Keep Mortgaged Home For Rental Property - Equity In ROI?

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gizmo
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Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by gizmo » Thu Apr 20, 2017 11:22 am

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.
Last edited by gizmo on Thu Apr 20, 2017 1:02 pm, edited 2 times in total.

swingandmiss
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by swingandmiss » Thu Apr 20, 2017 11:44 am

I've struggled with the same calculations on property held for a long time.

I did want to point out you won't have to pay capital gains if you have been living in the home for at least 2 out of the last 5 years.

alex_686
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by alex_686 » Thu Apr 20, 2017 11:46 am

gizmo wrote: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 am not entirely sure what question you are asking. Why do you care what the ROI is? I am not trying to be flippant, just trying to figure out what you trying to figure out. You have 1 evaluation of 99k in equity, another as 65k. Why are you slicing off 15% off of the market value? Is it to reflect sales costs? Is it to reflect a fast 30 day turn around instead of a longer marketing period? What sunk costs are we talking here?

If it is either of these I would use the 99k for your initial investment number. When modeling future returns you can use these assumptions for your finial terminal value, when you sell the house.

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David Jay
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by David Jay » Thu Apr 20, 2017 11:49 am

No capital gains on a primary residence.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

gizmo
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by gizmo » Thu Apr 20, 2017 1:04 pm

alex_686 wrote:
gizmo wrote: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 am not entirely sure what question you are asking. Why do you care what the ROI is? I am not trying to be flippant, just trying to figure out what you trying to figure out. You have 1 evaluation of 99k in equity, another as 65k. Why are you slicing off 15% off of the market value? Is it to reflect sales costs? Is it to reflect a fast 30 day turn around instead of a longer marketing period? What sunk costs are we talking here?

If it is either of these I would use the 99k for your initial investment number. When modeling future returns you can use these assumptions for your finial terminal value, when you sell the house.


I do not know if I am better off taking the cash out from a sale and putting it in an investment account, Roth, etc.

My gut reaction is to determine annual net profit from renting the house and compare that to the returns generated by $65M to $99M of capital in an investment account. Something about that still feels "off" though.

Admiral
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by Admiral » Thu Apr 20, 2017 1:10 pm

I would focus on profit (or palatable loss) from using the home as a rental, versus selling. If you sell, you pocket the profit. End of story. Or perhaps you use it to reinvest in the new home, thereby presumably lowering your loan, unless buying outright.

If you hold and rent, then the equation becomes one of profit after tax: How much can you reasonably charge in the market to cover all your expenses AND turn a profit. It may be that you clear, say just to use a nice round number, $250 in profit per month, or $3000 per year. Is that enough for you? Would you need more? Would you be able to cover the monthly cost if the house is not rented...and if so for how long?

If you're doing short-term rental (Airbnb) then the profit could be significant, though it may not put you in good stead with the neighbors, if you care.

If you don't need the money to buy the new home, AND it is a good rental market, do the math, and then try it for a year if it makes sense. You can always sell it later. In all cases you need to do the research first, and you may also need/want to prep the house for rental...certainly you will have to paint.

EDIT: Sorry, based on last post I see what you're getting at. Unless you plan to put the profit in bonds/CDs etc, you have no way of knowing what your return will be. Real estate, too, has downside risk. But if you do your due diligence (see what the market will bear in terms of rent) you will have a general idea of potential profit or loss to compare with investing the money.

pshonore
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by pshonore » Thu Apr 20, 2017 3:58 pm

David Jay wrote:No capital gains on a primary residence.
Sure there are but only if you have a net gain of more than 500K (MFJ status) including any gains "postponed" when that was allowed.

gizmo
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by gizmo » Thu Apr 20, 2017 5:40 pm

Admiral wrote:EDIT: Sorry, based on last post I see what you're getting at. Unless you plan to put the profit in bonds/CDs etc, you have no way of knowing what your return will be. Real estate, too, has downside risk. But if you do your due diligence (see what the market will bear in terms of rent) you will have a general idea of potential profit or loss to compare with investing the money.


