Should Retirees Sell Their Rental Properties?

Most people’s dream retirement does not revolve around trash, tenants, and toilets. As such, many of my clients sell their rental properties around the same time they are filing for Social Security. However, some retirees like the idea of having rental properties to supplement their other income sources. This begs the question: “Do rental properties make sense as part of your retirement income plan?”

I thought a case study would be useful to illustrate the cash flows and expected return from owning rental properties. Luckily (or unluckily as the case may be), I own two rentals, so I used my actual 2017 figures.

Cash flow is probably lousy if you still have a mortgage:

GOOD RENTAL BAD RENTAL
Property Value $260,000 $400,000
Rents Collected $15,600 $26,100
Mortgage Expense (PITI) $12,420 $25,224
Property Manager Expense $1,248 $2,088
Maintenance / Repairs $256 $6,868
HOA / Trash / Misc $515 $490
Pool Service $1,340
Gardener $1,360
Net Cash Flow $1,161 $(11,240)

A couple of things stand out about the BAD rental. The maintenance/repairs really punched me in the nose last year. That was because we had to resurface the pool, repair an HVAC unit, and fix a significant plumbing problem. However, these cash flows are not worst-case scenario. Neither property had any vacancy, and the interest rates on the mortgages are around 4%. Current mortgage rates for rental properties are around 5%.

The picture improves a bit if you look at rentals from a total return basis. Residential real estate has appreciated historically at roughly the rate of average wage growth (3%). If we add 3% appreciation, plus the amount I paid down the loan, the total return improves substantially.

How does the cash flow look if your rental properties are paid off?

You are typically very lucky to have break even cash flow on residential rentals if you have a mortgage. However, most retirees have owned their rentals for many years and have paid off the loan. Retirees who are buying rental properties for the income almost always pay cash for the property. So, let’s see how the numbers improve without the mortgage.

The chart below is identical to the one above, except I replaced the mortgage expense line with just the property taxes and insurance.

GOOD RENTAL BAD RENTAL
Property Value $260,000 $400,000
Rents Collected $15,600 $26,100
Prop Tax & Insurance $2,004 $3,512
Property Manager Expense $1,248 $2,088
Maintenance / Repairs $256 $6,868
HOA / Trash / Misc $515 $490
Pool Service $1,340
Gardener $1,360
Net Cash Flow $11,577 $10,442

The cash-on-cash return as a percentage of the property value (net cash flow/property value) looks a lot better without a mortgage, but it’s still only a 1.2–4.5% range (see below).

2017 CASH FLOW
(If no mortgage)
GOOD RENTAL BAD RENTAL
Cash flow (no vacancy) 4.5% 2.6%
If vacant 1 month 3.5% 1.7%
If vacant 2 month 3.0% 1.2%

My example assumes that the cost to turn around the property for a new tenant (cleaning, painting, advertising, etc.) is $1,300. My friend, Charlie Brown, who manages a few hundred single family residences at Transcity Property Management, recommends also budgeting one month of vacancy each time a tenant moves out.

Most retirees are not excited by these low yields since they could get equal or better cash flow from a wide variety of investments with more predictability and fewer leaky faucets.

Wait. Don’t properties appreciate and rents increase?

Rentals look much better if you view them as long-term total return investments. The total returns per year look more respectable if you add 3% appreciation (see below).

2017 TOTAL RETURN
(If no mortgage)
GOOD RENTAL BAD RENTAL
Cash flow (no vacancy) 7.5% 5.6%
If vacant 1 month 6.5% 4.7%
If vacant 2 month 6.0% 4.2%

Final Thought:

I like rental real estate because it is a great diversifier, paying the mortgage each month is a form of forced savings, and rentals may offer some tax benefits. Certain areas (e.g., the Midwest) offer better cash flow, but less appreciation potential, whereas high-priced areas (e.g., beachfront) typically have worse cash flow but more appreciation potential.

So back to our question of whether our retiree should sell his rentals. Most retirees decide to sell their rentals, which makes sense to me. The characteristics of rental real estate make more sense for younger working folks who have a long-time horizon, do not need cash flow, and can make good use of any tax benefits during their peak earning years.

Do you have rentals? I would love to hear your experience. “Reply” to this email.

For more on this topic, read: Rental Properties vs. The Stock Market.

Have a great week.