Should I rent or sell?

[Sean Michael]

I’ve been wanting to find a rental property since I started listening to bigger pockets, so when my wife and I decided we wanted to relocate from Denver to San Diego I thought it would be a perfect opportunity to rent our home in Denver and save for future properties in SD.

After running the numbers, I’m having some doubts about this strategy. After expenses and selling fees we would have about $250k in hand after selling.  If we rent the home, monthly rent will be about $2.5k.  Since I’m out of state I will be hiring a management company.   Many of them charge 40% of first month to get a tenant and 25% for lease renewals, as well as 9% per month for month-to-month management.  I pay $1.65k/month in mortgage/taxes/insurance.  When I run these numbers For one year that’s about $30k income - $19.8k house - $3.5k management = $6.7k net.  When I start thinking about vacancy or maintenance, I’m looking more towards $5k net for the year.

I have a hunch on what the right answer is, but want to check with others to make sure this is the right decision.  Even $6.7k is a return on equity of 2.68% (assuming I have 250k and can get from selling the home).  A yearly return of 2.68% is low enough that it seems easier to just invest this money in super safe assets and wait to find a better investment property in SD with a higher return and manage it myself.  Any thoughts?

[Justin R.]

@Sean Michael Look at your total returns, not just your cashflow.  I think of this as a four layer analysis - most people stop at layer one, which is fine, but it's not really ... enough ... when big $$ are involved.

Layer 1 - Cash in My Pocket or "Cash Flow"

You figured $5000 per year for this.

Layer 2 - Impact of Inflation

I'll assume it's a $600k Denver house (with $250k in equity).  Assume a go-forward inflation rate of 1.5% and ignore likelihood weighting for a moment:

• Annual Value Increase: $9000
• Inflation Expense on your $250k in equity: $3750
• Net Value Increase / year because of your leverage: $5250 

You're claiming Layer 1 net cash flow of ~$5k per year.  Add those together and, assuming no market-based appreciation (or depreciation), you can reasonably count on a year 2 ROE of $10000 / $259,000 = 3.9%.  The positive impact of inflation on total returns is an outsized benefit of leverage in high-value markets.

Layer 3 - Risk

This requires informed projections, but is real. It's all about assigning risk weights and likelihoods. On top of the obvious property-specific physical risks, there are many others.  What are the environment risks - flood, tornado, hurricane, earthquake, weather impact on the physical asset?  What are the tenant risks - tenant class, local employment opportunities, local culture?  What are the regulatory risks - rent control, tax policy change, city inspectors, CO costs?  What are the legal risks - tenant screening, non-payment, inside/outside asset protection?  What are the neighborhood risks - is progress advancing towards or receding away, stability of neighbors, competition in the area, brand of the area?  

Whether you assign actual numbers to each and model in order to get an aggregate present value or just rely on gut, there's some sort of current value to the potential positive or negative risks that a property has.  Buy a good triplex or quad and you maybe have a Year 1 Layer 3 present value of $7,000.

Layer 4 - Appreciation or Depreciation

Also requires informed projections, but is equally real.  I don't mean to be ivory tower about it, but post-high school education or advanced coursework in data science or financial modeling with risk sensitivity goes a long way towards brain training here.  Consider both types of appreciation/depreciation:

1. Market-based, either from changing CAP rates (commercial) or market-wide value changes (residential)
2. Market rent, meaning the rate of change in market-wide rent levels

Not interested in arguing the actual numbers - that's where the more information and familiarity you have for an area, the more successful you'll be at investing.  Suffice to say, there's a present value you can assign to both market-based and market rent appreciation that takes into account the relative likelihoods of both happening at any given level to the positive and negative.  On a $1.25M fourplex in North Park, I'm going to assume there's a year 1 present value of ~$21,000.

Bottom Line

Add it all up and you've got a risk-weighted present value for an investment opportunity.  In this theoretical example, you've got a Year 1 value of +$38,250.  Or, assuming you put that $250k into a Layer 1 and 2 equal investment in SD, an annual return of +/- 15%.  Up to you whether that's an attractive use of your capital.

My point in typing this out is just to hopefully provide some structure around considering the entire investment.  Not modeled here are the soft costs - your time, and the value of experience gained - which I would argue should be modeled into the present value as well.  It can be fine to just do quick analyses since full analysis can actually be an impediment to action, but when investing I think we should all at least acknowledge when we're going with our gut and when we're proposing a defensible, numbers-backed strategy.  Good luck, and looking forward to welcoming you to SD!