Moving to the Burbs? Keep the City Condo As Rental
The real estate market in coastal cities is booming. Here in Boston, property values and rents have skyrocketed since the Great Recession and there are similar trends in other large metropolitan areas. Many young people that purchased in the “right neighborhoods” have significant equity in their homes.
For those young families seeking a sprawling suburban home, it seems reasonable to sell the city condo at a massive gain and roll the equity into a down payment on a larger family home. But is that the best strategy? Before listing the condo and cashing in on the red hot sales market, young urbanites should review all their options to make sure that selling is the best strategy for long-term wealth. (For more, see: Top 10 Features of a Profitable Rental Property.)
Consider this: Real estate has created more American millionaires than any other profession or endeavor and for good reason. For those of us without full-time real estate careers, or the time to find and vet direct real estate investments, the “keep your condo” strategy is a way for people to tap into a trifecta of wealth building that a long-term real estate investment can offer.
A proper real estate investment can provide three advantages:
- Tax-advantaged current income: A good rental will produce positive monthly cash flow that is shielded from taxes through depreciation and other deductions.
- Long-term appreciation: Continue to build equity as renters pay your mortgage and the property appreciates over the time.
- Liquidity: As the property appreciates and rents increase, investors can borrow against their properties for major life expenses in a safe, sustainable and tax efficient manor
Very few investments offer positive cash flow, long-term growth, tax advantages and hassle free liquidity. Below, I’ll outline a common scenario and explain why this strategy works and discuss some common objections or hurdles.
First, an example. Let’s assume that five years ago a young couple with a combined annual income of $150,000 bought a two bedroom condo in Boston for $350,000, with a mortgage of $300,000 at 3.75%. Now, the couple has a baby and needs more space in the suburbs. They’re making more money, about $200,000 combined, and based on comparable properties their condo is now worth $600,000 and would rent for around $3,300 per month (again, these numbers are based on real stories). In five years, they’ve paid principal down to $269,000 and have $330,000 in home equity ($600,000 value less $270,000 mortgage).
If they sell, they can walk away with most of that cash. Sounds great, but the real question is whether they can find a better way to allocate some their $330,000 of equity to meet short and long-term goals. (For more, see: Tips for Renting Out Your Home.)
Let’s first look at the conventional strategy: Sell the condo, buy in the suburbs and invest the difference.
- $330,000, less 5% broker’s commission ($30,000) nets to $300,000 - all tax free.
- Assume $125,000 will be used for a down payment on a new home worth $550,000 with a 30-year $425,000 fixed-rate mortgage at 3.75%.
- The rest ($175,000) will be invested in low cost index funds along a 70/30 equity/fixed income allocation that we will assume grows annually before taxes at 7%
Assuming a modest 3% growth rate on real estate, after 10 years of investment growth and paying down the new mortgage, the couple’s balance sheet would look something like this:
Home Value: $739,154
+Investment Account Value: $321,730
-Mortgage Balance: $331,044
Net Worth: $729,840
The Cash Out Refinance Strategy
Now let’s analyze the real estate investment. If the couple needs cash for a down payment on their new home, they don’t need to sell the condo. They can refinance the loan at a higher appraised value, take some cash out and let tenants pay the mortgage.
Assume rather than selling, they refinance the condo with a new mortgage of $394,000 ($269,000 existing mortgage plus $125,000), effectively “pulling” the new down payment out of their home in the form of a 30-year, fixed-rate mortgage at 3.75%.
|Year 1 Cash Flow|
|Rent||3% Annual Increase||$3,300||$39,600|
|Mortgage Principal and Interest Payment||$1,825||$21,896|
|Taxes||1% Annual Increase||$500||$6,000|
|Insurance||1% Annual Increase||$117||$1,400|
|Vacancy and Maintenance Reserve||10% of Rents||$330||$3,960|
The numbers work. After the refinance, the property cash flows at $6,344 per year. The couple now owns a home in the suburbs and a cash flowing real estate property.
Advantage 1: Positive Tax-PreferredMonthly Cash Flow
Who couldn’t use an extra $6,344 per year? But it gets better because noneof that money is taxable in the first year. The property actually has a net taxable loss due to the concept of deprecation (another much beloved tax benefit of real estate investors that I won’t bore you with). Here’s the comparison of actual versus tax cash flow for year one. (For more, see: Tax Deductions for Rental Property Owners.)
|Mortgage Principal and Interest Payment||$1,825||$21,896||$1,825||$21,900|
|Vacancy and Maintenance Reserve||$330||$3,960||$330||$3,960|
Here are the annual cash flow numbers for years one, five and 10 using the same income and expense growth rate assumptions shown in the table above.
|Annual Net Profit||$6,344||$10,513||$16,509|
The cumulative profit after 10 years, before any investment, is $112,000. These funds could be allocated towards any financial goal - long-term investment, fun, college savings - you name it.
Advantage 2: Long-Term Wealth
You’re now building equity in two ways: Renters are paying down the mortgage and the property appreciates.
After 10 years of payments the note principal will be down to about $309,000. As this happens, the property continues to appreciate at a modest 3% annually, for a value after 10 years of $783,000. That means total equity in the rental property is now about $474,000. Here is a net worth comparison after 10 years.
|10 Year Net Worth and Income Projection|
|Sell Condo||Rent Condo|
|Mortgage After 10 Years||(331,044)||(331,044)|
|Mortgage After 10 Years||-||(309,000)|
|10 Years Rental Profit (not invested)||112,156|
|Annual Supplemental Cash Flow||-||16,509|
There is no question that the couple is better off financially in the “keep your condo” strategy. Even assuming zero investment growth on the cumulative rental profits, the couple has an additional $265,000 ($994,000-$729,000) in net worth and $16,500 in income. The numbers speak for themselves. And this is only after 10 years.
