CAP rates | What you need to look for when renting your house

Disclaimer: this is NOT exactly how CAP rates work! However, this is a simple framework that you can use when considering renting your home vs selling it.

I get it, you have a big gain on your property and you can rent it for more than the mortgage (and your mortgage is at a low rate!), but that doesn't mean it's a good use of capital.

In this video, I cover how to think about rental income and your home, when you should consider selling and reinvesting vs renting, and what a good CAP rate target is.

Transcript:

You just bought a new house, you moved out of your old house, and you're considering renting your house. Should you or should you sell it? Let's cover that today. I'm Chris Kaminski, co-founder and partner here at Consilio Wealth, where we specialize in working with tech professionals at Amazon, Microsoft, Meta, and Google.

So, you just bought a new house, you moved out to it, and you have your previous house that you love, and you have a very low mortgage interest rate on it. In fact, let's go out on a limb here and say that that house is worth $2 million, and let's say that you owe $500,000 on it, and your payment is around $4,000 a month, okay? I want to introduce a concept to everyone here called a cap rate.

Disclaimer, this is not actually how cap rates should be calculated. If you Google cap rates, which I would encourage you to do so, it's a more complex calculation of what I'm about to share with you, but I introduced this to all of our clients that are moving out of their homes that are considering keeping their homes for rent. And here's why this is important. What we find is that clients look at this as my payment is $4,000 a month. I can get $5,000 a month for rent. I'm making money. It's a good deal. I would argue it's a horrible deal because one of the problems in our area and for context, we're a firm based in Bellevue, Washington. Many of our clients are in the Washington area.

We specialize in working with tech professionals that live in this area and have lived in this area for many years. So, they've benefited from buying what was lower cost real estate, call it a decade ago, and they've seen very, very large price increases on that real estate. We also have clients in California and other states as well, but we've seen this kind of throughout the board with our clients. Okay, so here's the situation, $2 million home, you say that you can rent it for $5,000 a month. That's $60,000 a year. Take 60,000 and divide it into the $2 million value. It's a 3 % cap rate. Again, that's not exactly how you should look at a cap rate.

Technically, you should add in all expenses to your cap rate. like mortgage interest, even the payment, you should look at property taxes, you should look at maintenance, all these other things. But just very, very simply, what I want to look at here is essentially, what is the dividend that my house would pay me if there were zero expenses? Keeping this very simple. Okay, $2 million house, $60,000 of annual income, that's a 3% cap rate. That's a bad deal.

The real estate in our area has had very high appreciation and it's made it such that the rental market has sort of has an upward bound, at least from what we've seen. No one will rent that $2 million house for $10,000 a month or $11,000 a month, which is what they should rent it for if it were actually going to be a good rate of return. So, I would argue that if you live in a home like that, that you have a low interest rate on that you're renting it and you're just making a little bit of money, what you're banking on is further appreciation. That might happen.

But if you look at this purely from a rental income standpoint, which is what a lot of our clients are looking to do, right? They say, I like the income stream. The income stream is great. I would argue that your $2 million of asset value could be far better used in two or three or four different doors somewhere else. What if you could go buy a fourplex somewhere or two duplexes or a couple of town homes that are in another area of town? spend that same $2 million, now you've got four renters all paying you $1,500 a month, $1,000 a month, maybe even $2,000 a month. Now all of sudden you're in a more reasonable cap rate. So, what's a reasonable cap rate? In general, when you look this up, if your cap rate is around 5% or so, you're probably in a major metropolitan area where rents are generally pretty consistent, and property values are a little bit higher.

If you fall below 5%, you still can have a good deal, but really anything below four is not that great. If you're higher than that, if you're at say 8%, 9%, 12%, two things happen. Either you're in a highly desirable, somehow low-cost area, possibly you own an Airbnb that is in a highly desirable, low cost area, or possibly you're in a higher risk area. What I mean by higher risk is as cities continue to grow, people keep moving out and out and out in search of cheaper real estate, rents get pushed up maybe the values of those real estate has not caught up yet and the rents have gone above.

The risk there is if economies were to retreat and people move closer back to city centers, those rents fall off. This has happened throughout time as economies have expanded and contracted and population movements.

Right now, in the country, there are a lot of people moving south to states like Florida and Texas. They're moving out of California. The state of New York had a half a percent population decline, for example, last year. So a lot of these things are moving and that can all affect the prevailing markets.

The state of Washington seems like things are a little bit neutral, meaning that as employers are here, say Amazon and Microsoft, they are re-lowing teams, and they are re-lowing new employees to Washington state. The problem with that is that could contribute to increased housing prices, which is again, furthering the issue of why this example of a $2 million home renting at $5,000 a month is not a good deal. I'll close where I started.

This is not a fundamental education on how cap rates work. It is simply just a framework on how to view your own property and just take a look at it. If the gross amount of receipts that you're getting from your property is under 5%, you might want to consider changing that property with something that yields more. Final thought, it's expensive to sell real estate. Many of you bought your properties many years ago for not a lot of money and now it's worth a lot of money. So, you have substantial gains on these properties.

So, two things happen, you have a lot of capital gains and secondly, it's really expensive to move real estate, real estate commissions. In addition to that is excise tax in Washington state and every county there's excise tax. If you're unfamiliar with that, look up real estate excise tax. There's actually a calculator on the state website. You can see by county what you'll pay. There's an excise tax per county, which is typically a quarter to a half a percent. There's also an excise tax at the state level, which is a graded amount. So, the more your house is worth, the more tax you're going to pay.

Generally, this is going to range above one but below 2% unless you get into higher priced homes, then it can get higher than that as the break points go the wrong direction as you have a more expensive house. So I recognize that selling a house can be very expensive and that the capital gains on it can be a lot. Do note that you also have an exclusion so long as you've lived in a house for two out of the last five years for $250,000 of gain if you're single or $500,000 of gain if you are married, that exclusion is fantastic.

You would pay no capital gains tax on that amount of gain, which say if you have a million dollars of gain in your house, you will only pay tax on half of it. Note that that exclusion does not exclude you from excise tax or any of other transaction taxes. It just excludes you from the federal capital gains tax on your home sale. Lastly, the brand-new Washington State capital gains tax, which is for sales of transactions over $250,000 for long-term capital gains. That's actually a little bit higher this year in 2024. It's $262,000 this year because it's gone up by inflation. That does not apply to real estate transactions. That's good news. So just know that if you go to sell your primary home, you are not paying the Washington State capital gains tax on that transaction.

All right, I hope this was helpful in just fundamentally understanding a super high level of cap rates, not meant to be an education on cap rates, just a very high-level framework on how to think about turning your home into a rental.