Rental properties can be a fantastic investment vehicle in the right environment. They can strike a balance between income and capital gains or can go on either end of the spectrum. They are effectively a business, more than a cold investment, and should be run and treated as such. Rentals are also a fantastic way to build generational wealth. Regardless of how one goes about choosing and running their rental properties, there are instances where it makes more sense to be selling a rental property it rather than keeping it.
What Constitutes a Rental?
We all know what rental properties are. You buy a place people want to live in, you make sure it’s suitable for your demographic, and you rent it out to somebody who needs a place to live. You make sure your incoming rent covers all of your overheads, or that you have a supplementary income to cover the difference. Bingo-Bango, you have a rental property.
Some rental properties people deliberately run at a loss, covering the difference with income from other sources. If by choice(sometimes it isn’t!), the owners typically hope for some form of capital gains over the long term. Depending on your local law, the loss made while renting the property out may able to be claimed back in tax.
Why You Might Sell A Rental
There are plenty of personal reasons you might sell a rental. You may need to free up capital to cover a rather large bill or to pursue a different opportunity. Perhaps the rental is under-performing. There are a plethora of reasons you may sell your rental.
If you have bought your rental in a place that has faced capital growth, there’s a good chance you have a decent chunk of capital tied up in it. This also most likely means that your yield vs the capital tied up in the property has decreased. It typically goes that higher quality areas have lower yields, so even with higher rents, the same level of yield you had wouldn’t apply. Whether this suits you or not, it a matter of personal preference.
Of course, there’s peaks and troughs in the property, as with any market. If you’re following the time old mantra of buy low sell high, you may be selling a rental property as a manner of trying to time this cycle to grow your portfolio as well.
Let’s say you bought a property for $100,000 with a $20,000 deposit. your rent it out for $1000 a month and your total expenses are $1000 a month(somehow) and you’re paying interest only. You have been breaking even on the property for 5 years and now you have found an opportunity, such as a business that has come up for sale. When you reevaluate the property you find it’s increased in value to $175,000. Suddenly your 5 years of breaking even have turned into $15,000/year($75,000/5 years). Let’s assume 33% capital gains tax. After this, you’re left with 50k, plus your 20k Deposit – a total of $70,000.
You could now reinvest this from selling a rental 70k into three properties that cost $100,000 each, breaking even on each of them with $10,000 cash to spare. Or you might opt to invest into a dividend ETF granting a 5% yield giving you an ROI of $292/month or you might opt to buy one property and make a full deposit, bringing in a positive yield.
If you do the math, often times you can find a better yield from selling a rental rather than continuing on. Of course, this scenarios isn’t complete without mentioning the following: If your property has gone up 75% in value for real reasons, you can often increase the rent levels as well. They aren’t always proportional rent rises when compared to the gains, however. Sometimes it’s more than gains. More often it’s less. While you might get a better yield on your deposit, you’re getting a lower net yield on your capital, thanks to these gains.
In my local political climate, we are passing more and more socialist laws. These laws tend to favor those that don’t want to help themselves, while punishing those that work hard and make sacrifices.
Examples of these laws are limiting rent rises, not allowing you to remove a tenant for any reason, allowing tenants to get away with not paying rent for extended periods, having to continuously repair intentional and repeated damage and too many more to list. Effectively these remove control from your hands, and put you at the mercy of laws that you had no say in deciding.
The intent behind these law changes is to reduce house prices, meanwhile to stimulate the economy which is in a fast real decline, interest rates are lowered. All the while the cost of production is steeply increased thanks to increasing regulations and massive wage hikes. The intent is to help businesses grow by borrowing money…to pay for under-performing workers and policies which in effect do nothing. The real result in less new businesses and less jobs being created, and thus less pay. So peoples capital goes into shares and assets, which hikes the price anyway. So house prices slightly rise or stagnate, while becoming less profitable. Thus the renters can’t afford the houses, and investors don’t want them.
The answer to this conundrum – more regulation and lower interest rates. This exacerbates the problem further. And eventually, we have a debt bubble. More people buying unprofitable investments, and no real economic growth. All the while the media chirps on about ‘gdp growth’ and ‘low inflation'(CPI doesn’t factor in size or quality of goods, so it’s not a real measure of inflation). So people keep taking on more debt, buying things they don’t need like new cars, bigger TVs and so on. They hinge their lifestyles more and more on debt, getting hooked into the system, while the system keeps delaying the inevitable
This can only be delayed so far. That longer the fake expansion continues, the harder the crunch. Especially in an economy that doesn’t allow you to take mortgages with fixed interest over long periods(5 years max here). So to me, it only makes sense to reduce exposure to this inevitable crunch to protect my families finances.
In a free market, these law changes to ‘protect tenants’ would solve themselves. If landlords are too unfair, their reputation would see them struggle to get tenants, and the vacancies would crush their income. In tenants are awful, then they will struggle to find somewhere for their families to live, or suffer high rent hikes to suit. This keeps both parties in check.
The fallout from the governmental imposed crunch can go either way – a return to a more sustainable system, or more robbing from the productive to care for the unproductive as socialism’s claws sink even deeper.
