My Rental House Dilemma

by FI Fighter on November 5, 2014

in Guest Post

st_louis

I got started in real estate investing back in summer of 2012. Since that time, there have been many highs and lows, which have been documented on this blog. But that’s just one person’s perspective… and there are millions of other stories out there.

At this time, I would like to welcome Jon from Money Smart Guides for a guest post today on his own rental property experience!

Growing up, I knew that one of the keys to wealth was through investing. As a result of this, I began to invest in the stock market before I was 18 years old. Since I couldn’t invest directly because of my age, my Mom opened a custodial account for me and placed the trades I wanted to make. In the 17 years since, my stock market investing has gone from being an active investor trading stocks to becoming a passive investor in mutual funds and ETFs while paying attention to costs and fees.

I have had great success investing in the stock market using my plan. But not all of my money will be in the stock market. When I was turning 18, I learned that my grandfather owned a house in town that he rented out. Up until this point, I was clueless to rental real estate. I can still remember the day, talking about his rental and realizing that real estate was another great egg to have in my investing basket.

As I write today, I have one rental property. But it is bleeding money. I enjoy reading FI Fighter and threw out the idea of writing about my rental property issue to get some feedback not only from FI Fighter, whose input I trust, but also the great people that read this blog. I feel that through all of you, I can get clarity to my rental property situation.

Rental Property Background And Goals

Before I get into the numbers, I want to make sure everything is understood from the start. My wife and my ultimate goal is to retire early. We plan to be in a position were our monthly expenses are funded by the income thrown off from our stock market investments as well as the income from a handful of rental properties. Ideally, we would like to own 10 properties. We have done a good job saving up until this point and our investments (mainly retirement) are worth close to $500,000.

Onto the rental, which I bought back in 2007 right at the height of the mortgage bubble. I could not afford it at the time (I’m still amazed I got the loan) and that is still hurting me as I rent it out. The house, which is a townhouse, but for insurance is classified as a condo was bought for $167,000 with 10% down. This left me with a 30 year fixed mortgage of $150,300 at 6.375%.

Currently, my mortgage balance is right around $135,000 and according to Zillow and recent home sales, is worth about $130,000. In 2012, I moved in with my wife and began to rent out my house. In a given month, without taking into account depreciation, I am losing close to $300. Here is a breakdown of my monthly costs and the monthly rent I earn:

Monthly Costs Pic

A few notes about the monthly costs and income:

  • The unit has gas heat and that charge is included in my HOA Fee. Because of this, I can’t have a bill for it sent to the tenant. I’ve called a few times about having one sent and they tell me it cannot be done.
  • Because of the gas bill, my work-around is charging higher than standard rent. The current going rate for rent in my town is around $1,100 per month. I don’t think if I raise the rent anymore I’ll get many inquiries for renting the unit.
  • The mortgage payment includes principal, interest and taxes.
  • The insurance covers the dwelling as well an umbrella policy to cover us should anything happen to someone on the property.

What To Do?

I received a call from my current tenant that she will not be renewing the lease and thus will be moving out the end of October. I have the unit listed for rent as of this writing for $1,300 per month. The issue is that my wife and I don’t know what to do – keep renting it out or just cut our losses and sell. Here is a sampling of our thoughts:

  • I looked into refinancing and I can get a lower rate and lower monthly payment by extending it back out to a 30 year loan. Doing so will cost around $3,000 for closing costs, which when rolled into the mortgage just puts us that much further underwater.The refinance would have us essentially break-even each month without taking into account depreciation.
  • I cannot go the HARP route because my loan is not backed by Freddie or Fannie. In fact, the prices in the development dropped more than surrounding areas because it wasn’t even FHA approved. So after the housing bubble burst and you could still
    buy with a low down payment by going through the FHA, no one could in my development. You needed the full 20% down. No one was buying because they didn’t have 20% to put down.
  • There were a bunch of foreclosures in the development, which have been hurting comps. Prices have not really moved at all in the past 12 months. My thought is maybe the foreclosures are ending and the value of the homes will increase, taking us out of negative territory.
  • If we do sell, assuming for $130,000 we have to come up with $5,000 to pay off the mortgage and then pay the real estate agent fees. At 6%, we would end up having to come up with close to $13,000 out of pocket. Neither one of us wants this, but it might be the least painful choice.
  • The HOA fee goes up almost every year. When I bought in 2007, it was $235/month. Now it is $280/month. That just keeps cutting into any profit we could potentially make in the future. This is also why I am concerned about refinancing. I’ll break-even now, but next year when the HOA fee goes up, we’ll be in the red once more.
  • We have a high income, so we cannot write off the losses. We realize that we can carry these forward until we are in a lower tax bracket, but as of right now, we aren’t benefiting from a tax write off.

