Is it smarter to sell your home or convert it to a rental property?
Selling will allow you to convert your home equity into cash immediately. On the other hand, you'll have a bigger payday by converting your home to a rental property and allowing the home to continue to appreciate in value, selling at some point in the future. Assuming all goes well, that is!
What are your priorities? Do you want to maximize your profit potential? Or is minimizing your stress and time-commitment more valuable to you?
Selling may be a better option if:
- You need to use the sales proceeds for a down payment on your next home.
- You want to have more cash savings.
- You plan to use the sales proceeds to purchase an investment property.
- You want to use the sales proceeds to invest in mutual funds, index funds, or REIT’s.
- Your home’s value has appreciated greatly over the term of your ownership and you want to cash in on the gains.
- You don’t want to deal with finding tenants and managing a rental property.
- You are pessimistic on the direction of the economy and you want to sell while housing demand is still high.
Renting may be a better option if:
- You don’t need to sell to come up with the down payment for the next property.
- There is high demand for rental housing in your area.
- Renting your home at market rate would provide monthly cash flow.
- The total return you earn from owning your home (cash flow, appreciation, loan paydown, tax benefits) exceeds the what you could earn by investing the sales proceeds in alternative investments such as mutual funds, index funds, private business ventures, REITs, etc.
- You want to rent out the property for now and sell when you have a better use for the cash
Things to consider before renting your home:
Is there anything else that is relevant to your circumstances?
Running the Numbers: Selling vs Renting
Let’s take a look at the following scenario to see how one might chose to analyze their options:
You’ve owned your home for 10 years and are planning to move up to a larger home in a higher cost of living area. Your initial down payment was 5%, and the other 95% was financed with a conventional mortgage with a 4% interest rate. The home has appreciated an average of 3.89% per year since you took ownership. You have sufficient income and enough funds stashed away in your savings so that you don’t have to sell your current property in order to purchase the next one.
You haven’t been a landlord before, but are open to the prospect of renting out your home to add a stream of monthly income. Similar homes in your area have rented for $2,600/mo. While you haven’t had to replace any appliances or perform any major home improvements, you estimate that about $5,000 worth of upgrades would be needed if you want to get your home rental-ready in order to attract high-quality tenants.Assumptions:
Annual rent increase: 3%
Annual vacancy allowance: 3%
Annual appreciation 3.89%
All expenses increase 3% annually
Initial Home Purchase
Home Stats after 10 yrs ownership
Home Sale proceeds after 10 yrs ownership
*Estimated at 7% of sale price. Includes broker fee, transfer & recordation taxes, buyer credits, etc.
Stats after 5 & 10 yrs as rental property
Selling after 5 yrs renting
Selling after 10 yrs renting
Estimated Proceeds: Selling now vs renting then selling in 5 or 10 years
Selling now | Renting for 5yrs then selling | Renting for 10yrs then selling | |
|---|---|---|---|
Sales Proceeds | $192,788 | $330,874 | $492,762 |
Cumulative rental cash flow | $0 | $21,727 | $57,261 |
Present value of sales proceeds + future cash flow @5% discount rate* | $192,788 | $293,769 | $358,442 |
Present value of sales proceeds + future cash flow @10% discount rate* | $192,788 | $234,310 | $232,418 |
Selling Now
Sales proceeds: $192,788
Cumulative rental cash flow: $0
Present value of sales proceeds + future cash flow @5% discount rate*: $192,788
Present value of sales proceeds + future cash flow @10% discount rate*: $192,788
Renting for 5 years then selling
Sales proceeds: $330,874
Cumulative rental cash flow: $21,727
Present value of sales proceeds + future cash flow @5% discount rate*: $293,769
Present value of sales proceeds + future cash flow @10% discount rate*: $234,310
Renting for 10 years then selling
Sales proceeds: $492,762
Cumulative rental cash flow: $57,261
Present value of sales proceeds + future cash flow @5% discount rate*: $358,442
Present value of sales proceeds + future cash flow @10% discount rate*: $232,418
*"Present value" indicates what the future cash flows (from rental income & sale proceeds) are worth today, given an expected rate of return set as the "discount rate". These calculations are based on the principle that there is a time value to money, i.e. $100 now is worth more than $100 five years in the future.
Selling vs Renting: Which is the more profitable decision?
We can see that in this scenario, selling now vs renting for 5 years and then selling creates a substantially different outcome. Assuming the rate of appreciation will remain at 3.89% (This is a big assumption, and why you should always analyze multiple potential scenarios.), selling after five years of successful renting (another big assumption), you’ll net an estimated $330,874 from the sales proceeds and $27,484 in rental income (pre-tax) over those 5 years. Holding the property for 10 years results in an estimated sales proceeds of $492,762 and a cumulative cash flow of $57,261. In contrast, selling right away will result in net proceeds of $192,788.
If we apply a discount rate of 5%, the total cash flow from renting for five years and then selling is worth $282,539 in “today’s” dollars. The discount rate would need to be 13.6% to equal the sales proceeds of selling now.
With that information in mind, you may decide to keep the property unless you have an alternative investment that will generate greater than a 13.6% return. Only once your financial return drops below an acceptable level, or a better opportunity presents itself, would you plan to sell. If there's an opportunity to move up to a more profitable investment property, you may also look at the option of a 1031 exchange which will allow you to defer your tax liability by selling the current home an acquiring one of a higher market value, along with meeting other timelines.
On the other hand, maybe you don’t want the responsibility of owning a rental property, even with the assistance of a property management company. It might be preferable to sell and move the funds into more passive investments such as index funds, mutual funds, savings bonds, REITs, high yield savings accounts, etc.
Planning for uncertainties when renting your home
I encourage you to run through many different scenarios when performing your analysis, in particular so you can protect yourself from overly optimistic projections!
If you are considering renting your home, think about what the worst-case scenarios could be. What would you do if:
- There is a downturn in rental housing market and you have to reduce your monthly rate?
- You have a tenant who stops paying and you must evict them?
- Your rental property is damaged in after a natural disaster?
- The property management company that you hire does a poor job screening tenants or communicating in a timely manner?
- New rent stabilization laws limit your future rent increases?
- You discover costly repairs needed to get the property rental-ready that exceed your renovation budget?
Thinking through these potential challenges ahead of time and coming up with contingency plans will prevent you from taking on too much risk and putting your investment at risk.
Getting started: Request a rent vs sell report for your address
In your free report, you'll receive:
- Current market value of your home
- Estimated sales proceeds now and in the future
- Potential monthly rental cash flow
- Return-on-investment estimates for multiple scenarios
- Best-case vs worst-case scenario calculations
- Calculations of internal rate of return (IRR), capitalization rate, return on equity, and more