Decision Point: What to Do with the Rental Property?

Rental property:  It’s a popular path to develop passive cash flow for many in the Financial Independence Retire Early (FIRE) community.  When a property is purchased at the right location and for the right price it can certainly be a lucrative investment.  But when that rental property is your former primary residence… and was not purchased with long-term rental in mind, the numbers can be a bit more dodgy.  This is the predicament we here in the Heartland on FIRE household are in.  We just renewed our tenant for 6 months and the clock is ticking on whether to keep renting or to try and sell the house.  We can’t be the only folks who have faced this dilemma, so I figured posting our thought process and analysis may be a useful exercise for others.

First the Details

• The house is a 3 bedroom 2 bath ranch with mostly brick construction built in the 1950s.
• It was purchased with an FHA loan with 3% down… at the height of the market in 2008.  Yikes!
• The rent generated puts the house very near the 1% rule (meaning the rent is 1% or more of the purchase price). So, rent is not too shabby.
• We use a property manager that charges 10% of rent.
• Tenant is responsible for yard work and utilities, except for sewer service (this is typical of the area served by this sewer district).
• We gave the tenant an option of a 6 month or 18 month lease to sync up the lease cycle with the peak of the housing market which occurs during the Spring and early Summer.
• Roof is nearly 20 years old and the water heater is dated to the Precambrian period.

Here is a pros and cons analysis for each option in the Good, the Bad, and the Ugly style.

via GIPHY

The Case for Continuing to Rent

Good

• On most months the rent collected is in excess of the mortgage, property management fee, and sewer bill.  Principle payments add roughly $230 or so in equity each month.  This value will grow each year.
• Maintenance costs have generally been low and the house doesn’t have too many maintenance headaches like lots of carpet, etc.

Bad

• Even with a property manager, there are still the occasional headaches and maintenance items that come up. This is not 100% passive income.
• The property is generally not maintained to the standards we had when we lived there.  Emotions get stirred up whenever we see the yard work getting out of hand.
• The housing market in this area has been very slowly appreciating, much slower than the larger regional average.  Contributing factors include the school district reputation, age of the housing, and recent civil unrest in a neighboring municipality.

Ugly

• Large costs for a new roof and a water heater are looming at some point.  These costs can easily wipe out several years of positive cash flow.  In fact, when the 50% rule is applied (budgeting 50% of the gross rent for maintenance and capital expenses, like a roof) the property doesn’t truly have positive cash flow.
• Complaints about the tenants from the neighbors (while rare) are very frustrating.
• Who knows how a tenant can work out.  Will they destroy our investment?

The Case for Selling

Good

• It would be awesome to not worry about maintenance and tenant issues.
• The market has finally started to pick up and it may be possible to get a reasonable sale price for the house.
• As I discussed previously, we may need a chunk of cash in the next year or two.  Profit from the sale of the home could go a long way to making our savings goal.

Bad

• The aforementioned old roof will almost certainly pop up in the inspection when the house sells.
• The front door is in dire need of replacement if we go to sell it, as is a large picture window in the front of the house.  Also, the kitchen cabinets and counter are getting worn and could use a freshening up.  Finally, based on past feedback and the layout of the house, we feel that staging the house is a must.  ***insert cash register sound***
• Loss of tax deduction for depreciation and repair expenses.
• It is common in this neighborhood for the seller to pay the buyers closing costs.  This would take a large bite out of any profits.

Ugly

• We’ve tried to sell twice previously with no luck.  We are feeling kind of snake bitten that we may have similar results.  Losing rent for a few months, followed by a desperate attempt to find another tenant is not a ride you jump at a chance to buy another ticket for.
• Further, we will have to dump a lot of cash into repairs and updates.  The type of updates for a rental are often different than for selling.  As an example, adding new light colored carpeting shows well but is sub-optimal for a rental.

The Numbers

Taking the emotions out of this decision for the moment, how do the costs bear out?  Looking down the road, how does renting compare to selling?

Assumptions, assumptions, assumptions

There are a ton to make here and some of the largest unknowns can be found in the rental costs and timing.

Selling

• Expected sales price of $120,000 (from comparable houses on Zillow)
• Expected $94,000 remaining on the mortgage
• 6% agent commission ($7,200)
• $2,000 seller closing costs
• $5,000 roof replacement
• $800 water heater replacement
• $1,500 front door and window replacement
• $3,000 kitchen updates
• $1,200 staging costs
• Estimated profit = $5,300

Renting

• $1,250 monthly rent
• $125 property management fee
• $788 mortgage payment (includes principle, interest, taxes and insurance, aka PITI)
• $67 monthly sewer bill
• $50 average monthly maintenance
• $50 annual rental permit with the city
• Estimated Annual Cash Flow = $2,590
• Tenant turnover every 2 years (repairs such as paint, carpet, etc., and vacancy) = $3,000
• Assumed roof replacement in 3 years = $5,000
• Assumed water heater replacement within 1 year = $800

Assuming an average investment return of 6%

TO THE SPREADSHEET!!

Here is a table summarizing the yearly value of each option.  Let me explain a bit:

• Sell the House includes the value of the house profit when it is invested with an average annual return of 6%.
• Rental Cash Flow includes Net Operating Income (Rents – Costs)
• Rental Cash Flow + Equity adds the accrued equity for each year

Year	Sell the House	Rental Cash Flow	Rental Cash Flow + Equity
1	$5,618.00	-$1,054.60	$1,759.44
2	$5,955.08	$1,535.40	$7,274.48
3	$6,312.38	-$3,627.08	$5,152.42
4	$6,691.13	-$1,037.08	$10,902.78
5	$7,092.60	-$1,447.08	$13,777.79
6	$7,518.15	$1,142.92	$19,782.38
7	$7,969.24	$956.90	$23,145.64
8	$8,447.39	$3,759.71	$29,637.75
9	$8,954.24	$3,730.70	$33,443.55
10	$9,491.49	$6,699.94	$40,398.87
11	$10,060.98	$6,847.33	$44,689.58
12	$10,664.64	$10,003.57	$52,152.57
13	$11,304.52	$10,349.19	$56,974.82
14	$11,982.79	$13,715.54	$64,994.39
15	$12,701.76	$14,283.87	$70,399.49

Conclusions

The values in the table above are a snapshot summary from a much larger set of tables.  And boy oh boy, there is a lot going on here.

First off, it is amazing how much sale profit gets eaten up in commissions, and repair costs.  That said, selling the house would give us a leg up in the short term, which could help us meet some short term goals, such as I discussed in this previous post.   The emotional weight lifted from our shoulders would be greatly appreciated, but that is where the benefits seem to end, because…

Equity is the real separator here.  The idea being that, at some point, we would sell the house to capture this equity.  So, if we can deal with the high volatility of the rental option, then this may be the way to go for the long-term.

It should be noted that I have not assumed any increases in rent over this timeframe.  Also, I have not accounted for taxes and price appreciation over time.  We should be able to raise rents over time.  Any repairs or other expenses can typically be written off from a tax standpoint. We should see some price appreciation over the years.  I believe these points add to the case for the rental option.  So, for now, it looks like we will be staying in the rental real estate business.

So what do you think of this complicated situation.  Am I being too pessimistic on the house sale option?  Too high or too low for some of the costs assumed?

Thanks for reading!