You’ve made the decision to move. Maybe it’s because you were bursting at the seams and your family needed more space. Or you wanted to get the kids into that excellent school district. Or perhaps it’s time to enjoy the good things in life and you really wanted a backyard paradise with a great swimming pool. Whatever your reasons for moving, now you face a critical decision that could have important repercussions for your financial future.
Should you sell your current house, unlock your equity and take any capital gains that might have accumulated off the table tax-free? Or, should you turn your existing home into a rental property and use it as a building block for your real estate portfolio?
It’s a very good (and common) question that like most good questions doesn’t have a one-size-fits-all answer. But, I’d like to offer you a mental framework to help you think through this important decision.
Eliminate bad options
A decision is only difficult if it’s a choice between two very good options. If one of your options at your disposal isn’t particularly attractive, the decision makes itself, doesn’t it? So the first thing you should consider carefully is the validity of your options.
Is selling your house even an attractive outcome? For instance, if you were upside down on your mortgage as many homeowners were coming out of the Great Recession of 2008, selling your property isn’t a great option on its own, regardless of the alternatives. So that option will eliminate itself and make your decision more obvious.
Alternatively, would your property make a good investment property? There could be physical aspects of the property that would make it unsuitable for investment. For instance, the property could be very old and it would require significant capital expenditures or it could be too large. Or, the numbers on the property don’t work to generate a fair return on investment for the risk you’re taking in turning it into a rental property.
This is the point where you get out your pencil and run some simple numbers: Rent minus Operating Expenses minus Mortgage Payment equal Cash Flow. Are you looking at a positive return or will you need to “feed” the property from your pocket each month? While considering the validity of turning your house into a rental property, you may eliminate this option from contention and make your decision easier.
Side-by-Side Comparison
I assume that if you’re asking this question, you’re most likely facing a decision between two equally attractive options. If that’s the case, let’s move to the next level of the mental framework: the side-by-side comparison.
First, let’s look at the selling option. Let’s say you’ve built up nice equity over the years courtesy of your initial down payment, value appreciation and paying down the mortgage.
The first thing you want to do is determine the exact value of the equity you could unlock by selling. This isn’t a simple problem where you take your estimate of value and subtract the mortgage balance because that’s not what you’d get if you sold. You have to account for closing costs, selling costs, prorations and make ready. Closing costs are fees you pay at closing for things like title insurance, title company fees, recording fees, HOA statements etc. Selling costs are fees you pay to real estate brokers for facilitating the sale and any incentives you might offer the Buyer (i.e. closing costs contributions) to entice them to buy the house. Prorations are your share of property taxes, insurance costs and HOA dues for the portion of the year you owned the property. And finally, make ready costs are what you’d spend to get the house ready for sale (i.e paint, carpet, landscaping). Once you’ve accounted for all these costs, you can determine your net proceeds at closing otherwise known as the amount on your check after closing.
Next, you want to consider what you would do with this money if you sold. Would some (or all) of it make up the down payment of your new house? If you have that covered with other funds, where would you invest that money and what is your expected rate of return? You could purchase a different investment property or invest the proceeds in the stock market.
Now, let’s consider the option of turning your house into a rental property. Earlier we ran numbers to determine your annual cash flow. Divide the annual cash flow into the net proceeds you’d receive if you sold. That’s your return on equity – the return you’re earning on your equity by turning the property into a rental. How does that figure compare to the return you could earn by selling the property and investing the proceeds into an alternative investment? Beyond the side-by-side return comparison, it’s critical to make a judgment call on how your house is likely to perform over the long term. Do you feel that the property will see more value appreciation, solid tenant, and buyer demand or is the area in decline and things are about to get worse? If the long-term fundamentals don’t look promising, it’s time to sell and deploy that capital into an area that is poised for solid growth.
Another way to ask the question is this: If you were to sell your house, would you buy it again as an investment if given the chance or would you purchase a different investment? This focusing question removes the confirmation bias fog that tends to skew our judgment to confirm decisions we’ve already made. If you wouldn’t buy the property again if given the chance, then the only reason you’re considering keeping it is that you already own it.
In Conclusion
The decision between selling your house and turning into a rental property can be complicated. Sometimes, the right decision is obvious because one of the two options at your disposal is not feasible or favorable. But when presented with a choice between two good options, you should use a mental framework that walks you through the benefits and drawbacks of each option and compares them side-by-side in a long-term outlook context. This way you will see the empirical differences and make the smarter decision for your financial future.
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