The reluctant landlord
By: David A. Smith
We think of being a renter as a diminished state, yet rental has the tremendous advantage of low entry and exit costs, meaning greater flexibility. In a down market, we should spare a moment’s pity for people used to labor and household mobility, who find their unsold former home nothing but a headache, as explored in this Wall Street Journal article:
Is it – an unsold property, or just a bleeding albatross?
With housing prices still in the dumps, many Americans are finding themselves in the uncomfortable position of landlord.
[1] Some have been forced to relocate for a job and can’t sell their houses.
By far the more common type.
[2] Others have moved, but are holding on to their previous homes, hoping for prices to rebound before selling.
Many are finding that rent checks don’t come close to covering their mortgage payments.
Help my economy – rent my house!
Usually they will not; homeownership is generally speaking a higher-cost use than rental. But that’s a false choice – the right choice is between renting (for whatever income and work are involved) and keeping the property vacant (and, presumably, secured):
“The number of rental homes available is greater today than it was a year ago due to the foreclosure crisis,” says Mike Nelson, current president of Rental Home Professionals Inc., a multiple listing service of rental homes owned by the National Association of Residential Property Managers in Chesapeake, Va.
In Frederick, Md., Realtor Jim Bass says that because of rising demand, a couple of months ago his real-estate group started offering property-management services, tending to the rented homes of absent owners. Mr. Bass says a client recently rented out his 4,700-square-foot house after failing to sell his home, which he listed for $790,000. Now a tenant pays $2,995 per month—a shortfall of $2,000 from the $4,995 mortgage payment.
House for rent,
Reluctant landlords become such by owning a house already; as such, they have to carry its costs, particularly real estate taxes and property insurance, even if it’s vacant. For simplicity, let’s assume all those are identical in both scenarios. If so, then compared with a vacant and boarded-up house, the net rental income is ‘found money.’
The homeowner “feels that two years from now, the market will improve to the point where he can recapture that,” Mr. Bass says.
What is renting worth? Let’s do the arithmetic.
The net rental income is $3,000 per month x 12 x 90% (95% occupancy minus 5% management fee), or $32,400 per year. Versus a $790,000 value, that’s a 4.1% yield on the home –assuming that all the operating costs are paid by the resident, and that there is no real obsolescence other than the normal wear and tear that the homeowner would be paying anyway.
Guess how much is normal wear and tear, kid
Before you get too cheerful, remember this: if you sold the property as rental, the new buyer will look only at the NOI, and to derive NOI will subtract those selfsame real estate taxes and hazard insurance. Let’s figure taxes at 1.5% of sale value (high, and you could get a revaluation downward, but it’s a starting point), and insurance at 0.5% of replacement cost (which we’ll assume is the listing price). Between them they consume $15,800, leaving $16,600 of Net Operating Income as a rental. Capitalize that at 7.0% (say) and you’re left with $237,000 of value as a rental – or a painful 70% discount from the listing price.
Better sell your client’s house, Mr. Bass.
Experts generally advise against becoming a landlord in hopes of recouping lost home value.
The Journal’s statement here is a non sequitur. You don’t convert a single-family home to a rental as an exit strategy; you do it as an interim-holding strategy.
In some hard-hit parts of the country, such as
Until it’s worth what I paid, maybe you’ll rent it?
So what? The price you paid is a sunk cost; now your only question is relative value going forward.
Meanwhile, demand for rentals in many parts of the
Again, that’s no argument to do nothing; it’s an argument to become a landlord only if you intend to be professional about it.
Homeowners who owe more than a house is worth in very depressed areas may be better off selling even in a short sale, whereby the bank agrees to accept less than the full amount owed on the mortgage, says economist Edward Leamer, director of the UCLA Anderson Forecast.
Lender, would you rather I sit empty?
Another non sequitur. If you can negotiate an exit with the bank, then you need to compare (1) the incremental NOI you gain from being a landlord versus (2) the debt relief offered by your lender in exchange for your cooperative deed-in-lieu of foreclosure. If Item 2 is much bigger than Item 1, being a landlord means you’re managing the property for the bank, not for yourself.
Your credit rating takes a serious hit, but, he says, “better to take your losses and move on.”
Kyle Becker, 27 years old, and his wife didn’t feel they had much of a choice in becoming landlords. The couple and their infant son moved from
Either way, the decision dilemma of holding-versus-exiting is painful. For some, moving house is mandatory because they are building their careers and their earning power, so they go where their future income is.
In a normal markets, houses clear, so relocation carries with it only a manageable transaction cost. When the market freezes, the carry gets expensive:
Before they moved, they listed their three bedroom, two-bath ranch-style home in May 2008 for $139,000. They had bought it in 2005 for $110,000 and put $30,000 into roofing and siding. By February, they hadn’t received a single bid.
“We had only seven lookers over the course of a year,” Mr. Becker says.
If you’re just looking, why not rent?
Now, Mr. and Ms. Becker could have chosen to return to
Meanwhile, the couple was paying $1,200 a month in rent for a
Well, okay, how bad is that compared with their expectation? There are four scenarios:
The largest expense the Beckers incurred in their move is the loss of Mr. Becker’s income. (For simplicity, we’ll assume that Ms. Becker’s employment status and income are unchanged by the shift of location; more probably, she has greater earning potential in the higher-rent community.) Out of thin air we’ve invented a net income for Mr. Becker, pre-move, of $3,500, all of which is gone as he studies in
If he had to do it all over again, Mr. Becker says, he might have chopped the price of his Missouri house, where sales have been stagnant—with the exception of “distressed” properties in some stage of default.
The Journal helpfully offers ten tips for prospective and potentially reluctant landlords:
He wondered about the security deposit policy
All the foregoing calculation omits the time cost or psychic burden of owning a remote house for which one is the landlord, or the potential impairment in value resulting from having a renter in the house.
The calculation isn’t the same for all homeowners. Those who have paid off their home or have a small mortgage balance may be able to wait out the market.
Unlikely. People who have paid off their mortgage are far less likely to make a distant relocation like the Beckers have done. The people who move are those pursuing increased income:
Teshika Holmes, 36, says she received no bids for her three-bedroom house in
Ms. Holmes hired a property manager who charges 10% of the rent. Typically rates run from 3% to 12%. She also pays an increased premium of $500 a year for landlord insurance. Among other things, a landlord policy covers the loss of rental income if a fire makes the house uninhabitable. It costs about 25% more than a standard homeowners policy, according to the Insurance Information Institute.
$500 a year is less than $45 a month; take away the $80 monthly for the management fee and Ms. Holmes is still clearing $675 a month of net rental income.
Ms. Holmes says she has negative cash flow each month from her
There’s only one hiccup: the tax man.
Not just a good idea
Rental income is taxable, but can be offset with business expenses–including mortgage interest, real-estate taxes and homeowners insurance–and depreciation. Expenses in excess of rental income also can be deducted, up to a limit.
These are concerns but not show-stoppers. Nobody ever went broke paying taxes on found money. But there is a bigger tax danger:
Renting for an extended period can eliminate or diminish the value of capital-gains tax exclusions. Federal tax law requires you to live in the house at least two years of the previous five in order to qualify for the full capital-gains tax exclusion upon sale of $250,000 for a single person or $500,000 for a couple, with some exceptions.
So, prospective landlords, don’t rent your home longer than three years.
Time to sell
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