Rent or Sell? Cash Flow is Key
Are you planning on moving and are mulling over the big decision of whether to keep your current place and rent it out or to sell it and be done with it? For most people the answer is easy as they have to sell it to be able to buy the next place. For those in the position of not having to sell, the question is should you? In this post I'll give you a few questions to ponder and a short cash flow calculator to give you a clearer picture of the costs involved.
Real Estate Investing
First, let me start out by saying I'm a huge advocate of investing in real estate. More wealth is created through real estate than any other form of investing. A few reasons why people invest in real estate include: cash flow, inflation hedge, leverage, appreciation, forced equity, depreciation, and tax advantages. I won't get in to all of these here but if you want to learn about real estate investing, my go to source is the Bigger Pockets podcast and website.
Real estate is a great investment vehicle, but it doesn't mean every property is a good investment and nor does everyone wants to be a landlord.
If you want to jump straight to a cash flow estimator, click on this button.
Will you ever move back to into the property?
Washington, DC is a very transient town where people move and move back all the time. If you are moving out of the area, ask yourself will you ever move back to the area and would you realistically move back into the property? If the answer is yes and yes, then it might make to rent out the property for a while. But be real, how likely are you to move back into the property and do you want to?
Do you want to be a landlord?
Another good question to ask yourself is whether you want to be a landlord. Real estate investing can be a mostly passive investment, but it does require some oversight and involvement. And of course filing your taxes will be a little more complicated.
Do you want to be a property manager?
Being a landlord doesn't automatically make you a property manager as you can hire someone to manage the property for you. Remember though, every property has a property manager. If you don't hire a property manager, you are the property manager.
Do you want to deal with tenant complaints? Can you deal with a plumbing problem in the middle of the night? Do you know how to evict a tenant? It only takes one bad tenant to turn a new real estate investor into a never again investor.
Does it cash flow?
Some people buy property for appreciation, but smart investors buy for cash flow first. Cash flow is the money you have left over from the rent you’ve collected after all expenses have been paid. Markets go up and down but if your property cash flows you can weather the down turns with no problem.
Many people think "if I can rent it for X and my mortgage is Y, then my cash flow is X-Y". That simplistic formula is what gets many newbies in trouble. There are a number of other costs to factor in to the equation:
Vacancy - This is the period of time when it is not rented out. There will be turnover in the property and you might need to get in and get the place ready for the next tenant. Oh, and don't expect there to be a line of tenants ready to jump into the property as soon as it is vacant. Sometimes it takes time to find a new tenant, especially if it during the slower winter months. Your new tenants schedule might not line up exactly with yours either. To be safe, use a 5% vacancy factor into the equation. Not factoring in vacancy is the biggest killer to an investor's return.
Taxes - For most people, when you pay your mortgage each month, you are also paying money into an escrow account from which the lender pays the property tax. That is fine to do, but I like to keep it separate for calculating purposes. If you have a fixed rate mortgage, your mortgage payment won't change, but your taxes will most likely go up over the years.
Repairs - You will have repairs to make. Count on it. Tenants don't treat the property the same way you do as an owner. Typical repairs can be 5-15% of the rent depending on the type of property, the age, and the condition.
Capital Expenditures - Also known as CapEx. These are the big ticket items, like a new HVAC system or roof. You won't have these every month or even every year, however, you should set money aside each month in anticipation of future costs. CapEx can vary a lot depending on the property. Here is a great article on Bigger Pockets to shed some light on this expense. If you have no idea what number to use for this, use 3-5%.
Property Management - As I mentioned earlier, you either hire a property manager or you are the property manager. If you have a newer, 1BR condo, and are local, then self management shouldn't be too difficult. If you are living in another part of the country or especially if you are out of the country, hiring a property manager might be a good idea. Most property managers will charge 8-12% of the monthly rent.
Tenant Procurement - You will need to advertise your place to find your next tenant. Don't forget to factor your time in to showing the place to numerous potential tenants. If you don't want to do that, you can hire a Realtor or property manager to list the property, find a tenant, and negotiate the lease. Most will charge one month's rent for this.
Insurance - You will want to bump up your home owners policy to give you more liability and landlord protection.
HOA/Condo Fees - Just like taxes, these will go up over time. These are typically not passed on to the tenant.
Utilities - These are typically passed on to the tenant, but sometimes not.
Rules of Thumb
Rules of thumb are basic guidelines that investors use to get a quick sense if the property would be a good investment. Two popular ones are:
1% Rule
The 1% Rule says your investment should return 1% of the purchase price each month. So, if you bought the property for $500,000 then you would want it to rent for at least $5,000 per month.
50% Rule
This rule says that 50% of your rent will goes towards expenses over time (vacancy, repairs, CapEx, property management, etc). From that number, subtract your debt service. The remainder is your cash flow. For example, if your property rents for $3,000 per month, and your mortgage payment is $1800. Subtract 50% ($1,500) for expenses from the gross rent ($3,000). Your remainder is $1,500 from which you subtract your debt service of $1,800. The remainder (-$300) is your cash flow. In this example, that is a negative number. Negative cash flow is not good and is to be avoided.
Here is a quick calculator to estimate your cash flow.
This post is looking at the cash flow aspect of an investment property. What was not discussed was the tax benefits of real estate investments. That is a more complicated topic and varies from investor to investor.
For a longer view, you will want to take into account long term appreciation, transaction costs and tax implications. If you would like to discuss in more depth, please reach out.
