Posts tagged: Inflation

As a landlord since 2005, I’m constantly faced with the dilemma of selling a rental property or renting it out whenever my tenants move out. The older and wealthier I’ve gotten, the more I prefer to sell rather than rent out. I have a love-hate relationship with owning rental properties.

Being a landlord can sometimes create some very unpleasant experiences. Whether it’s getting paid late, experiencing damage, having to fix something, or resolving some type of misunderstanding, being a landlord is not for everyone. You need to be very disciplined and have good patience.

After I reached my limit of managing three rental properties, I stopped buying. Instead, I started investing my cash flow in private real estate funds that invest across the Sunbelt. This way, I could diversify my real estate holdings, and more importantly, earn more 100{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} passive income. Being a dad is a full-time job.

Once again, I’m faced with the dilemma of whether to rent out my investment property or sell it. But this time, we are in a unusually high inflation environment. If you’re facing the same dilemma, I will walk through the pros and cons like I do with other dilemmas in my book, Buy This, Not That: How To Spend Your Way To Wealth And Freedom. There are three chapters on real estate.

Every dilemma I face is viewed with a 70/30 decision-making framework. After analyzing the situation, my goal is to make the right decision at least 70{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} of the time with 70{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} confidence or greater. At the same time, I recognize that about 30{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} of the time, I will make a suboptimal choice and need to learn from it. I also accept there will always be some level of uncertainty.

Rent Out Home Or Sell In A High Inflation Environment?

When we are in a high inflation environment, the best thing we can do is own important real assets that inflate with inflation. This way, we get to benefit from inflation rather than get beat up by inflation. Cash continuously loses its purchasing power due to inflation.

Real assets include real estate, cars, fine art, fine watches, fine wine, rare jewelry, and other collectibles. But only shelter is a must-have item if you’ve got access to affordable transportation.

As a result, the 70{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}+ move is to rent out your rental property in a high inflation environment to capture higher rents. Real estate is not only a great hedge against inflation, it is a great beneficiary of inflation.

Now let’s go into more detail about why renting out your investment property in a high inflation environment is the better choice. Then we’ll discuss the reasons why you might want to sell instead. I’ve tried to make the arguments as balanced as possible.

Why Renting Out An Investment Property In A High Inflation Environment Is The Right Move

As a landlord, your goal is to maximize rents and minimize costs for maximum profits. You’re running a business. Profit maximization can also mean not raising rents if it may cause turnover. Each situation is different. Let’s look at why renting out is the right decision.

1) To ride the inflation wave as long as possible

If you are faced with the dilemma to rent out or sell, you should rent out when inflation is high. Take full advantage by capturing market rents. This is especially true if high inflation is transitory.

Since the mid-1990s, the average U.S. inflation rate has hovered between 2{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} – 2.5{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}. 2{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} is the official Fed inflation rate target.

U.S. inflation is now running at elevated levels. However, it is unlikely an inflation rate that’s 4X the 30-year average will remain for longer than a couple of years. Just look at this historical inflation chart.

2) To buffer against downturns

Given the economy is cyclical, landlords may one day face tough times when they must cut rents to attract tenants. Landlords may also face times where they will have higher vacancies than normal. Vacancy is what tends to kill profitability the fastest.

Therefore, the savvy landlord will take advantage of high rents when times are good and save the extra profits to cover for when times are bad. The situation is similar to saving money when you experience a tax cut to pay for future tax hikes.

3) To cover higher costs

Good times are one of the key causes of high inflation. People feel richer and tend to spend more, which pushes prices higher. Eventually, demand destruction sets in if prices get too high.

During a strong economy, property prices tend to increase. As a result, property taxes and maintenance expenses also increase. The hope is for rent increases to rise faster than property tax and maintenance expense increases.

Given the largest cost to own a rental property, a mortgage, is almost always fixed for a certain period, rents tend to increase faster than the cost of ownership. If so, rental profits tend to increase at a more rapid rate in a high inflationary environment.

Below is a recent Bloomberg economist survey that shows inflation is expected to fade to around 3{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} by mid-2023. We shall see! The economists have kept pushing back the date as to when inflation will peak.

4) To generate more valuable passive income

Even though interest rates have increased from their 2020 lows, interest rates are still historically very low. Low interest rates mean more capital is required to generate the same amount of passive income compared to when interest rates were higher. Therefore, the value of rental cash flow or any cash flow increases when interest rates are relatively low.

Earning real estate rental income is one of the best passive income streams due to higher yields and great tax efficiency. Non-cash depreciation expense helps reduce your taxable rental income. So do all other expenses associated with owning a rental property.

