June 6, 2012

Should You Sell a House at a Loss or Rent it Out?

Unfortunately a lot of people have homes where they are underwater on their mortgages.   Something in the range of  30% mortgage holders are underwater.    This can present a large problem if you are in a situation where you need (or want) to relocate.   One common solution to selling a home at a loss is to rent out the home.   However renting an underwater home can also result in negative cash flow.   In addition many people do not want the hassle of the extra work of being a landlord or simply aren't suited for the job.

Lets say you are underwater on your home and you are going to move.    How do you decide if its better to sell at a loss or to rent out the property?     

Lets look at a comparison

WE have two options.   First of all is to sell now at a loss.   This option is fairly easy to figure the cost due to simply counting the difference in equity.  For example, lets say your house is currently worth about $100,000 and you still owe $125,000.   Then you would take a loss of about $30,000 to close assuming a 5% Realtor commission.   

The second option is to rent out the home.   This will result in a cash flow that may or may not be negative.   To figure the cash flow you'd have to add up the pluses and minuses.  
Roughly speaking we could figure cash flow by adding up :
rent + tax benefit + principal pay down - mortgage payment - expenses = cash flow

Lets say the home in question has a mortgage of $1100 and would rent for $1000 a month.    Lets assume 95% occupancy.   Your mortgage is $900 for principal and interest and $200 for taxes and insurance.  You bought the house in 2003 with a 30 year mortgage at 6%.     Principal paydown is currently about $3000 a year.   Expenses run roughly $3000 a year typically and thats assuming some larger expenses in some years.   Your tax benefits would add up to something around $1500 a year.   Altogether that would give you :

$11400 rent + $1500 tax cut + $3000 principal - $13200 mortgage - $3000 expenses = -$1900

Option 1 : Sell today and lose $30,000 out of pocket.
Option 2 : Rent the house and lose $1900 per year.

To me this seems like a clear cut choice.   I'd much rather lose $1900 a year than give up  $30,000 today.   The choice is even easier if you don't have $30,000 today as most people don't.  

But what if you can afford the out of pocket loss today?    What if the annual cash flow for renting is much higher like say $4000 a year or $6000 a year?

If the cash flow loss from a rental is a significant portion of the up front out of pocket  loss from selling then that might making selling a clear option.   For example I'd much rather sell at a $10,000 loss today than take a $7000 annual loss by renting.  

Lets consider a situation where its not quite as clear whether the equity loss from selling or the cash flow loss from renting is better.

Sell : Take a $30,000 out of pocket loss
Rent : Annual cash flow loss of $5000

For this situation its important to figure how long till the house is hits positive equity.   You don't know this for sure since you can't tell how fast housing values will change.   We'll have to make an assumption about future home values.   To tell what the loan balance will be in the future you would have to look at an amortization schedule.  You can do that using a mortgage calculator.   Lets say that housing prices gradually appreciate at 2% a year and the home is currently worth $100,000 but the loan is $125,000.   You might hit positive equity in about 6 years in such a scenario.   This means you could be losing about $5000 a year for 6 years until the property has gained enough value and you've paid down the mortgage such that you can sell it and break even on the sale.  

Sell today : Take a $30,000 out of pocket loss
Rent and sell in 6 years : Annual cash flow loss of $5000 for 6 years.

This appears roughly equal.   However the Net Present Value (NPV) of $5000 over 6 years is lower than $30,000 today.

If it would take 8,9 or 10 years till the equity is break even point then renting for that long would be a larger over all financial drain than simply selling today.

Non financial issues

Of course renting out a property requires some work.   You may not be suited for being a landlord.   If the financial choice is not too different between selling and renting then many people would prefer to simply not rent.   Do you want to be a landlord?   Would this property be a good investment property if you weren't underwater?  Probably not.   

Risks of renting

There are various risks with running a rental property.   Your tenants may not pay rent or may damage the unit.   The property may require significant repairs over time such as replacing a heating system or putting on a new roof.  

--

7 comments:

  1. This analysis applies whether the house is underwater or not! Past decisions and prices are irrelevant to future decisions.

    The only way in which being underwater changes things is if you simply do not have the ability to bring cash to the closing table to cover the loss.

    ReplyDelete
  2. Mark : Yes thats actually a good point. The same kind of analysis would work to decide if you should sell a house and pocket some equity or keep it as a rental. I wrote it from the perspective of underwater homes since it seems a common phenomenon now with people becoming 'accidental landlords' because they're underwater and don't see an alternative.

    Jim

    ReplyDelete
  3. I bought a home in 2005, paid $739K. Sold it in 2011 for $509K. I'm very happy I did for a couple of reason: 1) horrible neighbors; 2) overpaid for the house, and didn't see it returning close to value for many years to come.; 3) rent would have returned about 3%, not counting vacancy, repairs, hassle, etc.; 4) found a very attractive home in another geographic location for $385K. This scenario doesn't fit everyone, but thought to share a circumstance where I was happy to take the loss.

    ReplyDelete
  4. Numerically $5000 a year for six years is less than $30000 now in NPV terms. That's true.

    However if you ascribe any value to your time at all, you are selling your time at an extremely low "pay" rate.

    Also, future appreciation is a guess and maintenance, taxes, vacancy, etc are just estimates. So on top of your time you are now facing risk.

    Why would you do that to yourself? Take on that loss of time and risk, just to slightly beat break even?

    ReplyDelete
  5. SteveD : Yes I agree. All good points.

    My example was focused on just comparing the straight finances. But even then you're making some assumptions on things like unexpected repair bills, unplanned extended vacancies, the future of the housing market ,etc. so its amounting to an educated guess. But other than the finances the non financial aspects are a very big part. The answer to "do you want to be a landlord?" could easily far outweight a few thousand dollars spread over 5 years.

    Jim

    ReplyDelete
  6. You have such awesome blog!!! I am very impressed your post, Thanks for share...

    ReplyDelete
  7. I am facing this decision now. We are accidental landlords. still 20-30k underwater, furnace/ac, roof all recently replaced but it is hours from where we live now. market has recovered considerably but factoring in any rental company costs bc we are not in a position to do it ourselves anymore and they don't want to list it for what we are getting now. but I know market will rebound more but the risk and the headache is making me think we should bring cash to the table and dump the property. a few years ago, we wished that it would only cost us 20-30k and here we are so now it is still tough to decide, always waiting for a better deal

    ReplyDelete

Blog Widget by LinkWithin