Understandable that all returns are unpredictable. That said, if a conservative estimate of proceeds from short term rentals is comparable to a 25% return, then my decision is made up. If a liberal estimate of proceeds from a short term rental is 2%, my mind is equally made up [in the opposite direction].


My concern is that I am not sure I am approaching the problem appropriately. Accounting for all costs incurred prospectively, it seems like a slam dunk to keep the property as a short term rental.

This does not account for the equity in the home though, which was paid for with cash out of pocket over the last year for substantial improvements (effectively gutting the home).

My big uncertainty - does that cash out of pocket over the last year matter at this point?

Is the only relevant comparison that between the net return of using it as a rental compared against the net return of investing the cash out equity from selling it?

Admiral
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by Admiral » Thu Apr 20, 2017 6:52 pm

gizmo wrote:
Admiral wrote:EDIT: Sorry, based on last post I see what you're getting at. Unless you plan to put the profit in bonds/CDs etc, you have no way of knowing what your return will be. Real estate, too, has downside risk. But if you do your due diligence (see what the market will bear in terms of rent) you will have a general idea of potential profit or loss to compare with investing the money.


Understandable that all returns are unpredictable. That said, if a conservative estimate of proceeds from short term rentals is comparable to a 25% return, then my decision is made up. If a liberal estimate of proceeds from a short term rental is 2%, my mind is equally made up [in the opposite direction].


My concern is that I am not sure I am approaching the problem appropriately. Accounting for all costs incurred prospectively, it seems like a slam dunk to keep the property as a short term rental.

This does not account for the equity in the home though, which was paid for with cash out of pocket over the last year for substantial improvements (effectively gutting the home).

My big uncertainty - does that cash out of pocket over the last year matter at this point?

Is the only relevant comparison that between the net return of using it as a rental compared against the net return of investing the cash out equity from selling it?


That is a sunk cost and not relevant going forward, IMO. The money is gone. You might be able to make the case that this expense (renovation) effectively will result in a higher long-term ROI based on a higher rent you can command. But that's just mental gymnastics.

If it were me and I did not need the sale proceeds for another specific near-term purpose (buying the new home, for example) I would explore renting it out. Try it for a year. Passive income is a nice thing if you can make it work. But there are tax implications, which many on this board who have lots of rental real estate can address better than I.

Good luck!

Bendee
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by Bendee » Thu Apr 20, 2017 7:02 pm

gizmo wrote:
Admiral wrote:
My big uncertainty - does that cash out of pocket over the last year matter at this point?

Is the only relevant comparison that between the net return of using it as a rental compared against the net return of investing the cash out equity from selling it?


The cash out of pocket means nothing other than how you factor in your numbers (i.e. increases to the sale price/rental revenue you would gain from it).

Some items to consider beyond the sale price and rental price:

1) Future gains/losses from selling down the road rather than today could factor into your decision. Where I live is a huge seller's market right now, so I would be inclined to say prices won't go up much in the near term. If you are in the opposite position, it might make sense to hold on to it.
2) Liquidity: Your 65k sounds like it would be invested in fairly liquid items. If you have money to take care of emergencies, this will be less of an issue, but it is something to consider
3) Non diversified risk: You are likely investing a large portion of your investments in Real Estate. Not just that, but a singular piece of Real Estate. What if there is a large/total loss not covered by insurance?
4) Taxes: This could be good or bad for you, but rental properties have some things that can be written off by taxes as well as some near term savings for a big payment when you sell it down the road (depreciation recapture). Definitely look at how this one will impact you before making a decision.
4a) Additionally, if you are not maxing out your tax-advantaged accounts at the moment, you could be putting that 65k into your IRA/401k/HSA/529/etc as space opens up and saving additional money.

alex_686
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by alex_686 » Thu Apr 20, 2017 7:29 pm

gizmo wrote:If it is either of these I would use the 99k for your initial investment number. When modeling future returns you can use these assumptions for your finial terminal value, when you sell the house.


