Irrational Owners?

Opting to Rent Instead of Sell:
Does it Make Sense?

Today's slow housing market is making many would-be sellers act stubbornly, if not irrationally.

Perhaps the best example is the long-time owner who is disappointed with prevailing prices, and instead opts to rent until the market improves. While this can be a rational, economic response to a soft market, in practice it seldom is. That's especially the case when the seller's original cost is a fraction of current fair market value, and some (or all) of their realized gain would be tax-exempt, due to the $250,000 and $500,000 exclusions available to singles and couples, respectively.

The following numbers explain why. (Note: while the numbers are assumed, they are based on my familiarity with Twin Cities home prices and rental market data covering thirty-plus years).

Assume that someone bought their home in the 1970's for $150,000. In 2005, at the height of the market, the home would have fetched $700,000 (yes, long term returns have been that good). Today, however, due to the downdraft in prices, the home is worth 15% less, or "only" around $600,000.

Instead of accepting a $100,000 "loss," the homeowner elects to rent for $2,500 a month. That generates $30,000 of income a year. Meanwhile, the homeowner is still obliged to pay property taxes, which we'll conservatively assume are $6,000 annually; property management fees, which would be approximately $2,000, unless the owner handled that themselves; $1,500 for property and liability insurance; and $1,000 annually for lawn care and snow removal, again assuming they paid a third party. Add to that a conservative estimate for repairs and maintenance, $1,000, and total expenses come to $11,500. Pre-tax income, assuming no vacancies and no marketing expense to find tenants: $18,500.

Of course, that amount is reduced by the owner's tax rate. Conservatively assuming a 25% income tax, and after-tax income from renting comes to about $14,000 . . . on a $600,000 asset! And that's without factoring in the wear-and-tear associated with renting, and the associated costs to make the house market-ready once selling conditions improve.

By contrast, assume the owner instead sells for $600,000. Subtracting a full-service commission of 6%, and another 2% for various selling costs (transfer taxes, title work, closing fees, etc.), and the seller still realizes more than $550,000.

And what about capital gains taxes? If the owner is married, there aren't any! The $550,000 net proceeds, minus the $150,000 purchase price, is $400,000 -- less than the $500,000 exclusion available to couples. Voila! They're done.

What would that money earn? Anyone selling a home they've owned for close to 40 years is probably near retirement, and therefore more interested in security and income than capital appreciation. So assume that the whole $550,000 nest egg goes into municipal bonds, which now yield 5% tax-free. Annual after-tax income: $27,500.

So why would any rational person pass up a risk-free $27,500 to make half that, with significant risk? Because they think they're leaving $100,000 on the table, which can be theirs if only they're patient.

Of course, the question is, how patient? Every real estate cycle is different, and no two markets (or neighborhoods) are identical. However, anecdotal data from past downturns suggest that it can take 6-8 years to revisit the high water mark from the previous "up" cycle. Too few owners consider that in the interim, prices may go down, not up.

Ultimately, timing the real estate market --just like stocks -- is notoriously difficult. The right time to sell is when one's life circumstances dictate, and when selling is the best financial option available of all the (current) alternatives.