Spring has seen a surge in the Boulder property market. As a result of the surge, many locals are considering selling their homes, or investment properties. I am going to share how I try to make better decisions with real estate.
First Step: Gather Information
Start with a family budget that lays out expenses and revenues for the next twelve months. Once created, budgets are easy to maintain.
A technique that I use as a budget reality check is comparing cash that leaves our family bank account (for a month, or a quarter) against our projected expenses. Over the years, I’ve had some surprises by comparing “cash out” to budgeted expenses.
The next step is gathering income and expense details for your key assets. In my family, we make this easy for ourselves by having a separate “house account” which pays out everything that’s house related. In my property business we track everything by property.
To help you out, page 55 of my recent book has a list of expenses as well as detailed case studies for various types of property investments.
If you resist pulling this information together then consider if you are seeking to hide something from yourself. I’ve been known to resist gathering information when it might contain bad news!
Step Two: Pull the information together for the target property.
Here’s an example from where I used to live. I’ve adjusted the figures to reflect expenses per $100,000 of house value.
If I rent the house then I have to pay:
- Rental Agent Commission – $321
- Insurance – $180
- Taxes – $677
- Maintenance – $136
- Furniture Removal – $85
- Mortgage – none for this property
- Utilities – tenant pays
- Damage & Hassle – possibly material, property is in excellent condition and ready for sale
Against that I have a rental projection of $5,145 per annum (per $100,000 of house value). Round numbers, the property is forecast to yield 3.7% [(5,145 less 1,399) divided by 100,000].
If you have a mortgage against the property then remember to consider the return on investment with, and without, your mortgage.
- Yield on valuation – take your net profit before interest and divide by the net value of the property (after sales commission and capital gains tax)
- Yield on equity – take your net profit after interest (exclude the principal amount of your mortgage payment – only include interest) and divide by the net equity that you have in the property
To illustrate, if there was $40,000 of debt per $100,000 of value then the interest payment would be $1,400 at a mortgage rate of 3.5%. The net profit after interest would be $2,346 on $60,000 of equity (3.9% net yield on equity).
Step Three: Consider Big Picture Questions
What will I do with the equity if I sell? For many of us, housing is a form of forced savings. If we had the equity sitting in a bank account then we might be tempted to spend it. If you are thinking about switching to another property investment, then you’re likely to do best by staying put. Property has very high transaction, and switching, costs (due to real estate commissions).
How often can I sell this asset? Certain assets, such as vacation homes, boats, luxury goods, can only be sold in good market conditions. This creates a paradox because your best window to sell will be when you’re tempted to hang on to the assets. If I want to sell then I remind myself to leave something in the deal for the buyer.
Where will you live? If you are thinking about selling your main residence then be clear about where you will move, and the expenses associated with your new location. Generally speaking, prime markets are the first to respond to an uptick. For example, the Boulder market saw this recent surge a year after Palo Alto ticked up. Secondary Colorado markets might take another year to see improvement. What’s been happening in your next location for the last year, how does that compare to your home market?
As an example, the value of my old house now “buys” 30-35% of the square footage in Palo Alto vs Boulder – it used to buy 50-60% of the square footage. When moving between cities, states and countries, timing plays a key role with purchasing power. When moving “prime” to “secondary” – it is possible to get priced out of a market. I’ve seen examples of this in the San Francisco Bay Area, London and Vancouver. If you sell out of a prime market then values can rise and make it very tough to buy back in.
What does your current mortgage, insurance and taxes “buy” if you were to shift to a rental unit? I like to compare own vs rent. My current house would cost me $1,000 per month more to rent than to own. This is a function of the down payment I put down and covered in my article on Mortgage Debt As Inflation Insurance.
What’s your tax exposure ? Agent’s fees and realized capital gains can make moving from owning to renting less attractive. As a landlord, being able to depreciate the house (but not the land) will reduce the taxable income generated by the property.
Three final questions that I like to ask myself:
- Can I afford to be wrong?
- What happens if I do the opposite?
- Under what scenarios does my preferred choice become a really lousy decision?
For now, my decision has been to continue to market my old house for sale. However, the yield from renting it out, rather than selling, is compelling.