If you are in a higher marginal income tax bracket, earning rental income also is more valuable as well. Earning stock dividend income is completely passive. However, the yields are usually under 2{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}.

5) Keeping your negative real mortgage interest rate

One of the downsides of selling a rental property is losing your low fixed-rate mortgage if you have one. Someone should start a fintech company that makes your existing mortgage portable if you buy a new property.

Many mom-and-pop landlords first owned their homes with a primary fixed-rate mortgage before renting them out. As a result, the mortgage rate is likely lower than a rental property mortgage rate. More than 90{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} of existing mortgages have an interest rate below 5{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}.

So long as inflation is higher than the landlord’s mortgage rate, the landlord has a negative real mortgage rate. As a result, it’s best to keep the debt for as long as possible and let inflation whittle away the real cost of the debt.

6) Minimize tax liability

If you sell your rental property, you may have to pay capital gains tax due to depreciation recapture and price appreciation. Paying taxes creates economic waste.

In general, the best holding period for real estate is forever. If you need money, you can tap your equity to reinvest it in something else. This is what billionaires do. They borrow from their equity holdings, partly so they don’t incur capital gains tax.

7) Minimize reinvestment headaches

If you sell your rental property and have a healthy gain, you will then have to figure out how to reinvest the proceeds. It’s often very hard to reinvest a much larger sum of money than you are used to. As a result, many people may sit on their windfall for a while. This may not be the greatest move if inflation is high given the purchasing power of cash declines quicker.

It took me about six months to reinvest my house sale proceeds in 2017. I had almost $1.8 million to reinvest and it was hard! The last thing I wanted to do was lose money after my rental property was just chugging along for so many years.

When you have your equity locked up in a rental property, you tend to just forget about it. All you care about is the cash flow that you use to stay free or pay for life.

Arguments For Selling A Rental Property In A High Inflation Environment

Selling your investment property in a high inflation environment is the 30{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} move. However, there are definitely some positives which I discuss below.

1) High inflation may only be temporary

If you live in a country where inflation is historically not so high, then chances are the pace of rent and property price appreciation will normalize (slow). If and when inflation does normalize, then you might not get as high of a price for your property in the future.

Given interest rates are rising to help counteract high inflation, the cost to get a mortgage is also rising. As a result, the incremental demand for real estate should decline, all else being equal, given affordability is declining.

The real estate market moves in cycles. When downturns come, you may have to wait one to five years before getting back to the high watermark. For some cities with increasing supply, they may already be in Phase III, so watch out.

2) When your depreciation benefit runs out it may be time to sell

One of the best times to sell rental property is when depreciation benefits run out, regardless of the inflationary environment. Depreciation is a non-cash expense that every rental property owner can take.

You can usually either accelerate your depreciation or straight-line depreciation. The most common form of depreciation is the straight-line depreciation method which is taken off an IRS instituted 27.5 years.

Formula:

1. Purchase price – Land Value = Building Value.
2. Building Value / 27.5 = Annual allowable depreciation deduction.

Example:

1. $500,000 purchase price – $200,000 land value = $300,000 building value

2. $300,000 building value / 27.5 = $10,909 annual allowable depreciation deduction.

3. Current annual rental income is $20,000 (4{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} gross rental yield).

4. Taxable rental income if we include no other costs like property tax, maintenance, and HOA costs for simplicity purposes = $20,000 – 10,909 = $9,091.

5. Total tax savings if you are in the 32{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} marginal federal tax bracket = $10,909 X 0.32 = $3,491.

Depreciation Doesn’t Last Forever

Deprecation expense is all about saving on taxes. The depreciation criteria basically states that you should aim to hold on to your property for the number of years you are allowed to depreciate.

If you are in one of the top marginal income tax brackets (32{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}, 35{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}, 37{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}), depreciation is your most valuable non-cash expense. If your overall income starts to decline, you may be more willing to earn rental income again given your marginal tax rate will be lower.

It’s important to note that depreciation amounts get adjusted back during the time of sale (aka depreciation recapture). For example, if you took 20 years of depreciation at $10,909 a year, you would reduce your cost basis of the $500,000 purchase price by $218,180 (10 X $10,909) = $281,820.

With a lower cost basis, you would pay more taxes due to a higher difference in sales price vs. adjusted cost basis. Depreciation isn’t free money in the end. This is why you need to be proactive in your estate and tax planning. Check the latest real estate tax laws.

