Can someone check my analysis of renting out my current PR?

Question

Hi everyone, my wife and I are considering downsizing. We think we're in a good financial position in general and on our current primary residence (PR) so we were analyzing renting. When I put all the numbers into a spreadsheet, it looks like we'd get only a 2% return on our money!

This seems wrong because the situation seems ideal for conversion to a rental: we bought in 2010 in the middle of the housing trough (low expenses), purchase and rental markets are really hot in our area, we are in one of the top elementary school districts in the city, etc (high revenues). Since I figured out such a low return, we both think that I must have done something wrong, so I was hoping that someone could check the analysis I did! FWIW, we would start with a management company and transition to self-managed in 1-2 years, though neither of us has any particular passion or aversion to rental management.

General details

Purchase @ $330k in 2010

Current market value: $560k

Current loan amount: $228k

Revenue

We spoke with a trusted friend who estimated that the house could rent for $2600/mo in its current condition.

Total (52 wk occupancy): $31,200/yr

Expenses

P&I: $1167/mo (~$14k/yr)

Property taxes: ~$5100/yr

Insurance: ~$1k/yr

Yard service, misc: ~$1700/yr

Management fee: 8% (~$2500/yr)

Total: ~$24.3k/yr

Taxes

Depreciation: $12k (Rough estimate found from https://www.calculatorsoup.com/calculators/financi... with cost basis: $330k, recovery period: 27.5 yrs)

Mortgage interest: ~$7900

Other deductible expenses (prop taxes, insurance, yard service/misc, mgmt fee): $10.3k

Total change in AGI = revenue - deductible expenses = $31,200 - $12000 - $7900 - $10.3k ~= $1000

We're in the 25% tax bracket, so these revenues and deductions add $250 to our federal tax bill.

Total/yr

Revenue: $31,200

Expenses: $24,300 + $250 = $24,550

Total profit/yr: $6650

Even if we managed the property ourselves, our profit would be ~$8500.

Conclusion

This is probably an optimistic analysis - it assumes 52 wk occupancy, and relatively low misc expenses.

Since we have so much equity (~$330k), our return would be in the 2% range (managed) or 2.6% range (unmanaged). This seems like an extremely low rate of return.

For comparison, if we sold and downsized to a house at $440k with $110k down + $15k closing and 5% realtor fees, we might net ~$180k. Even if we put $80k into the new house in renovations, we could invest $100k in stocks (avg return of 8%) and make $8k... that's nearly as much as managing the rental ourselves, with a lot less effort and a lot more upside.

Can anyone please point out any errors in my analysis? It seems like, even though we can rent for way more than our expenses, in terms of rate or return and absolute return this is not clearly a better investment than stocks. In fact, in a lot of ways it's worse.

Also, I have all of this in a spreadsheet so if you want me to rerun the analysis with different numbers (misc expenses higher/lower, rent higher/lower, mgmt expenses = 0, etc) let me know and I'll do that.

Dave Foster · Answer

@Avi Tevet, I didn't have to look past the value of the house and the probable rent to see it's not going to be a good investment for you. More expensive assets typically return less/sqft in rental. While a $1000sq ft property might sell for $100K and rent for 1,000/mo a 2000sq ft property which might sell for $200K might only rent at $1500.Rents have a tipping point at which people will stop renting and begin buying. That's part of the reason why rents/dollar of value are higher for smaller properties. Your problem my friend is that you bought too well!What @Bram Spiero is alluding to is that if you had that house leveraged to the hilt with little cash of your own in it your cash on cash return would be dramatically higher - but so would your debt.One other thing to consider is that right now you can sell that house and the profit from it would be tax free because of the sec 121 primary residence exclusion. That is a powerful thing to consider given that the numbers don't well for a rental as is. And there is the opportunity to take $200K in gain tax free. That's a real cash savings of possibly $60K. You'd have to rent that thing for quite a while to equal that bump.Sell, take the cash and reinvest in smaller units or since neither of you have a burning desire to be landlords go into one of the passive real estate investment opportunities available to you. Or take a really nice trip and do both.

Ralph R. · Answer

Avi Tevet Yourheaded down a poor path here. Your trying to analyze a very poor rental. Renting a 500k+ house for 2600 a month is like renting a rolls Royce for 20 dollars a day. It's way under rented. A 100k house needs to rent for 1,000 a month in my area for me to even take the calculator out of my pocket to check further on it. If I were going to analyze a 500,000 house I first would need to know it would bring $5000 a month rent. MINIMUM!! What you paid or what your loan is is irrelevant. Your primary is not a good fit as a rental. Even using your entry price of $330,000 it needs to rent for 3300 a month. That's why your numbers are skewed. Also you might try using the rental calculator found here on BP it's less complex than your numbers and does an excellent job. RR.

Bram Spiero · Answer

real estate, unlike stocks, allow you to leverage. That's the big difference when comparing to other forms of investment.

Dan Schwartz · Answer

@Avi Tevet sell the house. Put 5% down on your next PR and decide between the following: a) my home will appreciate ~20% in the next 4-5 years and I will escape PMI at that point via re-appraisal or refinancing, or b) I will be in this house 5+ years and don't want to change the purchase loan I'm securing. In that case, ask for pre-paid PMI. Take the remaining proceeds from your current PR sale and either leverage it in rental properties if you want to invest in real estate, or place it in the stock market if that's what you prefer. The tax exclusion is too good right now to pass up, and the house doesn't make a good rental, as others have pointed out. Good luck.

Avi Tevet · Answer

Alright, I think everyone and my analysis agree, this would not result in a good return. Thanks for the input!

Avi Tevet · Answer

Thanks for the input guys.After posting last night, I realized that I had made a mistake in the "equity" that I was using to compute the return. Basically in the above analysis, I assumed that we would sell the house and stick every equity dollar into the stock market, which would leave none for a down payment on our next house! I guess that would be valid if we were planning on renting, getting 0% down, or being homeless, but we're not - we're planning on sticking with the traditional 20% down or maybe 15% if our lender would waive the PMI for that down payment. So in terms of evaluating selling vs. renting our current PR, what do you think about evaluating the return based on the "available equity to invest?" This would be the leftover money that we would have after our hypothetical downsize/renovation, that we would put towards investments. Basically this accounts for the fact that if we sell, some of the equity would go towards a PR, so maybe it's not really fair to evaluate rental return based on the entire equity.