12

I am moving from Portland, OR to SF Bay area and therefore contemplating whether to sell or rent the house. I am not planning to move back to this house.

Property details:

  • Bought for : $267,000
  • Paid special assessment for major building repairs : $36,000
  • Current value: $320,000 - $330,000

My loan status is:

  • Amount borrowed : 236,000
  • Current Principal (2 years into the loan) : 222,000
  • Interest rate : 3.5%
  • Term : 30 years.

My projected rent is,

  • $1850 - 8% property management = $1702

My monthly expenses would be:
(my current mortgage split is 649 (interest) + 412 (principle). I am including the interest part as an expense)

  • Mortgage : 649 (interest part)
  • HOA : 510
  • Property tax: 352
  • Estimate of monthly repairs : 100

  • Total = $1611

That means my monthly income is $91 at present. In other words, each month I add $412 to my home equity out of which $91 come from rent and rest from my pocket.

I have a few questions to the community:

  1. Is my calculation correct?
  2. Does it make sense for me to keep the house (I would get decent value
    • the price now is 10% more than my purchase price)
  3. If I change to 15-year loan, that will decrease my interest share of the mortgage and my equity will build quickly. Will it make sense then?

Thank you. Appreciate your answers.

  • 2
    Does your mortgage payment include escrow that covers insurance? How much equity do you have? – Hart CO Oct 3 at 16:06
  • 2
    @RonJohn With most mortgages you sign an agreement stating that you intend to occupy the residence for 1 or 2 years, after which you can convert to a rental. It's a great way to acquire a new rental every couple of years and avoid commercial rates, if you don't mind moving around and have income sufficient to satisfy debt to income ratio requirements. – Hart CO Oct 3 at 16:30
  • 3
    That is a steep HOA fee, but does that mean common area repairs (i.e. roofs, maybe plumbing) are not your responsibility? If it includes specific amenities (pool or gym) can you delegate this to a tenant? – user662852 Oct 3 at 18:18
  • 3
    @user662852 Odds are most people in the area are not renting their units for $1,850/month and having tenant pay $510 HOA fee, typically it is baked into market rents, but if that's not customary in their location that would change the calculation significantly. – Hart CO Oct 3 at 18:22
  • 3
    It sounds like insurance is missing from the expenses list then. – Hart CO Oct 3 at 18:48
33

Does it make sense for me to keep the house

Are you willing to be a landlord for $91 a month? What happens if your house goes unrented for 3 months? 6 months? How will you pay its mortgage?

In my opinion, you don't have enough buffer to make this worth the risk. If you could afford for it to go unrented for 6 months then it might be a good investment in the long run. But you'd need a lot more return to make it worth it.

Think about it this way - if you didn't own the house, would you buy it (with a new mortgage) just to rent it out? Or would you buy a difference house in your new area?

If I change to 15-year loan, that will decrease my interest share of the mortgage and my equity will build quickly. Will it make sense then?

No, because you can't afford a higher mortgage payment with that rent price. You won;t see any real benefit until you sell the house and cash in the equity.

If it were me, I would just sell the house and put what little equity you have in it to your new house. When you have enough savings to cover emergencies, then you can start looking at real estate investment.

  • 1
    Thanks. I see your point. I guess the steep HOA fee and property tax does not make it a good investment. – user1200373 Oct 3 at 18:38
  • 2
    Is the HOA really $510/month? – D Stanley Oct 3 at 18:46
  • yes its a downtown condo ◔_◔ and also an old building. – user1200373 Oct 3 at 18:56
  • 1
    It doesn't seem very profitable at that rent level. The cap rate (net income/value) is only 2.7% before interest, and the 3.5% in interest kills all of your profit. You'd need to rent it fro close to $3,000 to be a good investment without a loan. – D Stanley Oct 3 at 19:09
  • 1
    If my understanding is correct, you bought this house for 267k but borrowed 236k meaning you invested 31k of your own money. If you sell it for 10% more than your purchase price (~294k), then your profit on the sale would be 27k. 27k return on your 31k investment isn't bad. It is the advantage of being highly leveraged. – A G Oct 4 at 11:45
19

Is my calculation correct?

