If you read “The Millionaire Next Door”, you see that, when measured solely in terms of its investment value, the house you live in is a liability. If it were valued as a true investment, you'd see that you are getting virtually no return for paying interest, principle, taxes, insurance, and maintenance every month. If you had a rental property that consumed this much cash, wouldn't you sell it? Then why not sell your house?
Moving right along; when values are rising, we tend to calculate the yield on our investments in terms of their after-tax net income and their growth in value. This is true of both stocks, bonds, and real estate. When equities are appreciating, many people rationalize negative cash flow because expenses can be deducted and gain can be avoided via tax-free exchanging; or taxed at very low capital gain rates. Thus, if a house were costing $3,000 per year in negative cash flow, but increasing by $10,000 per year in equity value, we could make a case for negative cash flow.
But, in today's market, even a free and clear rental that produces $1,000 per month in net after-tax income can be costing you far more than you know when you apply the same yardstick as above. In this case if the house were earning $12,000 per year in net income, but declining in value at $30,000 per year, your rents would make you feel all warm and fuzzy, but you'd be going broke very fast in terms of equity.
This was brought home to me very dramatically over the past 6 months. In September I bought a fantastic house for $150,400 at a foreclosure sale that came with a motivated tenant. He had been renting this house for $1400 per month for 2.5 years and didn't want to move. Assuming this netted $1,000 per month on $150,000 cash price, that was over 11% return on my money. How could I lose?
Six months later I bought a virtually identical house, on the same street, just a few doors down in the same neighborhood for $113,000. That meant that my $6,000 in net rents had cost me $37,000 in value. It gets worse: I could have sold the house shortly after buying it for $169,900 fairly easily. After costs, we'll say that I could have made $10,000 net profit. If you add this it adds to about $30,000 in lost equity value, renting this house to a primo tenant at a high rent had still cost me about $40,000 in six months.
The moral of this story is to take a critical look at the drop in your rental equities and see if it wouldn't be a much smarter idea to sell them and to use the money to buy better rentals at a much lower price and with much higher yields once the market starts back up.
