I met with clients this week that own a home in another state. They have owned it for a few years and during that time, they have used it mostly for their personal use (themselves and family). In the past year, they have started renting the property out to tenants.
When the house was first purchased, they thought they might live in it one day. That remains a possibility but they also want to understand/explore their other options – both continuing to rent it and selling it. As they start to evaluate these choices they asked for my input and things to consider.
As with any investment, I believe it’s important to consider quantitative and qualitative factors. With a publicly-traded investment, it is a bit easier to complete these steps. You can pull up your account at any given moment and see what your current yield is, what your gain/loss would be if you sold, what analysts are saying about the investment, etc. With real estate, you need to do a bit more work as this information is not as readily available.
Let’s walk thru an analysis of a real estate property – starting with the quantitative side. First, you can calculate a rate of return on the property – just as you can for a stock and bond. If you are renting it, you can first look at your yield on the asset. Add up all your expenses (property taxes, mortgage interest, maintenance, management fees, etc) and net that against your rental income. That net profit divided by the value of the property is your yield on that investment (just like a dividend or interest rate on a stock or bond).
Second, you can also factor in the appreciation (or depreciation) of the property over a given time period to give you your total return (similar to price appreciation/depreciation in a stock or bond). With real estate, it can be harder to determine as properties aren’t marked-to-market daily like exchanged-traded securities are but real estate websites and market comparables can help.
Once you know the total rate of return on your real estate property, you can compare it to others available in the marketplace (as well as against your long-term return expectations/requirements for your financial plan). Further, while this didn’t apply to my clients, you could also look at that rate of return versus an interest rate you’re paying on outstanding debt (and consider if you’d be better off selling the property and using the proceeds to settle the debt versus holding this asset).
Arguably the harder part to evaluate is the qualitative part. Items to think thru here include: time/mental energy to maintain two properties, plans for your future (will you eventually want to live in the property), emotional ties to the property, and likely trajectory of the area/value of the home. Real estate is inherently more emotional than other investments (such as stocks and bonds) so don’t ignore these factors. But be sure to challenge your feelings and ensure you aren’t ignoring the “math” side of the equation as well.
After completing the above steps, if a decision is made that the property should be sold, you should play out the implications of a sale before taking any actions. Why? A sale will likely have a material impact on your finances. First, taxes: If the property is not your primary residence and the value has appreciated, you will be subject to capital gains on the sale which can have many consequences (push you into higher tax bracket, result in higher medicare premiums, trigger Net Investment Income tax, etc). If the value has declined, you can take a loss and may wish to do so in a year when you have gains elsewhere. Second, before selling, consider what you will do with the proceeds. How will they be worked into your financial plan. Will you pay down debt? Add to investments? Purchase another property? It’s best to have a plan in place before taking any action.
As you can see, a real estate investment requires a similar – yet arguably more involved – assessment than publicly traded investments do. They can prove to be very rewarding and financially beneficial over time but you must stay in tune with both the quantitative and qualitative aspects over time to ensure it is helping you along your financial journey.
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