How Much is My Rental Home Worth?
Yesterday a family member called me about selling a rental house he owns. He said the home needed some work and he was calling me for some advice. It struck me when he called that I seem to have this conversation with one of our clients about once per week.
How much is my rental home worth?
I purchased my first home back in 2002 at the age of 22. Since then, I’ve purchased hundreds of homes and currently manage over 1,000. This is a question we receive often enough that I think it is important to address it.
While I’m not sure the best way to address it, I’m going to share with you what I shared with the member of my family. Hopefully it will be helpful.
It has been my observation that there are two types of people who buy homes in Birmingham. People who purchase it and plan to live in the home (we call them “retail” buyers) and people who buy and sell houses for a living (we call them “wholesale” buyers or “investors”). I’m going to cover the way each person purchases a home and the pros and cons with selling to each.
In our world, retail buyers are the end user who will be living in the home. This is how the majority of homes in the Birmingham area change hands. One person who lives in the home sells it to another person who is going to live in the home. This is the everyday transaction that you are accustomed to seeing. Below are some thoughts on selling to a retail buyer.
- They buy on emotion – As I said, I’ve purchased hundreds of homes. I don’t get too emotional about buying homes anymore; EXCEPT the one I currently live in! I’m willing to spend more money on the home I’m going to live in than I would if I was buying it as an investment. That is why it is an emotional buy (even for me). Additionally, they buy out of emotion, because they see themselves having experiences in the home itself. They don’t walk into the dining room and see the dining room; they see themselves having Thanksgiving dinner at the table with family. The don’t see a living room; they see themselves watching a movie by the fireplace.
- They pay more money – Because they are emotional buyers, they will pay more money for the home. This is typical to any type of emotional purchase.
- They are picky – Retail buyers have a list of things they want and they are picky about about meeting that huge list.
- They need a completed home – The majority of retail buyers are looking for a home they can move into immediately. Sure, they will paint one or two bedrooms to “make it their own”, but they will rarely redo the kitchen or refinish the hardwoods. So when selling a home to them, the home must be complete.
- They are in moderate to high income areas – People that live in low income housing typically don’t have money or the credit to purchase a home. So certain areas don’t regularly work for retail homes.
Bottom line, when selling your rental home to a retail buyer, it is going to take some work. You will need to provide a finished house in the right location. The good news is that it will sell for more money if you put in the time and effort.
This is most likely who you will be selling your rental home to. . . another investor. Below are some pros and cons of selling to an investor.
- They buy at a discount – By virtue of the very fact they are trying to make money, they will simply pay less for the house.
- They are less emotional, so they are buying typically using a formula – I know your next question is, “What is the formula?” While the formulas change and are unique to each investor, I’ll try to help you understand what types of things are included in the formula below.
- They will typically buy “as is” – Meaning, you won’t have to do much to the home when you sell it to them. Some, not all, will have a home inspection. But, all in all, it is an easy transaction.
- They will pay closing costs – This is typical, because they want to control how the transaction gets closed and this is the best way to do it.
- They usually pay cash and don’t require a loan – Which is nice, because house sales fall through when people can’t get financed for the home.
- They are typically in low to moderate income neighborhoods – This is usually where the best rental returns are located.
So what’s the formula?
Investors purchase homes a million different ways, but most of them can be lumped into two categories . . . “landlords” and “retail sellers”.
Here is the difference and some generalities regarding the formulas they use to buy homes . . .
Landlords purchase homes in an effort to lease them to a tenant and make money every month from the monthly rent. Their formula typically consists of 5 items:
Rent – (Income) What do they feel like the market rate for the home is going to be when they list it for rent? This takes into account where the home is, how many bedrooms, all the amenities of the home.
Taxes – (Expense) This is the money paid to the county for real estate taxes. Keep in mind this typically more (almost double in Jefferson County) than a typical homeowner would pay.
Insurance – (Expense) Insurance costs increase when a tenant is living in the home instead of the actual homeowner.
Interest – (Expense) If the landlord has a mortgage, they take this payment into account when they are putting their formula together.
Repairs and Maintenance – (Expense) Savvy landlords go ahead and account for some level of work needing to be done to the home on a regular basis. They don’t expect everything to go right all the time.
Using these 5 items, landlords will put together a return potential based on the cash they have on hand and their assumptions of the above items. If you know the information that is specific to your home like insurance and taxes, you can create some assumptions about repairs and maintenance and rent to get to a return and a good idea of what someone would be willing to pay for it.
Retail Sellers are a little bit different. They are in the business of purchasing a home, renovating it and putting it on the open market to sell it to a retail buyer. They buy at wholesale and sell at retail and make money for doing so.
The retail seller’s formula consists of the following items . . .
- Potential sales price – They start with the end in mind and work backwards from that number. What will someone pay for the home when they are complete with the renovation. It really is speculation at it’s best!
- Costs to sell the home – This is typically real estate commissions and closing costs that the retail seller will pay when they are selling at their potential sales price.
- Work needed to update/renovate the home – How much money will they be putting into the home in labor and materials to get the home looking like the end product they expect will realize the potential sales price.
- Interest – For most of the retail sellers, they will account for having debt, even if they don’t use a loan. Their money would be making money somewhere else, so they account for making the money here. They will typically plan on carrying the debt, therefore paying the interest, for a certain period of time.
- Taxes – just like above, they have to pay non-homestead exempt taxes during the time they own the home.
- Profit – They account for how much money they want to make once this thing is all said and done. Typically the profit coincides with the amount of money that is at risk. Thus a $100,000 investment would make less profit than a $200,000 investment.
Once this is all accounted for, they typically come up with an offer price. You can take the same information and attempt to plug in numbers to realize what you think your home would be worth using some realistic assumptions.
The advice I told my family member
After spending some time with my family member explaining the above scenarios I explained that there was really only two ways to make money in the house business. Time and money. He could invest the time and money to work on the rental home and realize whatever (be it a rental return as he was getting or a retail return) or he could sell the home to someone who would invest the time. If he decided to sell it, then he should expect someone to purchase it at a discount – because there is no other reason for someone to purchase a home that needs work, except to make money.
My biggest advice, since he had lived there at one time was, to do his best to disconnect himself from the situation and be as objective when deciding what to pursue as possible.
I’m actually shocked I even got the call. Most family members make decisions that I’m an expert in (houses) without even asking my opinion. I’m not sure if I gave him the answer he was looking for. I’m just like a good attorney . . . “It depends”.
Bottom line is you ought to be able to come up with a good idea of what someone would be willing to pay for your rental house using some very basic assumptions. I urge you to take the assumptions and do your best to answer the question to come up with the best course of action when looking at selling your rental home.