The sometimes difficult and often emotional decision to move from one’s home can be driven by a variety of factors. It could be a growing family makes the home too small, kids off to college makes it too big, you’ve had your fill of city life, or you just plain want a change of location, scenery, amenities, or feel. Unfortunately, however, the need to sell does not always line up with ideal selling conditions. In these situations, understanding your options can play an important role in maximizing long term value.
The strategy we wanted to discuss in today’s Katzen Report is renting one’s existing home in anticipation of an improvement in real estate values. If sellers that intend to rent, then this is a strategy for them. There certainly are pros and cons with this strategy, and its benefits can be quite situationally dependent. For example, in weaker markets, the high end usually is hit hardest. This is a strategy for themTherefore, someone up-tiering from say a $1 million home to a $5 million home generally will feel “hedged” in this trade; while they may have lost a bit on their current apartment, they’ve likely saved much more on the fall in the price of the one they are buying. In these cases, renting has less appeal. On the other end of the spectrum, you have sellers of pieds-a-terre who may not be replacing the home nor in need of the funds immediately, but rather simply may not have use for it anymore. In addition, you have the case of sellers that are downsizing, and therefore their asset may have performed worse than the home they are buying. For these three seller groups, renting can be an attractive bridge to stronger market conditions. Other considerations of course apply: are the sale proceeds needed to purchase the new home, and what is the current building’s rental policy. In the case of the latter, condos tend to offer great rental flexibility, and coops generally allow some (albeit shorter) rental windows. Lastly, a rental strategy (when the seller is buying a new home) will leave the seller long two properties at the same time, increasing overall real estate exposure. Thus, a seller must be comfortable with this (short term) “real estate heavy” asset allocation.
Now, in situations where renting is a viable and potentially compelling option, making the decision to be a landlord (even if only temporarily) can be uncomfortable given the fear of the unknown. This is completely understandable. Therefore, understanding the requirements, implications, and intricacies of being a landlord is essential. This is especially the case given the changing landscape; New York State, for example, just enacted new rental laws. In order to provide some clarity on what being a landlord entails, and whether it might be right for you, I have outlined several things to consider.
From a macro perspective, this strategy tends to work best when the “traditional” inverse relationship between home prices and rental prices holds. Currently, the data on this is mixed. A recent Forbes article stated, “The yin/yang of the sales and rental environments, in which historically they have moved in contrary motion to one another, remains out of sync: slower sales did NOT mean a corresponding rise in rental prices as it historically has. Instead, both markets sank in tandem, and are now plateauing together.” But, in more recent data, according to Elliman’s most recent May 2019 market report, the number of new leases in May was up 20% from the month before with the average rental rate of $4,218 which is up .6% from April.
Another topic associated with renting a property is the potential tax advantages. (Quick disclaimer -we are not tax experts, so please check with your accountant on these matters!) First and foremost, while the rental income is taxable, you can deduct expenses against the property’s income. That means property taxes, mortgage insurance, repair and maintenance expenses, home office expenses, insurance, professional services and travel expenses related to rental management, are all deductible in the year you spend the money. Should you choose to continue as a landlord but with a different property, you can sell a rental property and roll the proceeds into other rental property without paying capital gains taxes. Usually, you can also deduct losses against your other income Landlords also deduct the home’s depreciation. This deduction is an allowance for wear and tear over 27.5 years, which the IRS considers the “useful life” of a rental property. To calculate the depreciation, you begin as soon as the property is officially ready to rent. You can continue to depreciate the property until you have deducted your entire cost (or other basis if improvements have been made) in the property, or you stop renting it. Of course, this lower basis will be used to calculate your potential capital gain (or loss) upon sale.
Another factor to consider is this will be a rental property, and tenants may not be as motivated to maintain the property as owners are. Therefore, there is a risk of wear and tear. However, if the tenants are vetted appropriately, and the right sized security deposit is taken, this risk can be minimized.
Other aspects of renting your home may not be as clearly quantifiable, but can be important to consider. For example, renting your home might require a time commitment which could affect your quality of life. As a landlord, you need to keep up-to-date on rental laws. The minimum requirement is you are legally required to maintain a safe and habitable property for your tenants. Since renters expect quick responses to any problem, large or small, you always must be “on call.” And, you must collect rents and deal with delinquent tenants. Clearly, you can hire a management company to deal with all of these issues, but this, of course, will cut into your income. As a baseline, you should expect to pay a typical residentialproperty managementfirm between 8% and 12% of the monthly rental value of the property, although there are some management companies that charge a flat fee. Only a seller can decide if the benefits of hiring a management company is worth the cost.
Finally, a potential landlord must understand the protections afforded renters in the City. As mentioned earlier, this was only enhanced by New York State’s passing of the Housing Stability and Tenant Protection Act of 2019 on June 14th. The Act involves a number of measures to protect tenants, ranging from prohibiting landlords from denying tenants involved in past pending landlord-tenant disputes to limiting any tenant fees beyond actual costs. All in all, tenants’ rights just got stronger.
Clear as mud, right? In all seriousness, there a multitude of trade-offs when considering whether to rent one’s home in anticipation of selling at a higher price. First and foremost-determine whether renting is even a viable option given your individual circumstances. For example, needing the proceeds of the sale for the purchase of a new property makes evaluating a rental strategy moot. If your analysis suggests renting for a period of time is an option, your conviction on a rise in home prices (and over what time period and to what magnitude) should be weighed against the economics, workload, and exposures associated with being a landlord. Of course, we are always here to help evaluate these decisions, and hopefully, make a stressful situation a little bit easier to navigate.
Have a great Fourth of July weekend!