Should You Sell Your Home or Rent It?

I have a client at my mortgage broker business with the following problem; maybe you have the same problem and can benefit from the discussion that follows. Every person is different, but there are obviously enough similarities such that the investigative and analytical process could be beneficial on a general level.

Back to my example: My client, who we'll call John, and his family are ready to move up to a larger home from the one that they have been in for many years. He put it up for sale but there have been no buyers. To complicate matters, they have found a home they like and their real estate agent is suggesting that they turn their home into a rental instead of selling it. That way they can buy the new home now and have a rental unit. The question is: Is this a good idea for them?

My job in many of these situations is help people get in touch with their "propensity to take risks." Then they can better evaluate the potential risks of what they are contemplating. In general, owning a rental property has been an ideal wealth-builder. If you manage the property properly, your tenants' rent payments will ultimately retire the mortgage and you will own the property free and clear. Then the value of the property, hopefully having appreciated greatly from when you bought it, will add to your net worth. In addition, you will receive the rental income minus the operating expenses that no long include the mortgage payments. Sounds like pretty nice retirement income, doesn't it?

The easy way many people start owning property is not by selling their current residence when it's time to move on to another property. You keep it and turn it into your first rental property. There are some advantages to this. First, you know the property, compared with buying an unknown rental property and having no idea about what is likely to go wrong with it. You also know the neighborhood and what it is likely to rent for and, finally, your neighbors will be able to keep an eye on your property.

But there are some negatives too. For many families, just making one mortgage payment every month is a chore, and with the original home now becoming a rental unit, there would be two mortgage payments. Although you would hope to rent the home out for enough to cover the monthly costs, in many areas of the country, this simply won't be possible for a few years until rental rates increase a bit. Until then, you may have a negative cash flow to deal with.

Other negatives include the normal rental property management ones. You may have trouble finding creditworthy tenants. With our little foray into profligate subprime lending, my industry has taken some of the best tenants and gotten them into houses. The ones who are left over in the rental pool will not be as good tenants. You could potentially end up having zero rental income for a few months, and making that second mortgage payment could become more than annoying.

There are management issues too, because the grass will need to be mowed, the water heaters will need to be replaced; sometimes there are more serious problems too. Every once in a while the house will need a new roof. Someone has to do these things. If you hire someone else, that expense reduces your net income or increases the negative cash flow.

Finally, you could end up with a bad tenant. I won't go further, as I am sure your imagination can do an adequate job, but I can tell you that watching someone go through the hassle of getting someone evicted is not pretty. And usually they will have trashed the house out of spite as they leave town. Then it's another month or so of no income and several thousand dollars of expenses.

If you have not saved enough for a down payment on your new primary residence, you can refinance your current home and get a larger mortgage, using the excess cash as the down payment and to establish a reserve account to cover the potential problems we discussed above. Bottom line: This process entails taking on a lot more debt than you have been used to.

I think that you ought to put together a spreadsheet that allows you to see potentials for opportunity and trouble. You will get a three-year peek at what it is like to be a landlord because you'll still get favorable tax treatment if you live in the home for two of the last five years. After that, any gain from when you purchased the home is taxable. If you keep it forever, of course, it is not a problem. You can sell it now, and $500,000 of any gain is tax exempt.

The other thing has to do with appreciation potential. Obviously we are going through a tough time for housing right now, and values in many high-growth areas of the country are falling. I don't like to make predictions, but I think we are probably approaching the bottom. So, I suppose it's easy to say, "It's all up from here!" Maybe. If you are in it for the long haul, it won't make much difference.

I don't want to be accusatory here, but real estate agents can't make money until you do something (I don't either, for that matter, but I wouldn't urge you to do something unwise just to make a buck either) and if they can get you buy a home now, they can make a commission now instead of in a few months. You need to be the master of your destiny and do what is good for you, not for them.

Finally, a very wise man who owns a number of rental properties told me the first rule of being a landlord:

Any act of kindness will be viewed as a sign of weakness.

You want to be sure of your willingness to be a landlord. If you decide to, I can recommend my friend Robert Griswold's books, Property Management for Dummies and Property Management Kit for Dummies for an excellent education and continuing help if move ahead with your plan.

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