As you can see, there doesn’t seem to be a non-painful solution. I have it listed for rent now because if I hold for a year or two and housing prices rise, I hope to not be underwater and make a clean break from the house (though I do realize I would be essentially paying the money in monthly installments as I am losing money each month).

Long term, we don’t see this as a good investment property. I mentioned our goals because we want to do what is in our best interest to get there. We would rather feel some pain today if it means getting us closer to our long-term goals than benefit over the short-term if it means sacrificing our long-term future.

I am hoping that I didn’t leave out any information that would be needed in helping find a solution. If you have questions, please put them in the comments below and I will respond. Thanks in advance for all your help!

{ 19 comments… read them below or add one }

1 DoneByForty November 5, 2014 at 9:28 am

It’s a shot in the dark, but would your current house yield any better figures as a rental, if you moved into the townhouse?

Off the back of the envelope, losing about $300 per month is a $3600 loss per year. Selling now is a $13,000 loss, but also lets you avoid that $300 a month loss going forward.

The prediction to make is whether you reasonably think the house would raise enough in value for you to break even in a sale (walking away w/nothing, gaining nothing) sometime in the next 43 months (including any money owed back for depreciation, etc.). I couldn’t make a prediction, but you might have some insight that would allow you to make a decent guess.

I, personally, would probably take the loss and move on.

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2 Jon @ Money Smart Guides November 5, 2014 at 11:04 am

We aren’t interested in living in the rental and then renting out our current house. While our current house would net us a small monthly profit, it’s just not something we are interested in. But I appreciate the idea.

As for breaking even in the next 43 months, I would have to run the numbers to see.

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3 Dave @ The New York Budget November 5, 2014 at 1:46 pm

I agree with DoneByForty on this one. I might take the loss on this one and move on. Of course, that could end up being a dumb decision and the housing market might explode in the next few years. But at the end of the day, I’d rather not take that gamble.

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4 Jon @ Money Smart Guides November 6, 2014 at 7:26 am

Thanks for the advice. I don’t think seeing if the housing market takes off is a good idea either. It would be like waiting for the perfect time to buy more stock in the stock market. No matter what is happening, you can always come up with a reason to keep waiting.

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5 Jason November 5, 2014 at 4:39 pm

Well, there are a lot of variables at play here so I’ll point out a few observations in the hope that they help:)

First, you summarize the Cash Flow situation of the property (not the true annual gain/loss on the property). That’s fine, that’s what most people focus on and it’s very important. However, to get an accurate picture of how much you’re ‘losing’, you need to factor in the principal pay down (I’m guessing ~$300/month at this stage?), tax benefits (don’t you get at least the $3K passive loss write off?), vacancies, repairs/maintenance, etc. And future appreciation is always the big unknown.

Saying that, I make sure all of my rentals cash flow at least a little, on a 15 year note, taking into account all of the above. That typically means I’m making a pretty good return. Sounds like you bought at the wrong time, have a poor (but not TERRIBLE) RE investment, one that is likely to be subpar for some time. If you’re planning on adding to your RE portfolio I’d be tempted to hold on to this one, see what happens in the next few years, and hopefully use the accumulated losses to offset some huge gains on your next deal. If you’re getting out of the RE game and sticking to mutual funds or whatever, take the loss and move on.