I do not know if I am better off taking the cash out from a sale and putting it in an investment account, Roth, etc.

My gut reaction is to determine annual net profit from renting the house and compare that to the returns generated by $65M to $99M of capital in an investment account. Something about that still feels "off" though.[/quote]

I would say 65k. That being said I am still not sure how you are getting that number and I am not sure what sunk costs you are referencing. I can see where you are getting 99k, 225k appraised value - 126k in debt = 99k. I agree one should that out estimated taxes, real estate fees, etc. However you have seemed to discount your property by 15% for these costs. That seems excessive.

CurlyDave
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by CurlyDave » Fri Apr 21, 2017 2:32 am

If the options are keeping the house or realizing a net $65k, the cost of keeping the house is clearly $65k and this is the figure to compare to other investments.

As a long-time real estate investor, I think you are on the right track to keep it. The transaction costs of buying and selling real estate are very high which points to buy and hold being a successful strategy.

While the idea of having a large chunk of your assets concentrated in one building is a valid concern, it does not worry me that much. Insurance, including business interruption, should protect you.

As the equity in the house rises over time, and you get more experience in the local rental market, you can take money out of it by refinancing. This is frequently less costly than selling, and, if you find rental real estate is suitable to you, allows you to start building a string of rentals by using the proceeds of a cash-out refinance as a down payment.

Also, you can defer capital gains taxes almost indefinitely through a section 1031 exchange into other rental property.

DW and I did this when we retired and moved. It worked out beautifully.

* * * * * * * *

When you analyze the investment, do not forget the tax benefits of being able to depreciate the property. You save tax dollars today, and can either pay taxes in the future when you sell (in inflated dollars), or can defer them through either a 1031 exchange, or simply raising money through a refinance. Most real estate investors analyze cash flow which requires a more sophisticated analysis than a stock or bond investment.

The out of pocket expenses over the past year are a sunk cost and are not relevant to the choices in front of you now, except to the extent that they may be depreciable on a faster schedule than the structure itself. This will improve cash flow.

Time and inflation are your friends when you own rental property.
Last edited by CurlyDave on Fri Apr 21, 2017 3:08 am, edited 1 time in total.

Valuethinker
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by Valuethinker » Fri Apr 21, 2017 2:48 am

gizmo wrote: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.).

alex_686
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by alex_686 » Fri Apr 21, 2017 7:08 am

Valuethinker wrote: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.


If I recall correctly, Shiler's data point to 0% to 2% price increase in houses is the US over the past 100 years after inflation. This return was just the capital appreciate of the asset. It did not included the rent generated by that property. Factor that in and returns start to look better.

DVMResident
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Re: Keep Mortgaged Home For Rental Property - Equity In ROI?

Post by DVMResident » Fri Apr 21, 2017 10:02 am

OP, I highly recommend this book for calculating RE ROI: What Every Real Estate Investor Needs to Know About Cash Flow And 36 Other Key Financial Measures

Personally, my target is a RE ROI 2x (adequate) to 3x (preferred) cash-on-sale forward 10 E/P of S&P 500 because I want a high ROI for taking the risk of a concentrated asset. I suggest calculating cash-on-sale within the 3 year window primary home exclusion and after the 3 year window.

At a 56% LTV and still within the primary home exclusion window, I'm guessing the house is underleveraged and currently have too much tax advantage (a good problem) to make an attractive rental. But do the math and let us know.

alex_686 wrote:
Valuethinker wrote: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.


If I recall correctly, Shiler's data point to 0% to 2% price increase in houses is the US over the past 100 years after inflation. This return was just the capital appreciate of the asset. It did not included the rent generated by that property. Factor that in and returns start to look better.


Shiller ignores most US house owners use leverage to juice returns. Consider an overly simplified example: $100k house with $20k down. After a year, 2% inflation brings the value of the home up to $102k. A nominal $2k ROI on $20k down is pretty good ROI. Americans end up with most of their value in their house (by accident) through leverage/inflation plus a little principal pay down.

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