More or less. Your list of expenses is not complete and repair/maintenance expenses can vary wildly. You'll also depreciate the house (not the land), so with your current numbers you could be running a loss for tax purposes which can offset income tax on other income and basically act as a discount to your cost of equity, so instead of paying $412-91 for $412 of equity each month it could be a bit less. This depreciation will be recaptured if you ever sell.

Does it make sense for me to keep the house (I would get decent value the price now is 10% more than my purchase price)

Probably not. Unless you have confidence the housing market in that area will continue to grow and you can comfortably afford to cover rental losses (periods of vacancy, major repairs, etc.). I have properties that generate paper losses (profit if not for depreciation) that are great investments, but your rent to price ratio is not appealing given management fees/HOA/taxes.

If you're willing to give it a go, you can rent it for a couple years and then sell without losing your primary home sale capital gains exclusion. Personally, I have funds on hand to cover a zero-income scenario for 6-8 months (all tenants stop paying rent, job income goes away). That might be overly cautious on my part, but the point is that if you aren't sufficiently liquid then it's not an experiment worth trying.

If you're intending to buy in your new area in addition to a down payment you'll need sufficient income to qualify for a new mortgage. The banks will not consider your potential rental income in their debt to income ratio calculation. After a couple of years of renting they will start counting a percentage of your rental income.

If I change to 15-year loan, that will decrease my interest share of the mortgage and my equity will build quickly. Will it make sense then?

At 3.5% you aren't likely to get a significantly lower rate at 15-years, and it would drive your cash flow further into the red. I don't see this as an option.

6

Without knowing your financial goals, income, other assets, etc, I can't make a recommendation. For example, do you have a sufficient emergency fund to cover both the expenses for this home and your new one should you lose your tenant and/or your job?

However, one part of the calculation you did not mention is tenant turnover. Does your projected rent include the possibility of vacancy between tenants?

  • 1
    Thank you. I did not take tenant turnover into consideration. At this point, I do not have an idea about how the tenant turnover is. I would not buy a new home immediately because property prices are very high where I am moving to (SF bay area). – user1200373 Oct 3 at 18:35
  • I also live in the Bay Area so I understand. Do you plan to eventually move back? Were you planning to sell the rental in a few years to help pay for a home here? – Charles Fox Oct 3 at 19:25
  • I won't move back to my current place (Portland) but might move to other city after few years in SF bay area. – user1200373 Oct 3 at 20:30
  • If you plan to sell in a few years when you move to the next city, note that you may have depreciation recapture when you sell. In addition, the capital gains exemption only applies if you have lived in the home for 2 out of the last 5 years. – Charles Fox Oct 4 at 15:22
5

The only way to see the full picture is to create a spreadsheet with two sides:

  1. On the first side, map your income from the investment property over the years, including everything down to potential vacancies, repairs costs, and closing costs
  2. On the other side, map how much you'd make by selling the house at a given point of time and investing the remainder into an index fund

If the index fund side wins, sell the house. If it doesn't keep it. Of course, there's an element of uncertainty as to how well the stock market would perform vs. how well real estate in Oregon would perform, so this might come down to your personal evaluation and willingness to take risks.

  • The index fund won't win right now, at the top of a long running bull market with nowhere to go but down. The same could be said of property value, though. – Harper - Reinstate Monica Oct 5 at 23:35
  • @Harper both real estate and index funds should be considered long term investments, even in a bear market – JonathanReez Supports Monica Oct 6 at 0:50
  • Alright, but if you buy at the top of the bear market, I can't promise not to laugh... Granted you could be "out of the frying pan into the fire" in some real estate markets... – Harper - Reinstate Monica Oct 6 at 1:06
  • @Harper there's way to make money if you're confident the market is going down :) I don't think it's necessarily safe to bet that there will be a stock crash in the near future. – JonathanReez Supports Monica Oct 6 at 1:30
  • If OP wants to have real estate in his portfolio maybe it makes sense to consider his ROI of the property vs a REIT ETF instead of an index fund. – JohnFx Oct 6 at 23:16
4

Three additional things to consider.

