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On the list of things I hope to someday own, a rental property may just be last.
My parents owned rental properties near a college campus in the early 2000s and through the Global Financial Crisis. I still have nightmares from the maintenance calls that the world’s least-handy son was tasked with handling. I’m sure my nightmares pale in comparison to my parents’. Okay, there, my biases have been stated.
This is the question I get all the time: “Should I sell my rental property?” More specifically, “I’m retired or retiring. I don’t want to be a landlord. What should I do with this rental property?”
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In most markets post-COVID, price appreciation in the real estate market has pushed off that decision. Recently, things have started going the other way.
Here’s the back-of-the-envelope math we would use if we had 15 minutes and no technology to answer this question.
Figure out the cap rate
The cap rate is essentially the real estate version of yield: Income divided by property value.
Where things get tricky is figuring out what the income is in this calculation. If you charge $5,000 per month for rent, you don’t get $5,000 per month. You have to factor in property taxes, insurance, maintenance and possibly homeowners’ associations and property managers.
This assumes there is no mortgage, which is what we will assume for this column.
You take that net income value and divide it by the current market value. This is your cap rate. In high-cost markets or with safer investments, cap rates are lower. In low-cost markets, or for higher-risk properties, they are higher.
You are banking on more capital appreciation if you have a lower cap rate.
I live in the Washington, D.C., metro area, and it is common for me to look at a Schedule E, where income and expenses are reported, and see a very large chunk of the income eaten up by property taxes and maintenance.
Determine what’s acceptable for you
As mentioned earlier, we rely heavily on technology to make these decisions. For any property on the balance sheet, we can use a drop-down menu to select a year to sell it and see whether the success meter goes up or down.
The numbers never tell the whole story, but they definitely help. There is a free version of this software you can try.
If you don’t want to get too detailed, a 5% cap rate is typically the benchmark I use. There are always going to be exceptions to rules of thumb, but numbers much north or south of 5% tend to be red flags for me.
If you are far below 5%, you are essentially making a bet that the property will appreciate significantly. If the stock market has historically returned around 10% and you are comparing residential real estate with a cap rate of 5%, you would need 5% annual appreciation on top of that to match those returns.
If you have a cap rate of 8%, you need only about 2% to match the returns. This addresses returns but not risk-adjusted returns, which makes the comparison imperfect but useful.
Determine how it will impact your financial plan
Yesterday, I was talking with a friend who derives a large chunk of his monthly income from rental properties. There was a legislative change in Philadelphia that meant that he was losing about 40% of his rental income.
He will be okay, but there is a downstream impact. He will either have to make more money elsewhere or sell those properties.
For many of our clients, these are homes they have owned for 40 years, and selling them won’t make or break their financial situation. But it will have a significant impact on their life and on their taxes.
Let’s start with the impact on the person’s life. A slight reduction in a success rate that comes from selling a property may mean two different things for two different clients.
For Mary, whose kids live all over the world and who has a long list of hobbies, she’d gladly take that reduction for the freedom it will give her. For Sarah, who is a tinkerer and who has always been interested in real estate, she’d rather keep it. We have more clients in the first category.
Tax impacts tend to be negative if you sell, but that’s not a good enough reason, alone, to hold on to the property. The tax computation on a rental property sale is complex, and the tax owed is never less than you expect it to be, mostly due to depreciation recapture.
That big deduction you got to take for almost 30 years gets recaptured (taxed) upon sale, in addition to gains on the property. I would recommend you have a CPA or enrolled agent (EA) give you an estimate before you make any big decisions.
If you’ve read this far, the odds are you don’t love being a landlord. Think of the decision as getting out of a long-term relationship you’re not happy in.
Unfortunately, breaking up is not that simple. Selling a property is a big decision, often with many commas. I’d run the numbers and make sure that even if you know you’ll be happier post-breakup, you’ll still be okay financially.