Advantage 3: Tax Free Liquidity
Access to funds is an important piece of financial planning. You can’t spend money if you can’t access it. While the liquidity of financial assets is alluring, there are serious tax consequences when selling appreciated stocks in a time of need. Unloading 10 or more years’ worth capital gains to pay for an emergency expense can be a very painful experience.
In contrast, borrowing against cash flowing real estate for liquidity can help avoid taxes and preserve expenses with virtually no out of pocket expense.
By way of example let’s assume our young couple needs $100,000 ten years after buying their suburban home. If they sold their condo they would look to their investment account for funds. In year 10 the investment account is $321,000, with a taxable basis of $175,000. That means about 46% of every dollar is considered a long-term capital gain, taxable at a combined federal and state rate of 20%. In other words, accessing $100,000 would generate about $9,200 in taxes.
No one likes writing a check for $9,200 and the tax numbers worsen as the needed funds increase. Remember we are assuming that this young couple has been disciplined, long-term investors and hasn’t squandered away proceeds from their condo sale a decade earlier.
But with cash flowing real estate, owners can refinance the property and effectively borrow the $100,000 with zero taxes, allowing future renters to pay it back over 30 years. While they will forego some annual cash flow as a result of taking a higher mortgage, and pay more interest over time, these are worthwhile trade offs considering the cash flow will regenerate and the property will appreciate for years to come.
In other words, long-term, buy and hold real estate investors aren’t afraid of debt and can use it to their advantage. Many real estate investors borrow against their properties to pay for college, weddings or medical emergencies with no out of pocket cost.
Pitfalls and Common Objections
So why doesn’t everyone do this? It’s certainly not for everyone and there are some roadblocks. First, there may be real estate downturns to weather. This strategy also requires investors to become comfortable with (and qualify for) significant amounts of debt. Third, you have to be a landlord and this comes with its own set of operational headaches. I’ll address these issues below. (For more, see: Tips for the Prospective Landlord.)
Popular Objection 1: What Happens If the Real Estate Market Drops?
As long as it makes money, you should keep the property and not worry about any temporary downturn in the market. You don’t lose money until you sell, and what would force a sale is negative cash flow, not a drop in value. If after 10 years the property has dropped in value to $550,000, and rent covers all expenses, we don’t care about property value.
The initial equity is the buffer against a market downturn. In fact, many long-term real estate investors don’t mind having property “under water” (where the loan exceeds the value) if it continues to cash flow each month. Like any other long-term investment, you have to ride out the downturns.
Popular Objection 2: I Don’t Want to Be a Landlord
Nobody wants to get the call at 2 a.m. on Christmas about a toilet overflowing during a snowstorm. That’s what everyone is afraid of. While the horrible inconvenience is a possibility, landlording can be an efficient and “hands off” process after some initial work. Hopefully you can establish a helpful team that will handle these issues so you don’t have to. It may take a few years, but it can be done. Keep the long game in mind and don’t give away a goldmine because you may have to pay a security guard $15 per hour to occasionally guard it.
For every toilet nightmare mentioned above, there are dozens of successful “hands off” landlords that experience success renting to long-term, professional tenants. Put the time into managing the property efficiently. (For more, see: Rental Properties: Cash Cow Or Money Pit?)
Now that we’ve dealt with the two most common objections to buy and hold real estate investing, here are some legitimate risks that could undermine success.
Legitimate Risk 1: The Rental Market Subsides
Without quality tenants, none of this works. If there is a prolonged vacancy or tenant in default that required the costly and time consuming legal process of eviction, this investment could turn sour very fast.
In more stable rental markets like New York and Boston, which both experience increased rents throughout the recessions, this is an ideal strategy. Ideally the young urbanite condo is located in a top-tier location servicing a top-tier tenant (professionals, graduate students, etc.). In other words, there are some baseline rental assumptions that would not be present in more volatile real estate markets servicing a lower-tier tenant.
Legitimate Risk 2: Be Comfortable and Responsible With Debt
Debt is like fire. Although inherently dangerous, if managed properly and utilized responsibly, it can significantly improve our lives. If accessed without care for the future or full comprehension of risk, it can ruin everything.
There is a lot of debt involved in this strategy in that it requires multiple mortgages and refinances, so even that may exclude borrowers without sufficient income to meet lending requirements. But for those with enough income to make the strategy work, I wouldn’t be discouraged by the debt in and of itself.
There is a lot of really bad debt, but fixed rate 30-year term mortgage debt is very good debt. First, the interest rates are very favorable, usually below 5%. Compared to credit cards (16+%) and student loans (5+%), it looks great. Second, unlike other types of debt, the interest on mortgage debt is tax deductible. Third, it’s a fixed, predictable monthly payment that, if affordable, should be very manageable for diligent and responsible borrowers.
Don’t be afraid of debt, just understand the risks.
For young people with highly appreciated properties in desired neighborhoods of major cities, the “keep your condo” strategy could provide an accelerated wealth building tool that provides benefits for years to come. Before you sell that condo, run the numbers. (For more from this author, see: 3 Financial Planning Questions for 30-Somethings.)
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.