Many people consider renting out their home instead of selling it. They may not be able to get the price they want, or they may want to get into the real estate investment business. While renting out a home may seem simple, it takes work, and there are many things to consider: taxes, maintenance, vacancies, property management and more.
Renting Out Your Property
If you need to move and are considering whether to rent out or sell, do not take the decision lightly. Renting out a home is not easy, and there are many things that can go wrong! Some properties make great rentals and some don’t. Some properties, no matter how hard you try, simply do not make money because the rent is not high enough to cover all the expenses.
It takes a lot of time and work for real estate investors to figure out what good rentals are, find them, and manage them. It is unlikely a homeowner will get lucky and the house they happened to buy to live in will make a good rental, and they know what it takes to rent it properly.
The biggest mistakes people make when renting out their home is not doing their homework and not learning what it takes to properly manage a rental.
The pros of renting out a property
If you can find a good rental, they can be a fantastic investment. A good rental property will make money every month after all the expenses are paid. You will pay down the mortgage over time, and it will offer some amazing tax advantages while you own it. If you keep the property long enough, there is a very good chance it will appreciate in value as well. While real estate does not always appreciate as fast as other investments, the return on your investment can be very high because most homeowners have a small amount of money invested in the home compared to what it is worth.
When deciding whether to rent out or sell, you need to know all the numbers. Not every house will make a good rental property because price-to-value ratios vary all over the country and even in the same town. Price-to-value ratio is simply what the home will rent for compared to what it is worth.
The most important number to know is what the home will rent for. You can look on Zillow, Craigslist, or even call property managers to get an idea of what similar houses are renting for.
There are more expenses than just the mortgage payment, however. You also must consider property taxes and insurance, which are usually included in the mortgage payment, but not always. On top of those expenses, you must consider maintenance and vacancies. This is where most landlords get tripped up.
After you have figured out what your expenses will be and what your rent will be, you need to see if it makes sense to turn your houses into a rental.
Here is an example of what the monthly numbers may look like:
- Rent: $1,500
- Mortgage: $1,000
- Taxes: $150
- Insurance: $100
- Profit: $250
This is how most landlords determine profit, and this looks like a decent rental on the surface. However, they are forgetting two things. First, there will be vacancies or months when the rental property is not rented, but the landlord is still paying the mortgage, taxes, insurance, and utilities. Second, no matter how nice your house is now, there will be maintenance needed. The tenants may do some damage, and the house will need things replaced over time like the water heater, the furnace, the roof, etc.
Here is an example of what those costs might be per month:
- Vacancies: $150
- Maintenance: $150
The vacancies and maintenance will vary based on where the house is, the vacancy rates, the quality of the tenants, the age of the home, the condition of the home, and many other factors. My cash-flow calculator helps you figure out what those costs will be. You may have none of these costs for months, but one problem or large repair can change that very quickly. We can now see the property loses $50 every month if we account for vacancies and maintenance.
You also need to consider that the costs can vary greatly in each state as well. Property taxes in New Jersey can be 10 times what they are in Colorado. Hazard insurance is much more in certain areas of the country, and there may be other costs, such as HOAs and utilities, depending on how you rent the property and who pays what costs.
If you can find the right rental, it should make money after all of these expenses are paid!
Below is a video that goes over how my rentals have performed.
While you own the house and it is making you money every month (it should be at least), you may also see the value increase. When I buy rental properties, I try to get an amazing deal that I can fix up or add value to. This allows me to make money as soon as I buy, but that is hard to do if you already own a rental. You may be able to add a bedroom or add value in some other way to increase rent and forced appreciation.
In most cases, houses will increase in value over time. Some markets see more appreciation than others, but given time, almost all houses will go up in value. I have seen some crazy appreciation in Colorado, but I have thought of it as a bonus, and I do not count on it. Not only will you see the value of the home increase, but you should also see rents increase over time.
Principal pay down
If you have a mortgage on the property, you should be making money every month and paying down the mortgage as well. You will not see the benefit of the mortgage being paid down unless it is completely paid off, you sell the home, or you refinance it, but it is a benefit. The longer you have the loan, the more principal will be paid off each month.
The cons of renting out a property
A lot of people dream of owning rentals or being a real estate investor but have no idea what it really takes. It is hard work and takes time to learn all the ins and outs of how real estate works. Do not jump into real estate without doing some research and learning what it will take. It is not all money and freedom.
The wrong tenant
We have all heard nightmare stories about rental properties being trashed by tenants. Those stories do happen in real life, and they mostly happen because the landlord picks the wrong tenants or does not check on their houses. A property that could be an amazing rental with the right management may turn out to be a horrible investment with the wrong management.
The numbers in the cash flow section above assume the landlord is managing the property themselves, which can work well but often does not. To be a landlord you must be tough, take your time choosing tenants, perform an in-depth background check, and keep track of the properties. The biggest nightmare tenant stories usually come from landlords who do not know what they are doing. They do not check credit or verify income, and they never check on the properties.
