Some of the best life decisions start on a napkin: movie ideas, business ventures, phone numbers of future mates. Real estate decisions can work the same way. Simplifying decisions to what fits on a napkin may help you decide between selling or renting. So, does your property pass the napkin test? Keep reading to find out.
Napkin Testing 101
Napkins can only fit so much written information, so you consider just the data that fits in that small space. You’ll need to boil down to just the main factors. When deciding how to handle a property, that means knowing the market value, lien amounts, and potential rental rates.
To be fair, the napkin test for renting or selling an existing property doesn’t actually pass or fail your property. It “passes” either way (unless you do nothing and let the home fall into disrepair- then you lose big time). But this can help determine which option holds more financial advantages for you in the long run. Unscientific studies have shown that conducting the napkin test at establishments with libations could provide better outcomes. Afterall, bev naps- those staples behind every bar – force you to become even more efficient with your numbers. (Legal disclaimer: results may vary.)
Regardless of the actual size of your napkin, consider this strictly a numbers game.
Lump Sum or Long-Term Investment?
You need to do some research on sale prices for comparable homes to determine the property’s market value. If you sold it today, realistically how much would you get? If the home has a mortgage or other liens, subtract them from the market value to determine the sale profit. Hold up though: that’s not what will get deposited into your bank account. Estimate roughly 8 percent of the home value for real estate agent commissions and closing costs. Subtract that from the sale profit. Now you have the total profit you can expect for the selling column.
Now comes the rental column numbers. Again, you have to do some research on rent rates for comparable homes in the same area as your property. If you rented your property out today, realistically how much would you make? Subtract mortgage payments from that rent amount to come up with an estimated before-tax cash flow. Expect this number to pale in comparison to the lump sum from selling. But that doesn’t reflect the overall picture. Take the annual cash flow multiple it out in several-year increments. Now you can better understand the potential return on investment after 7, 15, or 30 years. But you’re not done yet. On average, homes appreciate in value by at least 3% a year. Adding the appreciation value to your long-term investment total gives a more accurate comparison. Chances are that original lump sum starts to look pretty paltry in comparison now.
Limitations of the Napkin Test
The equation doesn’t take into consideration increasing property values, higher rent rates, and additional tax breaks. Also, after satisfying the mortgage amount, the same rent becomes pure cash flow. Experts also recommend considering the cash on cash return. This is the ratio of annual before-tax cash flow to the total amount of cash invested to get a percentage. Generally, this should be above 8 percent (although experts make recommendations on a much wider range).
Here is a little demonstration of what the napkin test looks like in action. Prepared to be dazzled by napkin math magic:
|RENT OUT HOUSE
But as we mentioned above, that’s not the full picture…
|Commission/Closing Costs (typically 8%)
|Net Selling Profit
|RENT OUT HOUSE
|Cash on Cash Return (Annual Profit divided by Down Payment)
Now let’s look at longer term renting profits, beyond one year:
|RENT OUT HOUSE
|Profit x 7 years
|Profit x 10 years
|Profit x 30 years
Through the years, owners will typically raise the rent (while mortgage rates stay the same), which would increase net profits. Also, since mortgages are finite, so when you pay off the mortgage, the rent is pure profit with the additional tax benefits.
Also, homes appreciate in value, conservatively at approximately 3% a year. That means 30 years down the line, your house would be worth $485,452. So, selling the same home that would’ve given you around $9,000 profit, would result in net wealth of $564,652 in cash and property value by renting it during that time.
Of course, you should only consider this a preliminary exercise. Consulting with a real estate investment professional to work out the finer points can confirm your napkin decision. As a full-service brokerage with years of knowledge and experience in investment sales, The Realty Medics can help. Call our experts at 321-218-4753 or find out how much your home could rent for with a free rental price analysis.