Keep Or Sell Rental Property

Reader Question

Hi. I've recently inherited a home out of state and am trying to make sense of what to do. The house is free and clear and in good shape and worth approximately $150k. My options are:

1) Keep the house and not rent. My monthly expenses are approximately $500 which includes property taxes, insurance, pool and yard maintenance, and utilities. We would use it as a vacation home. No hassles with renting.

2) Rent out the house. I've got a lead on a reliable tenant and area rates are $1000-$1300/month. I would continue to pay for pool and yard maintenance.

3) Sell the house and invest in a taxable account. I've got a buyer willing to take it off my hands for $150k.

There is sentimental value in the property but I need someone who could guide me to what would be the financial 15 years down the road when I'm ready to retire. I'm leaning renting out until the housing market hopefully rebounds and then sell. I just don't know how to properly evaluate this situation and value your opinion. Thank you.

My Reply

Sentimental value aside, based on what you wrote I would sell the property. I have to doubt the $500/month figure for all-inclusive costs. A conservative long-term estimate for maintenance costs alone is 2% of home's value. If you are lucky maybe it'll end up being just 1.5%. I don't think it's a good idea to expect less than that. Most years you will undershoot that number but every few years you will have a big ticket item that will bring the long-term average in line with that 1.5-2.0%. Pool's presence only increases the potential number of those big ticket items. You may also find my How To Value Real Estate article useful when thinking about this... 

On a $150K home, 1.5-2.0% works out to about $200/month for maintenance alone. That leaves just $300/month for combination of property taxes, insurance, and utilities (basing on your $500 monthly expenses number) and that sounds very low to me. I'd guesstimate more like $700-800 for ongoing monthly expenses with all future maintenance and repairs figured in. That leaves $200-$600/month profit after rent, depending on where in $1000-1300 range rent actually comes in. Let's pick the mid-point, $400/month, which gives you about $5,000 in annual profit.

But that $5,000 profit number assumes 100% occupancy and no management company. You would have to handle every issue yourself, from advertising, to collecting rent, to dealing with handymen/plumbers/painters/etc, to evicting non-paying renter, etc. And 100% occupancy is never realistic.

And even in this optimistic scenario, your return on the property would be just $5,000 / $150,000 = 3.3% (this is real return, since it can be expected to grow with inflation as property appreciates and rents increase). 

By comparison, a boring 50/50 stocks/bonds portfolio got you about 5% real return historically. Biggest drop in a 50/50 portfolio has been about 30% -- on par with recent housing market losses nationwide. So I think it's a fair comparison. It's true that expecting the same 5% from the 50/50 portfolio going forward would be quite optimistic due to the very low yields on bonds. But even if the 50/50 only gets you 2.5% real return that would still be a better deal than the house, in my opinion, because (a) it would require zero effort from you and (b) the 3.3% yield from rental is fairly optimistic, requiring 100% occupancy under our assumptions (one month a year without rent would bring the rental return down to the same 2.5% -- but you'd still have to work as a landlord).

The house does have potential for appreciation which could make your return higher than 3.3%. But so does the market. There are so many variables that can influence the appreciation of either homes or stocks that it's hopeless to try to guess which will appreciate more (or depreciate less). I wouldn't consider this factor.

I admit I am biased against landlording in general. I view it as a job or a business and one that has plenty of headaches, no guarantees, no job satisfaction, and limited upside potential even if things go well (unless you are heavily leveraged with a mortgage, but that's not the case here with you). But even going past my bias, I just don't see the numbers being attractive here. If the property could rent for, say, $1800 a month, then we'd talking 8% or higher real yield under our assumptions and I would be singing a different tune. As is, unless you hit the jackpot with property appreciation, the property is going to provide very pedestrian returns and guaranteed headaches that come with being a landlord.

I would sell the property and invest in something like the 50/50, using I-Bonds (if you haven't maxed them out already) and municipal bonds, since it's a taxable account. CDs might be an option too -- PenFed has OK rates with cheap option to break early.