I managed my rentals until I had 7. When I switched to a property manager, my life was so much better because I was not dealing with tenants and I made more money! The property manager charged late fees and chose better tenants, which helped the bottom line even though I had to pay the property manager.
If you do not know how to manage a rental property, I suggest using a property manager. They can cost from 8 to 12 percent of the monthly rents. Plus, they may charge a leasing fee. That leasing fee can run from $200 to a full month’s rent depending on the property manager.
If we add those costs to the equation, you are now losing quite a bit of money every month:
- Rent: $1,500
- Mortgage: $1,000
- Taxes: $150
- Insurance: $100
- Vacancies: $150
- Maintenance: $150
- Property Man: $150
- Profit: -$200
If you choose to manage the properties on your own, you are saving that money, but remember, it takes time to manage a property, and most people do not like to work for free. You should take into account the time you spend managing a property.
Here is a video that shows what a bad tenant can do to a property:
Should you keep a rental if it loses money?
As you can see, you need a lot of room between the mortgage payment and the rent collected. There are a lot of expenses that come with rental properties, and that is why it can be hard to find profitable properties. It is highly unlikely that most homeowners chose a property to live in that will also be a great rental. Are you willing to lose money on the property to get into the rental property business? Here are some things to consider:
- $200 a month may not seem like a lot, but that is $2,400 a year, and it adds up. You may also get unlucky with the wrong tenant who causes a lot of damage or must be evicted and lose much more money.
- It takes a lot of time to manage rentals or find a great property manager. Do not think this will be easy.
- There are advantages to having a rental, like you are paying down the principal balance on your loan every month, you have great tax advantages, and the rent and value could increase in the future.
Some people may be okay with losing money in order to keep a property. Over time, it may become a good rental and a smart investment, but be prepared to weather some rough times in the beginning.
Some people also want to keep the rental because it will not sell for as much as they hoped. They want to wait until prices increase and then sell. Remember, there is no guarantee prices will increase, and you need to consider all the money you are losing while you wait for those price increases.
Selling your property
Selling a property can be difficult, but so is keeping it as a rental. It is expensive to sell a property, but most of the time you should come out ahead if you bought the house right and do not have to sell right after you buy (unless you are flipping). It also might be wise to sell if the rental will not make money or you do not have the time to find a great property manager or rent out the home yourself.
The pros of selling a property
The biggest pro to selling a property is that it saves you time. You will still have to find a real estate agent and may need to do a little work to get the home ready to sell, but you may have to do those things to rent the home as well. When you sell the home, you will no longer have to worry about the tenants, the property management, or the expenses.
Capital gains taxes
Something that many people do not consider in this situation is the tax implications. I am not an accountant or attorney, so for specific advice please consult a professional and not me. When you live in a home for at least 2 out of the last 5 years, you may be able to take the profit tax free. You do not have to do a 1031 exchange or buy a new property. You simply get the profit tax free up to $250,000 for an individual and $500,000 for a couple.
However, if you turn the property into a rental, you may lose that tax-free status. Again, talk to your accountant to figure out the details. If you bought a property for $200,000 and it is now worth $400,000, you may be losing a tax-free profit of $200,000 and turning it into a taxed profit by making the house a rental.
The tax rules on rental properties are complicated, and they can be amazing for investors, but they are not as amazing as the tax-free rule for owner occupants.
You get the cash now
When you sell, you also get to take the profit right away. With a rental, the money comes in for a very long time, but it comes in very slowly in most cases. If you have a lot of equity, you will get a big chunk of money right away. Of course, it is wise to invest that money and not just spend it on shoes.
The cons of selling a property
It takes some work to sell a property as well. Houses do not magically sell themselves unless you want to take 30 percent less than they are worth. In that case, give me a call and I can take the property off your hands! In all seriousness, it takes money and work to sell a house.
Real estate commissions
When you sell a house, you almost always get the most money by using a real estate agent. They can charge a commission that eats into your profits, but most of the time, the higher selling price the agent can get you makes up for those commission costs. All commissions are negotiable, but HUD pays a 6 percent broker commission with half going to the listing agent and half going to the buyers agent.
Getting a house ready to sell
To get your house ready to sell, it might take some sprucing up. In most cases, a house does not need to be quite as nice to rent out as it does to sell. Buyers are pickier and will require updates as well as the major structural and mechanical items to be in good shape. It may take more money to get a house ready to sell, but you will get that money back once you sell it. If you rent it out, you may get more rent, but it will take a while to recoup your investment.
Which is better: renting or selling?
I know this article makes it sound like rental properties are a horrible investment and a pain in the butt, but they are not. I love my rentals, and they have created millions of dollars in wealth for me and a passive-income source that is hard to beat. The thing about rentals is they are neither simple nor easy. It takes a lot of time, research, and experience to figure out how to find profitable rentals. Most people who want to turn the house they lived in into a rental do not take the time to learn how rentals work.
If you want to get into the rental property business, learn about rentals first! Learn all you can and then decide if your house will make a good rental or if you are better off selling it.
A good strategy might be to sell your house now, take the tax-free gain, and use that money to buy a better rental property.