Finally, as far as refi, be sure to calculate your break even period – the point at which the refi costs is offset by interest rate savings. Lowering your mortgage by extending the maturity date is one thing, but calculate how long this decision will take to fund the $3K. If it’s more than 2-3 years I may sit tight. If you can stomach a bit more cash flow drain each month, I’d also consider a 15 year note. Mentally for me I like knowing in 15 years these babies will be paid off. 30 years is just too long for me to get excited about one becoming debt free. Plus the interest savings is substantial.

Finally, if you do decide to add to your RE portfolio, are you handy? I’ve found my best deals to be properties in major need of updating, and I’m pretty handy and enjoy it. My last house was purchased for $65K, I put $25K in rehab (plus about a month of working on it after hours), and it rents for $1,495. Of course, I’m in Dallas where RE is relatively cheap and it’s a landlord’s market right now, but it may work for your situation as well.

Hope that helps a little~

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6 Jon @ Money Smart Guides November 6, 2014 at 7:29 am

That does help. I do plan to stay in the RE game and never thought about keeping this one to offset some gains from the next one.

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7 Happy Healthy and Wealthy Girl November 5, 2014 at 9:07 pm

Hey, if I would be you, I would prefer to wait until all foreclosures are gone and prices went up. So at this moment I will refinance, so the house will stop being in a monthly negative territory and then actually your renters will slowly pay your mortgage.
Selling right now doesn’t make any sense to me. You can just invest this 13k into stock market instead. Just be patient.
Good luck!

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8 Jon @ Money Smart Guides November 6, 2014 at 7:30 am

Good to know….I keep checking to see if any other foreclosures come up and they do seem to be slowing down. Currently there is only one listed. The rest of the houses are regular for sale. The foreclosure is listed at $120K while the others are between $125K – $140K.

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9 Curtis November 6, 2014 at 5:05 am

Hi, Jon
Sorry to see this situation. It’s painful to read about. I think deep down you already have a pretty good handle on what needs to be done. No one likes to lose money on an investment, but this particular investment needs to be booted out the door ASAP.

You true losses are more than the monthly cash flow would lead you to believe. Jason alluded to the losses from vacancy and maintenance. I understand that the HOA will cover certain exterior repairs, but the carpets, paint, appliances, etch are all leading up to a future expense and must be accounted for. That’s what depreciation is for. People look at it as free money, but the reality is that you’re being reimbursed for these breakdowns in advance. At some point you will have to cover these maintenance expenses, breakdowns and replacements.

Factoring in all the above, your losing between 5-6k per year. In the best case scenario, would the property appreciate by this much? Then all you do is breakeven if you wait to sell. It would have to appreciate substantially to justify waiting to sell in my opinion.

If I were living the same scenario, I would bite the bullet and sell. The emotional relief of knowing your not feeding an alligator would justify selling in my book. Unless you’re buying for appreciation (which is akin to gambling), Rental real estate should always be cash flow positive.

Just my two cents (Worth four with inflation)

Anyway

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10 Jon @ Money Smart Guides November 6, 2014 at 7:32 am

Thanks for the input. Everything you say makes complete senses, including your signature!

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11 Mrs. Bug November 6, 2014 at 1:28 pm

I had a very similar situation myself. We had been renting out our previous home and were losing money each month and then on top of that our renters trashed the house so we had to do massive repairs. We ended up selling at a loss and paying out $18K at closing but it stopped the bleeding and now we are much better off than we were before. I say cut your losses and move on if you don’t see the market picking up significantly within the next year. The area where we now live is on a huge increase in values so you may want to check out your area first. Best of luck.

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12 billy November 6, 2014 at 6:53 pm

I am going to be the minority here, I think after re-fi and some restructuring of cost (such as removing PMI, you probably will reduce the loss quite a bit and even possibly break even. This will improve your cash flow position and stop bleeding. Next you just need to wait for a while till the real estate market recover. It will, eventually, just need some time.

It will only be considered “sunken cost” which means the more you put in the more you lose, and you will never recoup the loss. but it is not the case here.

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13 No Nonsense Landlord November 7, 2014 at 5:19 am

You are correct, it does not appear to be a great rental situation. Subtract any amount that goes to principal, as that is money being put indirectly into your pocket for later. That might help.

