February 7, 2011

Why Your Landlord May Charge Lower Rent than Buying a Property

In some places renting is often cheaper than paying a mortgage for a similar property.   This would seem to imply that the landlords are not getting a very good 'deal' or just making a poor investment.   If the rent is less than a mortgage then you'd think the landlords are losing money.     My wife and I own rental properties that have a negative cash flow if you just look at mortgage versus rent.   However in our case the tax benefits give us a net benefit.    There are various reasons why a landlord may be taking a loss on rent versus mortgage costs for a property.  Here are some that I can think of:   

They have no choice.  The underwater landlord.   Nowadays I think one of the most common reasons that a landlord may be renting a place at a loss is that they are 'stuck' with the property and unable to sell it.   Today this is actually fairly common.   Many home owners are underwater on their mortgage and owe more on the property than they could sell it for.   A lot of people in this situation decide to rent the property out rather than take a very large loss on a sale or go into foreclosure.   These properties weren't bought as an investment and the numbers don't work very well.   And their mortgage is larger then the property warrants so the payments may be especially high compared to rents.   For example lets say you bought a nice 4 bedroom house for $300,000 a few years ago.  Today the house is only worth $210,000 and you have to move out of state for another job.  You decide to rent it but today you can only get $1600 in monthly rent.   The mortgage, taxes and insurance is $1900 so you're losing $300 a month.     For the landlord they are looking at selling the property to take a $90,000 loss or losing $300 a month.   They may be able to afford that $300 monthly much easier than coming up with $90,000.   In the meantime they are likely hoping that the property value will go up over time so that eventually the property will have equity.

Speculating on investment Growth.   I would hazard a guess that this reason is one of the more common reasons a landlord may rent a property for less than a mortgage.   If your landlord has a rental they may be hoping that the value of the property will go up over time.   They may look at the rental investment as giving them a return due to growth from the property value.   If they expect the property value to go up then that may more than compensate for slightly lower cash flow or negative cash flow.   Consider an example:  Say I buy a house for $100,000 and my payments and expenses add up to $900 monthly.  I rent it out for $800 a month.   I'm losing $100 per month or $1200 per year in cash flow (ignoring taxes for simplicity).    However if I expect the property to go up 5% in value then that is a $5000 increase in my property.   So I may figure, hey I'm losing $1200 in cash flow but gaining $5000 in investment gains so I'm ahead $3800 total for the year.     Of course nowadays expecting an increase in a property is not as realistic, but 5 years ago it seemed common to assume a property would go up 5-10% in a given year.

They made a mistake.  Anytime that someone buys a property as an investment they are doing so based on assumptions about their real costs and what realistic rents will be.   If you buy a vacant property or one which hasn't been a rental before then there may be no rental history to look back on.   Or occasionally I've seen sellers or realtors give "overly optimistic" estimates of the financial situation.   So the landlord made some calculations based on how profitable the property would be.   But they may have over estimated income or underestimated their costs.  Maybe they thought they could rent a house for $1200 only to find out that nobody would pay that much and they had to lower their rent to $1000 to get a tenant.    Or maybe they didn't realize that taxes, insurance, maintenance, bills, HOA, etc would add up as much as they do.   If the landlord bought the property with the expectation that bills would be $1000 and rent would be $1200 and then rent turned out to only get then $1000 and bills add up to $1100 then their expected $200 positive cashflow turns into $100 negative cash flow.

Property tax differences.    In some states property tax increases are limited so that your property tax bill may not go up very much over time.   In California in particular I understand they don't let the property taxes go up only 2% maximum regardless of how much the property may go up.   So for example if you paid $25,000 for a house in 1980 in California and had a $250 tax bill and held that house the entire time until today your tax may be only $452 today even though the house could be worth $250,000.  So a landlord could potentially be paying a small fraction of the property taxes that a new buyer might pay.   If the normal tax rate today is 2% then a new buyer might be paying $5000 a year in property taxes compared to the $452 rate the current landlord is paying.  Thats a $379 advantage for the landlord in this example.   So if he's renting to you for $200 less than you could buy then he is still coming out $179 ahead.

Tax benefits.    When I file my taxes as a landlord I get to deduct all the costs associated with the property.   I also get to claim depreciation on the building.    Lets say I own a home worth $200,000 and I rent it out.   I get to deduct the interest on the mortgage and the property taxes like a home owner would.   I also get to deduct the cost of any utilities, repairs, office supplies, travel, advertisements, maintenance, etc.   Lets say the trash bill is $50 a month or $600 a year.   For a home owner thats $600 out of pocket.   For me I pay the same $600 bill but I also then get to deduct that from my taxes to save myself $100-$200.   Of course I don't want to be paying $600 bills just to save $100 on my taxes, but that $100 tax savings is an advantage the landlord gets which a home owner doesn't.    Depreciation is a bigger impact.    You get to depreciate the property over a 27.5 year period.   So every year I get to claim 1/ 27.5 of the value as a tax deduction.  For that $200,000 home I get to depreciate the value of the house.    You can't depreciate the land but you do get to depreciate the structures.  Say that the land is worth $50,000 and the house is worth $150,000.   Spread over 27.5 years that means the depreciation for the $150,000 structure is 150000/27.5 = $5454.    Thats a $5454 deduction on my taxes and if I'm paying 28% rate then that is $1527 per year in actual savings.   This alone would give me $127 per month.

Paying down principal.   When I make my mortgage payment part of it goes to interest and part goes to principal.   The money going towards principal is paying down the debt and a net gain.   I don't really consider the principal payment as a loss or a cost.     Again lets look at a $100,000 house.   If I buy a house for $100,000 with a 20% down payment and 6% interest loan a few years ago then my mortgage payments for it might be $480 a month.    If I'm renting the house out for a $400 rent and those are my only costs (for example sake) then I appear to be losing $80 a month.   However the $480 monthly payment is partially interest and partially principal.  Actually after a few years I'm putting over $100 per month into principal.  That money pays down my debt and is not a loss to me.

Landlord has No mortgage.    If a landlord has a property with no mortgage then they may feel much less pressure to have higher rents.   Without a mortgage payment their expenses are lower and they have an easier time getting positive cash flow.   Lets say you own a house worth $80,000.    You own it outright.  Your total annual expenses are $2000.   If you rent that property for $500 a month then you've got $6000 rent and $2000 expenses for a $4000 annual profit.   $4000 income on a $80,000 property is 5% return on your equity.

Bottom Line: Sometimes landlords may be taking in less rent than a mortgage on a property would cost.   This may or may not mean the landlord is 'losing money' on the deal.  

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