(1) Are you planning on buying a house in the new town you will be moving to or are you renting? If you choose not to sell your old house and buy a new house you will have less money available for a down payment, which will result in a longer mortgage at a higher interest rate.

(2) This assumes you will be able to have a renter 100% of the time, if you are unable to fill the space how long will you be able to continue carrying the house at a loss?

(3) If the house has increased in 10% over the last two years do you expect this trend to continue? If so that suggests that the value of your house is increasing by 0.397% per month. That means that you could add $937 per month as expected equity gain, which sounds good, though you could probably see a similar or higher rate of return if you took that extra cash and invested it in a low cost index fund.

  • Thank you. (3) is a nice way to look at it. $937 per month looks attractive, but off course that's on the assumption of continuing to see same gains. – user1200373 Oct 3 at 20:45
3

You're overlooking some huge tax considerations.

Deducting mortgage interest

First, you get to deduct the interest, taxes and insurance on the home, because it's your primary or secondary home. So I see $1001 of interest and taxes, armwave $99 of insurance, and that's $1100/month or $13,200/year of deductions.

(By the way, if this is news to you, you can re-file your 2016 taxes as late as April 15 2020 and collect that deduction.)

Second, you get to deduct depreciation on the home. You have to break the investment into the a) bare land and b) improvements (everything that isn't land). That is a huge HOA (reason alone to run screaming from this property, in my very biased opinion) so I'm guessing maybe they didn't sell you any land rights in the development, so the entire capitalization could be depreciatable. Let's make that happy assumption. You depreciate this over 27.5 years, so that means $9709/year of depreciation. Or $809/month of deductions.

Turning deductions into coin

So now we have $22,909 of deductions. Deductions are not coins in hand. Deductions are the right to exempt that income from taxes. This always comes off the top of your taxes, so we're concerned with the top bracket you are in. That tells you the rate at which a deduction turns into brass in pocket.

For instance someone with a reasonable tech job might be in a 25% Federal bracket and 8.3% California bracket. That totals 33.3% (I'm bending the numbers a percent or so to make them work out pretty). What do we have, assuming those figures?

  • Mortgage interest ($1100/month) gives $367/month of cash tax benefit.
  • Depreciation ($809/month) gives $270/month of cash tax benefit.

I do believe you have left this $637/month of benefit out of your calculations. That's a bit of a game-changer.

  • Standard deduction for 2019 is $12200 so the actual profitability is less than the full $22209 of deductions – JonathanReez Supports Monica Oct 6 at 1:33
  • @JonathanReez yeah, I thought of discussing that, but we dont know what other deductions OP would be able to exploit if itemizing. It ends up being pretty complicated. – Harper - Reinstate Monica Oct 6 at 5:06
  • Oh, and the interest becomes smaller as you pay-off your house, so OP would need to adjust for that too – JonathanReez Supports Monica Oct 6 at 5:31
  • Thank you for educating me on the tax advantages. The only other deduction I have is state tax which will be close to $20,000. If I decide to rent, I can itemize to get an extra deduction of (22,900 - 4,400). – user1200373 Oct 14 at 2:11
  • I just found that there is a cap of $10,000 on the state and local tax you can claim as deduction. Damn! So the extra deduction I can claim if I keep the house is (22,909 - 14,400) – user1200373 Oct 14 at 2:20
2

This is how I see the calculation:

My projected rent is: $1850

now the expenses:

My monthly expenses would be: (my current mortgage split is 649 (interest) + 412 (principle). I am including the interest part as an expense)

  • Mortgage : 649 (interest part)
  • HOA : 510
  • Property tax: 352
  • Estimate of monthly repairs : 100

Don't forget the insurance, management fee, and principle:

  • Management fee: 148
  • Principle: 412
  • Home insurance: 50

Your total: 1611 + the added parts: 610 equals $2,221 per month.

