Cash In, Cash Out, and Cash Flow?
Most homeowners at least ponder the rent versus sell decision when it comes time to move. After living in your home for six months or sixteen years, it is critical to analyze both options and understand the pros, cons, and risks associated with each.
Face it, buying the home you live in was an emotional experience. Whether it was winning a bidding war, taking a risk in an up or down market, or buying your significant other their dream home, emotion tends to run high when it comes to purchasing your primary residence. Insert seamless plug here for agent representation during the buying process vice going it alone.
On top of making an emotional decision, you also took on a liability when you signed on the dotted line. You were buying a liability that cost you money every month, not a cash-flowing asset.
Now, a difficult choice is on the table. Do you cash in and walk away with some decent coin, or do you cash-out refinance, rent the property, and start producing cash flow? Unlike when you purchased your home, this should not be an emotional decision. It’s time to think like an investor.
Let’s separate the people faced with this decision into three categories. First, the “never sell” category. Second, the “always sell” category. Third? You guessed it! The “I can’t decide” category.
The never sell category has already made up their mind to cash flow until the cows come home. They are either beginning their road to financial freedom through real estate or continuing their journey. Typically, they are avid Bigger Pockets Podcast8 fans who list “Rich Dad Poor Dad” by Robert Kyosaki as their favorite book. They made their decision when they purchased the property that someday it would be a rental.
The always sell category has already made up their minds, only this time to take the money and run. This category purchased a home banking on appreciation or breaking even when it came time to sell. Usually, this category is low risk, and many have experienced or at least read horror stories of the unpleasant life of a landlord. Savvy investors are also in this category but instead would rather cash flow in the stock market or other investments than in the real estate market.
The third “can’t decide” category is this article’s target audience, and this seems like a good time for my disclaimer. I am not a financial advisor, and the intent of this article is not to provide such. I am a Real Estate Broker and investor providing you with things to consider when making the rent versus sell decision.
Reason to Sell
Why should you sell your property? I can think of a dozen reasons, but let’s keep it simple and only address one. In most markets, whether you purchased your home six months or sixteen years ago, you are going to walk away with a large sum of money. For most, this is an amount your account has never seen before when that wire hits your account. However, depending on how long you’ve owned the property, it might not be as large as you think when April 15th comes around and the tax collector knocks on your door. Please consult an accountant to understand the tax implications of selling your home so you can make an informed decision based on accurate information. This number is critical when deciding to rent versus sell, and we will dive into that later.
If you can walk away with a considerable chunk of change, then why would you ever consider renting your property instead? There are two reasons, cash out and cash flow.
Reasons to Rent
Cashing-out refers to your ability to refinance your property, walk away with a tax-free check, and have your tenant cover the cost of capital. It also takes some, if not all, of your financial risk off the table. Like Mr. Wonderful from Shark Tank, you need to consider your dollar bills, soldiers. Your soldiers are at risk anytime they are out of your immediate control. In this case, they are being held captive as equity in your home, and the only way you can rescue them is via a cash-out refinance. Don’t you want to recover your soldiers and put them to work somewhere else? They want to work for you, not sit idly by.
Cash flow is the money you make after your tenant covers your expenses. Positive cash flow is considered income, but there are incredible tax benefits to owning rental real estate. Please consult your accountant for more information. I would also recommend reading the book “Loopholes of Real Estate” by Garret Sutton, Esq. or reading forums on sites such as Bigger Pockets to better understand depreciation, capital improvements, income, and expenses.
Now that you understand the basics, how do you compare the two options and make a decision? First, you need to estimate the “after-tax” number from the proceeds of your sale. Next, you need to assess the equity in your property and the opportunity for a cash-out refinance. Finally, you must analyze your income and expenses to determine your cash flow and calculate your cash on cash return. Cash on cash return is how you can objectively make your best rent versus sell decision.
Estimating your after-tax number from the proceeds is a must, but you also need to determine how you will invest and what return you anticipate earning on your profits. Are you buying a new Tesla instead of investing? Great. Have at it. You earned it. But remember, life’s about choices. Enjoy your Tesla, but don’t try to compare a liability to an asset. It just doesn’t work. The cash on cash return comparison requires two income-producing investments.
After determining your after-tax number, estimated return, ability to cash-out refinance, and estimated monthly cash flow, you can calculate and compare the cash on cash return for both options and help inform your decision.
Return from Sale — “Cash In”
Let’s say your after-tax number on the sale of your home is $200,000, and you conservatively estimate your return to be 6% or $12,000 per year. The cash on cash return is simply 6%. Easy enough. Also, it is essential to note that measuring cash on cash return is on a pre-tax basis.
Cash on Cash Return = $12,000 / $200,000 = 6%
Return from Rental— “Cash Flow”
Next, you need to compare your “cash in” number with your “cash flow” number. For this example, you calculate your monthly positive cash flow from your property to be $1000 per month or $12,000 per year. The numerator is the same in this case, but what about the denominator?
When purchasing a home solely as an investment, investors know exactly how much cash is coming out of their pocket so they can estimate returns. Homeowners struggle with determining this number. For comparison purposes, you must use the same denominator that you used when determining the return on your sale, in this case, $200,000.
Cash on Cash Return = $12,000 / $200,000 = 6%
Return from Refinance and Rental — “Cash Out” and “Cash Flow”
But what about the cash-out option? Let’s say you are eligible to cash out refinance for $100,000 at 3% interest. It will cost you approximately $250 per month more in interest, decreasing your annual cash flow of $12,000 in the previous example by $3000 per year to $9,000. That sounds like a bad thing, right?
Don’t forget that you now have $100,000 you can invest. If you plan to make the same 6% return or $6,000 on the $100,000 you now have to invest, you are increasing your overall return by adding this to your cash flow number.
Cash on Cash Return = ($9,000 + $6,000)/ $200,000 = 7.5%
Comparing cash on cash returns is one way of objectively comparing the decision to sell or rent your property. In the previous examples, if you relied on this factor alone, you would refinance and rent your property. That might work for some investors, but some would choose to sell because a 7.5% return does not meet their criteria due to the amount of work they anticipate with managing the property.
Recognize there are multiple other factors to consider when making your decision such as the risk level, amount of time and effort required to manage each investment, and analyzing the likelihood of best and worst case scenarios. The better you become at making accurate assumptions and managing your risk, the easier this decision will become. Until then, please consult a financial advisor and certified public accountant to make your most informed decision.