3) When there’s an easier way to own rental property, sell to simplify

The main reason why I sold a rental property in 2017 was that I was becoming a first-time father. I didn’t want to have the stress of owning that rental property weigh on me. The rental property had constant turnover due to having 4-5 roommates who always threw house parties.

After selling the property, I reinvested $550,000 of the proceeds in real estate crowdfunding. Platforms like Fundrise make it easy to invest in private real estate across the country. I transferred capital from expensive San Francisco, to faster-growing and cheaper cities like Austin, Houston, Miami, and Memphis.

The older and wealthier you get, the more you probably want to simplify life. Diversifying your property holdings and earning more passive income are great moves. Personally, I’ve invested $810,000 in real estate crowdfunding since 2016 and have received over $500,000 in distributions.

4) When cap rates are no longer attractive, sell your rental property

If there is a lot of inventory coming to the market and the cap rate premium over the risk-free rate of return is not sufficient, you may want to sell your rental property. The cap rate is calculated as the ratio between the annual rental income to the property’s current market value.

For example, let’s say your property trades at a cap rate of 3{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}. It’s appreciated handsomely over the past 10 years by 110{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}. Meanwhile, the 10-year bond yield is at 3.6{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}. Why own rental property when you can earn risk-free Treasury bonds yielding more?

It may be better to sell your rental property and reinvest the proceeds in other cities with higher cap rates. Cap rates in the heartland are easily above 5{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}.

When it comes to real estate investing, consider following my BURL Strategy. In other words, Buy Utility, Rent Luxury. It is one of the best real estate investing rules to follow.

5) When you have a major life event, sell your rental property to simplify

There are some key life events that warrant the re-evaluation of owning investment properties: a new family member, a death in the family, a terrible accident that requires extra care, an unwanted layoff, or a job relocation to name a few. 

Managing rental properties take time, even if you hire a manager. Therefore, the more complicated your life, the more you may want to sell your rental property to help simplify life.

When my son was born, I decided to sell one of my main rental properties because I wanted to focus on fatherhood. It was difficult to lose the annual six figures in rent. But selling the investment property was the best thing I could have done for my mental health.

6) If you expect a really bad recession, sell your rental property before prices decline

Clearly, if you expect a recession and real estate prices to fall, then selling before prices decline may be a good move. The problem with selling is creating tax liability and finding safe ways to reinvest the proceeds. Further, you might time your sale right, but you might not time your repurchase right.

Think about all the people who sold real estate in February 2020, right before the lockdowns began. They probably felt good for a few months as the real estate market came to a halt. Some owners panic-sold as well. However, just a couple of years later, home prices are up 20{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} – 50{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} around the country.

Due to real estate transaction costs, it’s much more costly and difficult to time the real estate market. However, if you expect a massive downturn, like the one we saw from 2007 to 2011, then selling your rental property while inflation is high is an excellent move.

I just don’t see such nationwide declines given the structural undersupply of housing. There is also a permanent shift higher in the demand curve given the acceptance of working from home.

7) When real estate commands greater than 70{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} of your net worth

During the financial crisis, many Americans got wiped out because 80{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9}+ of their net worth was tied to their primary residence. In contrast, I recommend everybody shoot for the value of their primary residence to equal 30{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} of their net worth or less.

Once one type of investment equals more than 50{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} of your net worth, you put yourself at greater risk of bigger downswings. It’s good to have a variety of non-correlated investments that tend to zig while others zag. Diversification is why ultra-high net worth people like Bill Gates buy farmland and fine art.

8) When you begin to exceed the $250K / $500K tax-free profit

If you sell your primary residence, the government allows you to pay zero capital gains tax on the first $250K in profits for individuals, and the first $500K in profits for married couples. This tax-free profit benefit is huge for those in the highest marginal income tax brackets.

Some of you may want to rent out your primary residence to generate passive income. As long as you’ve lived in your primary residence for two out of the past five years, you get to take advantage of the tax-free profit exclusion. However, the exclusion gets prorated based on the years you’ve owned the rental property.

After selling your rental property, to defer taxes, you can 1031 exchange your investment property by buying another investment property of greater value within 180 days. You’ll first have to contact a 1031 exchange company to handle the exchange.

It’ll cost you about $1,000 – $2,000 for the optionality of doing such a transaction. If you can’t find an investment property you like in 180 days, then you eat the $1,000 – $2,000 setup cost.

9) When commission rates decline, selling your rental becomes cheaper

One of the main reasons why there aren’t more real estate transactions is because commission rates remain stubbornly high. We’re talking still a 5{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} selling commission rate (2.5{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} to the listing agent, 2.5{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} to the buyer’s agent).