Selling to Pay Off Your Own Home(or other debts)
Being mortgage free is a hot topic of debate in the FI community. There are two schools of thought. Maximum yield vs guaranteed yield+peace of mind+security. Some of us who are more willing to take risks and put our assets on the line pursue greater returns. This can have the benefit of building a stack of wealth much faster, but also potentially runs the risk of losing a portion of it as well. By putting realized gains into our own homes or other debts, we can lock in a near-guaranteed return which grants the added benefits of security and peace of mind as well. There are arguments for both sides, of course, which I’ll discuss further below.
I’m 100% on board with owning over renting. It’s great to have a place of permanence you own to hang your hat and call your home. But frankly, more often than not, A personal home is a terrible use of capital from an investment perspective. You may see capital gains from your own home, which is about the only way you can see a return, outside of owning a duplex or similar, which then it is actually just rentals+home.
The problem with viewing capital gains as a return is that you still have to pay the loan from somewhere. Living in your home rarely pays a yield. So the money you borrow becomes a liability that needs to be serviced. If this is lower than rent in your local geographic location, you’re onto a winner. There are other costs to owning a home, but let’s ignore that for the sake of simplicity.
Let’s say you borrow money at 5% to own your home, worth $100,000. You have put a $30,000 deposit down, so now your payments are $292/month. Locally renting may be $350 a month. So cool, you’re up.
Now you’ve sold your rental and have $70,000 cash, as above(ignoring those other example factors). You can use this to get a guaranteed $292 in yield a month by paying your house down. Or, you could invest it into some ETF that yields 10%. Now you’re looking at a return of $583 a month – basically double. You could use that to service the debt on your house and have some to spare for the principle. This is maximizing your yield. Realistically you still have to worry about transaction fees and timing for this as well as income tax(depending on the vessel).
While maximizing yields by selling a rental looks good on paper, there’s a downside. What if the ETF doesn’t perform? Or what if interest rates rise to 12% due to economic shifts? Now you’re stuck and have a worse yield that you would have if you locked in that basically guaranteed 5% by paying down your mortgage. This is the counter-argument.
If you were to use the lump sum of cash to pay down your mortgage you’re effectively locking in a 5% return. You’re owning your house either in a greater capacity or outright. This can increase your peace of mind as well. Lower payments and lower overheads are basically less stress too. Finally, you’re also more secure in that outside of a catastrophic event, you now own your home and little can take that away. You will still benefit from the capital gains on your own home, only in a lower capacity. Sometimes it’s worth sacrificing a little yield for the security of you and your family. This is doubly true in the case of Dynastic Land and owning a Family Sanctuary, which should be freehold asap.. But it’s all personal preference.
If we’re talking other debts, the same principle applies. Typically debt secured with property is going to give you the most effective interest rate. If you free up cash from selling, you may instead opt to pay down a credit card debt you’ve racked up from a ‘former life’. If this is 20% on 50k, then the reduced interest payment of 10k a year is a pretty obvious benefit.
Would you securely keep this or risk it or get more in the future?
It doesn’t have to be so binary of course. I’ve presented an either/or scenario. The 3rd option is striking a balance between the three. Say you split that $70,000 in twain and put $35,000 to your home and the other $35,000 into the ETF. Now you’ve reduced your personal mortgage to $35,000 with payments of $146/month(@ 5%) and can still invest in that Etf pulling a 10% return, granting $291/month return. This would leave you(other factors ignored) with a positive return of $145/month. Not quite the same as maximizing your yield, but now you have the added peace of mind of a lower interest payment to service your otherwise unproductive debt.
My strategy was to break even at first at the very least, then gradually increase my rents so I can start to generate income. This worked on some properties and didn’t on others. Those it didn’t, I still managed to sell them and put the capital gains to work for us. The two I have left now bring in a modicum of income to boost our family coffers each and every month.(2019 update: Due to further moves by the socialist NZ government, I have reduced our rental portfolio to a single rental)
There is only one property in our portfolio presently that I plan to keep intergenerationally, however. It’s the one in the best area, it’s the largest, has had the most capital growth and still has room to be renovated and rented out for 30% more. This is a strategy that works for my families objectives. We could still probably further see a better yield selling it and investing elsewhere, but the gains in this scenario are what we are truly after. I wrote more on this, here.
It’s Your Call
Nobody is going to know what’s best for your family when it comes to selling a rental. That’s why it’s called family finance. It’s your call which is going to better suit you.
If you choose to pursue greater yield, then you may put your assets at risk in doing so. The upside is that if it does work out, you face the potential to reap much greater rewards. Compounded over long enough, these can make a huge difference to your families wealth.
Paying down your own home(or other debts) using the lump sum from selling rentals will lock in and give you guaranteed return. Paying down your own home won’t typically give you the highest monetary benefit, but will give your family security and peace of mind, and it’s impossible to put a dollar figure on that.
Paying down bad, high-interest debts makes even more sense. Doing so will give you a huge, guaranteed ‘return’ in the form of reduced interest rates. A definite priority for anyone chasing financial freedom or intergenerational wealth.
If you’re selling a rental, what do you hope to achieve – higher return or a safer situation? Any other reasons you might sell down or hold a rental? Do you fear scialist changes effectively rendering your property unprofitable? Drop me a comment and let’s discuss.
There’s a sister article to this one explaining what I did with my rental which you can find here.