Advertise it at $1,100 per month, or even less. Include an HOA fee of $280 per month, which included heat, etc. $1,100 + $280. You get to ‘sell’ at the same price, but can mandate the extra fee. You are just excluding the HOA fee from the rent. They still pay the fee to you, not the HOA, one check.

Make sure your tenant is great when you do not have much margin. You would not even have the extra rent of you did not combine households. And if you sell, you have to pay a Realtor too, not just the $5K.

You may also be able to do a no fee refi. Slightly higher interest rate, spread out over 30 years, will be a smaller payment. Principal stays the same, interest rate goes down, more years to spread the payments over.

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14 Joe November 8, 2014 at 10:55 pm

Hi Jon,
I am in the same boat as you are. My area has been flooded with new development that has kept my property value low. Each month I am taking a hit b/c the rent doesn’t cover the mortgage. I’ve thought the same things that others have posted.
A good idea someone mentioned is the passive loss negates passive gains from other rental properties. Also, if you do sell, any passive losses you have accumulated can be used towards the cost basis of the house to allow for a bigger capital loss – at least that is what I have read.
One idea that hasn’t been mentioned is a strategic default. Now some might frown upon that, but you might consider it if you don’t mind taking a hit on your credit score. Also, depends if it is a recourse/non recourse loan. But the sweet spot to do this was 2012? when the law allowed you to do this without having to consider the loss as income. Still an option maybe.
Another thought is doing a short sale – depending on how much underwater you are. Didn’t take a deep look at your numbers.
Others can chime in and tell you whether these are good options. I am certainly no expert.

I’ve been jumping back and forth on what to do myself! I figured if I bought some cash flowing properties to cover the monthly rental deficit, it might not be that bad. Considering I can make the passive loss work for me – it might be the best option out of all the crappy ones!

Good luck and let us know what you decide.

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15 Danny C. November 10, 2014 at 7:38 am

I agree with Jason that your cash flow situation should be revised by backing out principal pay down and including tax benefits like mortgage interest deduction, depreciation, etc.

It also looks like the refi option has a quick return on investment if how you described it is right. $3,000 to refi takes you from a $300 monthly loss to break even for a net gain of $300 giving you a 10-month payback period. That sounds like a winner to me.

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16 Max November 10, 2014 at 9:00 am

I think that FIFighter is rare in the markets that he chose that turn such a profit. I think a lot of people are in similar positions as you are and while it’s less than ideal you have to still remember if you include depreciation you can take a loss each year on your taxes which would probably be beneficial to you given your higher income that you mention. If you sell it then I think you could re-coup some of the losses as well and re-invest as you see fit. Regardless, you have the tenant mostly paying off your mortgage for you.

The issues you identified are what have kept me from investing in townhomes/condos, but I’ve heard other success stories.

Best of luck.

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17 JP November 10, 2014 at 3:50 pm

Condos are tricky, so from now on I would focus on Multifamilies with a 25% cash on cash return. You will be protected even in a down market. Although your situation may seem grim, remember that your tenants are paying down your mortgage and building equity over time.

Here is what I would do…

1. Refi to stop the bleeding, remove PMI if possible
2. Hold until you feel that the appreciation is worth selling

“Our favorite holding period is forever”
-Warren Buffet

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18 FI Fighter November 12, 2014 at 9:10 pm

Great responses, thanks so much everyone! And thanks to Jon for the awesome guest post 🙂

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19 Kathy December 2, 2014 at 10:17 am

I’d love to see an update later about what he chose to do and how it feels about it after the fact.

I know this is late – but I’d probably wait until 3-4 sales comps after the last foreclosure to see what my new normal is, with intentions to definitely sell (hold a year or two maybe?).

Unless he purchased brand new (I missed it if he mentioned that already) in which case I’m less optimistic about there being a significant rebound. A lot of times I see people paying a premium for having a brand new place built to spec (paint, flooring, counters, etc.), but the resale market doesn’t necessarily support that price.

Best of luck Jon!

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