could use advice on the rental house

[Caroline]

Greetings all:

As I've mentioned before, I own a single-family home in the SF bay area (aka:  "housing bubble ground zero), which I rent out.  (I own my own home in addition.) 

Some figures:

Purchase price five years ago:  $129K
Selling price of the house next door (with one less bedroom and in poorer condition)  $537K
Amount I owe on the mortgage (at 6%):  $60K (I've been paying extra $200 per month on it.)
PITI Payment per month:  $881.00
Monthly rental income:  $1200.00

I've read other threads here on selling vs keeping the rental. Lots of good ideas, historical stoies, and "gut" wisdom. But I didn't find anything specific about how to do the numbers to compare options.  How do I choose between:

a.  X% profit now, after sales costs and taxes, to be invested somewhere else (if any other attractive investment was even out there right now)?

b.  Keep the property and the mortgage (as originally planned) and let tenants buy the house for me.

c.  Same as b except pay off the mortgage with the cash I have languishing in my account.


Can any of you "quants" out there help me to structure this question?  What assumptions make sense?  How do I answer the underlying, fundamental question -- when should a rental property owner's buy-and-hold plan be scrapped in favor of locking in a gain?

Many thanks for any wisdom,
Caroline

 

[wabmester]

If you view the property as an income-producing investment, then you want to look at the cap rate.

When you bought the property, you had a great cap rate. Over 10% (without knowing your expenses and vacancy rate).

If the property is worth $500K now, your cap rate has fallen to below 3%. You can make better than 3% just about anywhere you look. Sell if you're doing it for income.

 

[Mountain_Mike]

Hi Caroline!

Paying off the house would seem to be a smart move. If you can live without the cash languishing somehere, consider that your $60,000 "investment" would return a gross of $14,400 per year (24% return on investment)! Not too shabby. I know there would be taxes, insurance, maintenance, etc...but I still think the return would be good. Plus, if/when you sell the profits would be all yours!

On the other hand, if you sold and netted $500,000, a 4% withdrawl would gross $20,000 before taxes.

I would still lean toward paying off the mortgage, but you'd need to run the numbers for different possibilities. I understand, the downside is the fear that the bubble will burst and you will have missed the opportunity to sell at the inflated price.

Decisions, decisions....

 

[Mr._johngalt]

If you view the property as an income-producing investment, then you want to look at the cap rate.

When you bought the property, you had a great cap rate.   Over 10% (without knowing your expenses and vacancy rate).

If the property is worth $500K now, your cap rate has fallen to below 3%.    You can make better than 3% just about anywhere you look.   Sell if you're doing it for income.

Good advice!

 

[TromboneAl]

What I would do is set up 3-4 scenarios, and make assumptions and calculations for each.  For each, calculate how much money you'll have after, say, 10 years.

For example,
scenario 1: You sell the house today
Assumptions: how much you get for the house
how much return you get on the sales proceeds that you invest

For example, you get $500K after closing costs, and you invest that for 10 years with a 4% annual return.

Scenario 2: You keep the house for 10 years then sell
Assumptions: how much rent you get, how much you pay on mortgage, upkeep expenses, vacancy rate, inflation, how much you'll get for it at that point

Then you'll have a bottom line for each scenario.  You might have a clear winner, but a lot will depend on your assumptions.  

 

[Mr._johngalt]

One word................Cap Rate

JG

 

[greg]

Caroline:
I would look at things a little differently. I would back up a little and modify your asset allocation model to include all your RE, including your home unless you never plan to move, plus your financial asset portfolio. If you total up your pile and find that the RE portion is out of whack because of recent housing appreciation, say 50%, then it's time to rebalance-- (Remember asset allocation forces you to buy low and sell high.)--unless you want to live dangerously and expect housing to continue with its stratospheric momentum.

If you decide to sell, the problem with RE is that it comes in such big chunks. But this is a nice problem. And, don't forget, you still have an appreciating home, to catch more of that rise--if it continues, maybe, maybe not--probably not. What you do with that humongous pile (new asset allocation distribution is a separate issue). I always have an asset allocation model that includes every possible asset I can put my hands on--including DW I'm overweight my DW, but I can live with that risk.

--Greg

 

[Martha]

I always have an asset allocation model that includes every possible asset I can put my hands on--including DW I'm overweight my DW, but I can live with that risk.

--Greg

Hey, did you just call me fat?

DW

 

[greg]

Hey, did you just call me fat?

DW

Nooo! I said I have my arms around you (and I'm holding you up) and THEN I'm overweight.

--DH

 

[Caroline]

To ALL -- MANY thanks for the help -- I was on the fence before -- balanced precariously between holding for the long term and selling while the price is still right.  All the while knowing that predicting the future is impossible and crazy-making.

From Wabmester: 

If you view the property as an income-producing investment, then you want to look at the cap rate.   When you bought the property, you had a great cap rate.   Over 10% (without knowing your expenses and vacancy rate).  If the property is worth $500K now, your cap rate has fallen to below 3%.    You can make better than 3% just about anywhere you look.   Sell if you're doing it for income.

Thanks, Wabmester.  This is exactly what I was looking for -- a clear rule for deciding what to do that will work no matter what the bubble will do, where interest rates are trending, etc. 

The original reasons I bought the house were to diversify (during the stock bubble) and to give my single-mom sister a place to live and rent rooms for me, so I didn't really pay much attention to this when buying.  Now, (if I understand you right), the cap rate tells me that with the house having appreciated, the money could be better invested elsewhere.  Perfect. 

Add this to the fact that sis is moving in with her boyfriend (finally!) and the way forward is clear to me.  As my dear old Dad would say:  "Git while the gittin's good!"

From Apocalypse:

If you total up your pile and find that the RE portion is out of whack because of recent housing appreciation, say 50%, then it's time to rebalance-- (Remember asset allocation forces you to buy low and sell high.)--unless you want to live dangerously and expect housing to continue with its stratospheric momentum.

I did this a few months back -- real estate is nearly 40% and climbing fast.  As to living dangerously and expecting housing to continue to rise -- I don't, and I don't!  ALWAYS good to be reminded to sell high and buy low!  All I've got to do is figure out how to pay the taxes with a smile on my face.  But that's a good problem to have, as you say.

I always have an asset allocation model that includes every possible asset I can put my hands on--including DW    I'm overweight my DW, but I can live with that risk.

You guys are killing me here!  What fun!   

 

[treypar]

One other option is to exchange into another rental property in an area that you would want to retire to or have a second home. This would avoid the cg tax on a sale.