenged properties typically sell eventually and the deal of the century comes by about, well, once every 100 years. As in other markets, there are always some properties that, for a variety of reasons, don’t sell. The reasons a property might not sell include condition, location, layout, lot and perhaps most important price.
When a property isn’t selling, owners often asks whether they should consider renting it out. While we are generally big fans of owning investment property, most sellers in this situation fail to think through all of the factors that should be considered in making this important decision.
In many cases, it may be better for the homeowner simply to lower the sale price.
But it may make sense for homeowners to pull the house off the market and rent it out if they are moving away for a relatively short term but will return to the area; or if they have a long-term time horizon for holding the property as a rental, have built a financial model that takes into account all the costs of being a landlord and are comfortable being a landlord.
If you’re thinking of going down this road, the first thing you should do is to identify and acknowledge your emotional reasons for selling. What we typically hear is that homeowners didn’t get the sale price they wanted so they consider renting out the property for a while as a placeholder so they can wait for the market to bounce back. This logic often has less to do with the actual costs/benefits of renting, but rather the emotional burden of selling at a perceived loss.
Second, you should look at the actual numbers. Many homeowners do a quick back-of-the-envelope calculation to see whether renting out the home would cover the direct carrying costs of owning it. The costs they typically consider are their mortgage payment, taxes and insurance. However, the problem is that this quick calculation almost always underestimates the true costs of being a landlord.
Here are a few of the common expenses/costs overlooked by sellers:
- Vacancy: Sellers need to account for the time it takes to lease their property and any gap between tenants. Landlords typically assume 5 percent vacancy a year, which diminishes gross rental income by the same amount.
- Property management: Homeowners often overlook property management costs (roughly 8 to 10 percent of gross rents) in our area. Even if homeowners plan to manage properties themselves, they should account for the value of their own time and effort.
- Leasing fees: It takes work to find a tenant. Management companies typically charge one month’s rent to find a tenant.
- Ongoing maintenance and capital reserves: Sellers should remember to budget for ongoing maintenance (leaky toilets, appliance repairs, etc.) and larger capital expenses (roof repairs, HVAC repairs, etc.). Ten percent of gross rents is a good rule of thumb.
- Opportunity costs: The opportunity cost is defined as what the homeowner could earn on the equity in his home if it were invested elsewhere. Sometimes, the opportunity cost can be substantial. For example, homeowners with $100,000 in equity in their home (after paying off all debt, taxes, fees, etc.), should factor in an additional cost of $3,000 to $5,000 per year, depending on what the expected return on capital might be.
Third, a would-be seller should consider the “soft” costs of renting as well. For example, renting can put tremendous wear and tear on a property (both from acts and omissions from a tenant). Tenants typically do not take as good care of the property as does a homeowner. A lot of damage can happen to a home in a short time frame, especially for a single-family detached house.
Finally, if there is significant appreciation in the property, an owner may lose out on a valuable tax break. The U.S. tax code allows homeowners who have lived in a home at least two of the previous five years to exclude up to $250,000 of capital gains ($500,000 for a married couple) from their taxes. Homeowners who rent out their home for more than three years therefore will lose out on this valuable exemption. (Consult an accountant on this.)
Once homeowners factor in all of these costs, the rental option often turns from a roughly break-even scenario to one that generates a deficit each month. This puts additional pressure on the capital appreciation required to make the rental option a sound choice. In other words, the capital appreciation has to more than compensate for the monthly deficit. In a flat or down market, the rental option can be financially devastating.
In the end, owners who do their homework and conduct a thorough analysis of their options will make a better decision.