That means that you are losing $371 a month.

From a tax perspective you will be able to reduce the impact of the income by everything on that list with few important caveats:

  1. You can't use the principle payment to reduce your income.
  2. You can only count actual expenses for repairs. That means while you can estimate $100 per month, you will will only claim the actual amount.

That means the tax impact will be:

  • income $1850
  • reduced by : 2221-412 or 1809

That means before counting depreciation the IRS considers that you are making an estimated $41 a month in profit.

You can and must claim depreciation on the property. You must because when you sell the property the tax forms will force you to account for them in the calculation even if you never took them.

When calculating the depreciation of a single family home without a HOA it is simple: you depreciate the value of the improvements and but not the value of the land. With a townhouse or a condo with a HOA, that becomes more difficult. Some of that value when you buy and sell is the area outside the walls. You need to get a tax advisor to make sure the split is done correctly.

Paid special assessment for major building repairs : $36,000

That special assessment can be problematic. If you were renting the property when that assessment occurred you would need a tax opinion if that can be claimed at the time you make the payment, or if that special assessment has to be depreciated over the lifetime of the item.

Once you get an estimate of the depreciation, you will know if during a typical year you will make or lose money. The risk is that repairs, special assessment, and HOA increases will happen happen at a greater rate than you can increase the rent.

If I change to 15-year loan, that will decrease my interest share of the mortgage and my equity will build quickly. Will it make sense then?

This leads to several considerations. The higher rate of principle payment will mean that your monthly expenses will include a higher amount that doesn't reduce the impact of the rent. You will have to run the exact numbers.

Another consideration is that if the lender knows you will be renting the property they may have different income and down payment rules. They will factor in that you will not always have the property rented, so it can be much harder to qualify for a 30 year loan for a rental property let alone a 15 year loan. Some lenders will not even consider a loan for rental property.

Even without the new loan, you need to make sure the HOA allows rentals. Too many rentals make it hard to sell units because some lenders will not make loans in those communities because of the belief that absentee owners mean eventual loss in value.

1

First, you should be looking at the cash flow as well as the profits. You are making $91/month in profits, but because you still have to pay the principal part of the mortgage, you actually have a negative cash flow. If you refinance to a 15-year mortgage, that effect is even more pronounced: your cash flow will be worse (because you have to pay more in principal), but your profits will be better (because the interest part of your expenses goes down faster).

Second, you already had a major special assessment. You have to plan for more of those in the future.

Third, the property management fees very substantially eat into your profits. If you manage the property yourself, you are doing much better.

Fourth, do not assume that numbers will remain the same in the future. Obviously, the principal part of the mortgage will grow over the years, but also HOA fees can go up dramatically, especially in older condo buildings. I have also seen a situation where an investor bought one unit, got himself on the board, and then manipulated the HOA fees to exorbitant heights so he could snap up additional units for a song.

Finally, keep in mind that real estate may not continue to appreciate as fast as it has in the past. It used to be a good investment because it appreciated faster than inflation. But that also meant that rents and mortgage payments increased faster than inflation (and incomes). That worked for a surprising number of decades, but today we have reached a point where too many people can't afford housing any more. That puts a cap on appreciation, and depending on where you are, it may cause your property to lose value dramatically, and permanently.

As a general rule of thumb: buying into an HOA as an investment decision is rarely a good idea because you don't have enough control.

And my personal second rule of thumb: if the median house price is more than twice, or maybe three times at most, the median annual income in a given area, you have a housing affordability problem. In many areas, the median house today costs ten times the median annual incomes, and that's simply not sustainable.

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