When It Pays to be a Landlord

The tight economy and housing markets have made a traditionally difficult question more difficult. When you no longer plan to use a house, should that old residence (or second home) be rented or sold? The question traditionally arises when someone decides to retire to a new area or after years of using two houses decides to stay primarily in one.

Many people do not have this choice. At retirement, they need to sell the old home in order to buy the retirement home. Those who have flexibility, however, want to make the wealth-maximizing choice.

Before delving into the numbers and taxes, consider the intangible factors.

Being a landlord can have its headaches. There might be late night calls about plumbing, the HVAC system or other problems. These issues can be harder and more expensive to deal with if you are an absentee landlord.

There also is the risk of renting to a bad tenant. The consequences of this could range from late or unpaid rent to legal fees to a neglected or damaged home?or in the worst case all of the above.

Many landlords hire a property manager to avoid such problems. This is an expensive way to handle the potential problems. Also, it solves the problems only if you hire a quality property manager.

Another intangible is the rental market can fluctuate. There will be times when rental vacancies are low. You will be able to rent easily and at a good price. In most areas there will be other times when rental vacancies are high. When you can find tenants the rent will be lower than at other times. You need the financial cushion to be able to make it through periods when the property is empty or the rents do not cover all your expenses.

Before renting, be clear whether you want to generate income or holding the property for appreciation. If you are renting for income, for example, but have a large mortgage and local rents will not cover that and other expenses, then renting really won’t generate income.

The next step is to investigate the potential financial payback from renting.

First, determine the rental value of the house and the state of the rental market. Until recently, apartments and rentals were doing well nationwide, because the credit crisis and declining home prices kept many people from buying homes. In recent months, however, rents have stagnated or declined in many areas.

If you don’t have knowledge of the local market you might need the advice of a realtor, property management company, or landlord’s association. In addition, review local publications and web sites for an idea of rents being asked and the supply of properties. Another option is to run an ad for the property to study the response.

The point is to determine if your property would be attractive to renters and at what price. You might learn that your location is not where renters want to be or that it lacks features or amenities that draw renters willing to pay the rent you need.

After estimating the rent that could be earned, remember to subtract likely expenses and plan for periods of vacancies between tenants. Maintenance, some cleaning, and yard care would be your responsibility. There will be large periodic expenses, such as replacing the air conditioning unit, and regular minor repairs. There also are the expenses of finding tenants, collecting rents, and cleaning between tenants.

After taking these steps, you have an idea of the possible net rental income. Compare that to the annual income or total return you could earn by selling the home and investing the net proceeds. Treasury yields are very low now. But the interest is reliable, and they bonds do not have surprise expenses or principal depreciation. This is one benchmark to determine if renting is likely to generate more wealth than investing the sale proceeds. Or you could compare the rental income and appreciation you expect to what you anticipate from your investment portfolio.

Another calculation is the capitalization ratio of the house. Divide the net rent (gross rent minus insurance and property taxes) into the value of the house. In a normal market, the capitalization rate is 5% to 10%. In that case, rent if you can get the market rate or better. A cap rate below 5% means home prices probably are too high. It probably is best to sell the property while you can.

A cap rate above 10% usually indicates low home prices. In that case, consider renting for a few years to see if the property market turns around, if you can earn at least a break-even rent. Keep in mind, though, that the potential appreciation of the home over the next few years should be compared with what you might earn by selling now and investing the proceeds.

If after considering the financial overview renting makes sense, increase cash flow by taking advantage of all the tax benefits of renting. We will discuss in next month’s visit how you can maximize the tax shelter benefits of renting that old home. RW April 2009.