Honestly rather struggling on how to best articulate my question - fingers crossed what is below at least gets the ball rolling.
Family and I are currently exploring the possibility of purchasing a new home. While our current home could be sold to free up cash, it could also be used as a short term rental.
We have approximately $99,000 in equity in the home ($126,000 on a $225,000 appraisal, 56% LTV); we believe it is not unreasonable to sell the home within 30 days and walk away with $65,000 after accounting for capital gains, closing costs, and realtor fees.
If used as a short term rental, it would more than cover the mortgage, insurance, taxes, ancillary items like lawn care, as well as good faith estimates for maintenance.
I am flummoxed though on how to consider the equity when calculating rental ROI.
Is this a sunk cost that is immaterial? Is the "cost" of starting it as a rental the opportunity cost of not selling the home?
I would like to figure out what our return will be as a percentage of investment - 5%? 10%, etc. I effectively want to get a comparison between opportunity cost of maintaining the home as a rental compared to selling it and putting the equity in an investment account.
Edit based on questions below
- Equity variation between $99M and $65M to reflect realtor fees, closing, and getting an immediate sale. Sale for full appraisal may take several months.
Capital gains due to only living in the house for one year; will be minimal due to improvements impacting the cost basis, but will still be present.
The way you figure out the return on an investment property is Cap Rate =
investment income (net of all expenses, void periods etc.) pa / gross value of the investment
So a 200k house that nets $10k pa rental income is a 5% cap rate. If the market price of the house moves up, the cap rate falls.
In terms of your own portfolio, you care about equity.
So you have your net equity in the house (what you would realize upon sale of the house, now, less all costs including taxes and repayment of mortgage).
Net income/ net equity = Return on Equity
The point about Real Estate is you can leverage it, whereas with stocks that's usually a pretty bad thing to do (margin call!).
So you can increase your return. But note also you can increase your risk.
In your shoes, I would sell it and be done with it:
- houses generate unexpected costs
- rental houses have higher wear and tear
- one bad tenant and you will swear off ownership forever - I've had friends whose families have had death threats from tenants
- if you have to move cities because of career etc. this becomes a worse pain
Also there's a capital gains tax point, no? If you sell now you avoid capital gains, whereas in the future you would pay it (as it is no longer principle residence)?
Unless you plan to go into the real estate business, building a portfolio of rental properties and learning how to manage them (with a goal of eventually having a big enough portfolio that someone else manages them for you), being an "accidental" landlord never struck me as a good use of time or money.
Compared to investing in stocks and bonds, yes returns on the latter will likely be low. A 60/40 stock/ bond portfolio is likely to return c. 5% pa (more if inflation is higher) and it could be less than that given where we are now.
Returns on homes in the long run average are negative, adjusted for quality improvements. That seems to be the conclusion from the Robert Shiller data, and also see "Safe as Houses: 8 centuries of housing prices" by Neil Monnery-- exceptional book compiling international data. Both very eye opening.
Return on housing equity can be positive because of the leverage effect. But in the long run, housing is not a great investment.
Caveat: if there's a lot of NIMBY going on in a growing area (Silicon Valley, New York, Los Angeles, Seattle) then housing prices can just soar out beyond the limits of affordability. But in large parts of the US, that just doesn't happen. The city grows, and it takes in more housing land (Dallas FW, Houston etc.).