Where every other commission rate has declined due to the internet, real estate commission rates are still holding strong. The irony is that if commission rates were lower, there would probably be more overall commission dollars to go around. Further, I would have probably sold one of my properties in 2012, right before the massive surge. Hooray for high transaction costs!

Below is an example of how much it costs to sell a home nowadays. We’re talking roughly 6-7{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} of the home’s value in selling costs. Who wants to sell and pay so much in fees and taxes, while also losing their low mortgage rate? There had better be a great reason, such as an impending Great Depression.

10) When there are major upcoming repairs

Some of the main recurring major expenses include a new roof every 15 – 20 years, new paint every 10-20 years, a new HVAC unit every 15-30 years, a new water heater every 10 – 15 years, repairing decks every 20-30 years due to dry rot, and remodeling kitchens and bathrooms every 20-30 years.

You may also have to update old electrical wiring to code. It can cost $10,000 – $50,000 to rewire your entire house. In San Francisco, if you own a multi-unit building over a garage, you may have to spend $100,000 – $300,000 to retrofit the building due to a new law that was past several years ago.

One of the reasons why I sold my rental property in 2017 is because I had leaks in the back windows which would have cost me $20,000+ to replace. Further, I had old knob and tube wiring. It would have cost me at least $30,000 to update my wiring to modern ROMEX wiring.

It’s Better To Hold And Keep Renting Out

After thoroughly going through the pros and cons of selling or renting out an investment property, I still believe the longer you can hold onto your rental property the better. Getting rich with real estate is like a war of attrition. He or she who holds on the longest generally wins the most.

Higher-than-average inflation generally isn’t great for the average person, unless the average person is getting a bigger raise and owns a lot of real assets that are also inflating rapidly. Therefore, landlords might as well enjoy the benefits of higher rents while they can given their costs are also inflating.

Personally, inflation is affecting my family due to rising food, gas, childcare, and tuition costs. Meanwhile, both my wife and I don’t have jobs, which means we can’t take advantage of rising wages. How sad! My type of household is getting hurt by inflation the most, even more than the traditional retiree with lower expenses.

The only thing helping my family offset abnormally high inflation is our rental property portfolio. However, given two out of my three tenants aren’t moving, I’m not benefiting. I feel too bad raising their rents so I eat my rising costs, which they don’t understand or appreciate.

As you can see from the above chart, rent growth is very strong for single-family homes. It will likely stay elevated as more people permanently work from home. Therefore, I like Fundrise funds because they predominantly focus on investing in single-family homes in the Sunbelt for rental income.

Only Benefitting Slightly From High Inflation

I’ve only got one rental property in San Francisco that will now earn higher rents starting in June 2022. I’m renting the property out to a new tenant relocating back to San Francisco from the east coast. They are paying 10{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} higher rent than what my previous tenants were paying. Further, it’s only a family of three with no pets versus the current family of four with a dog.

Every tenant is a leap of faith. So fingers crossed this latest tenant is a good one!

My long-term game plan is to own a three-property rental portfolio until the year 2045. By then, my kids will be 25 and 28. They will hopefully have stable jobs, be in graduate school, or know what they want to do with their lives. If not, they can always manage the rental property portfolio until they do.

To me, owning rental property is not only a hedge against inflation, but also a hedge against a difficult life. I firmly believe I was excessively lucky to land my job after college and escape 13 years later. I doubt my kids will be as fortunate, so I’m planning ahead.

Owning rental properties is one of my main retirement income generators. Without rental income, I’d probably still be grinding away in banking. Therefore, whenever I have an itch to sell, I just remind myself rental properties are what’s keeping me free.

Recommendations To Build More Wealth

To invest in real estate 100{d4d1dfc03659490934346f23c59135b993ced5bc8cc26281e129c43fe68630c9} passively, take a look at Fundrise. Fundrise is the leading private real estate investing platform with over $3.2 billion in assets and 400,000 investors. Fundrise focuses on undervalued properties in the Sunbelt where cap rates are higher. I have $810,000 invested in private real estate to diversify and take advantage of a multi-decade trend.

To read more analysis on how I approach some of life’s biggest dilemmas, pick up a copy of my new book, Buy This, Not That: How To Spend Your Way To Wealth And Freedom. The more optimal decisions we can make over time, the better our lives will turn out. Winging it is not a good wealth-building or life strategy!

For more nuanced personal finance content, join 55,000+ others and sign up for the free Financial Samurai newsletter and posts via e-mail. Financial Samurai is one of the largest independently-owned personal finance sites that started in 2009.