Chapter 13
Selling Income-Producing Properties
In This Chapter
◆ Pros and cons of selling income-producing properties
◆ Overcoming obstacles to selling a home occupied by renters
◆ The powerful key to marketing investment properties
◆ How to calculate income for buyers
◆ What really attracts buyers to rental properties
Selling any home that is occupied by renters can present its own special set of challenges. However, these challenges can be overcome with good planning and thoughtful strategies. In this chapter, we examine the decision to sell an investment property, how to work with renters when selling, and how to market rental homes you plan to sell.
Types of Investment Properties
There are several different types of investment properties. Among them are condominium units, multifamily dwellings (buildings with two or more rental units), and private homes that have a rental unit attached to or on the same property. Additionally, you may have a boarder apartment or mother/daughter layout within your own home. All of these types of rentals provide passive income. Passive income is another way to make money on your investment, in addition to its increase in value over time.
def·i·ni·tion
Passive income, as defined by the IRS, comes from one of only two sources: a rental property or a business in which the taxpayer does not “materially participate.” For example, you might be an investor in a company where you do not work and yet receive repeated ongoing income from the investment. Passive income is received on a regular basis with little or no effort to maintain it.
Deciding to Sell a Home with Rental Income
Unlike your primary residence, the decision to sell investment real estate is less emotional and mainly rooted in dollars and cents. It’s much more of a business decision than choosing to sell a private residence and should be evaluated in as objective a manner as possible.
Here are some of the pros and cons of selling an investment property.
Pros of Selling
There are several reasons for unloading investment properties. There may be more than one that applies to you.
◆ The property is experiencing a negative cash flow. (Your expenses are higher than the income it produces, causing you to lose money each month.)
◆ The property is not appreciating in value as fast as you would like it to.
◆ You are tired of maintaining it.
◆ You are tired of dealing with the hassle of renters.
◆ You need an immediate infusion of cash to manage a financial crisis.
◆ You want to use the proceeds of the sale to do a renovation or buy down (reduce) the mortgage on your primary residence.
◆ You want to buy another or bigger investment property, also known as a 1031 exchange.
def·i·ni·tion
A 1031 exchange got its name from Section 1031 of the IRS code. It is a law that allows you to defer federal (and some state) taxes on capital gains from the sale of a property that was used for trade, business, or investment purposes only. However, you must exchange the property for another that is similar in nature and equal to or greater in value than the one you are selling. Also known as a tax-deferred exchange, it is based on the premise that when you reinvest proceeds from a sale to another property, you haven’t really received funds to pay taxes on—it’s only a paper gain. Eventually, you will pay taxes when you sell a property that is not being replaced with another.
Cons of Selling
On the other hand, there are many reasons not to sell. Selling any investment can be a difficult choice to make and you may question that choice for years to come. Real estate, as an asset, has always appreciated in value over time. There have been significant dips and even major market corrections, but prices never go down and stay there. They always rebound and climb higher and higher, historically. This is the strongest argument against selling. Additionally, an investment property can provide a safe harbor for your money when other markets (such as stocks) are more volatile. It spreads the risk in your investment portfolio around. The following are reasons not to sell income-producing real estate:
◆ You will no longer own an appreciating asset—something that is growing in value.
◆ You will no longer have passive income.
◆ Without a real estate investment, you may not be as financially diversified as you should be.
◆ You may pay income taxes on the profit from the sale.
◆ You may lose a powerful tax deduction and/or tax shelter.
◆ You may regret the sale down the road.
Before you decide to sell such an investment, remember what you put into acquiring it in the first place, not to mention what you did to raise its value over the course of your ownership. You had to find the right property, secure a loan, negotiate an inspection, find and screen reliable tenants, and make it to closing. You may have made many capital improvements to the property, such as new appliances; heating, plumbing, and electrical upgrades; landscaping; and possibly even a new roof. It’s important to establish if you meant for it to be a long-term real estate investment. If so, then you should hang on to it for the long term, if possible. If, on the other hand, you bought it for the short term or to “flip” it, that’s another scenario entirely (we cover this in Chapter 14).
def·i·ni·tion
We define a long-term real estate investment as one that you hold for 10 years or more. The reason is that the market will fluctuate over the course of your ownership. It can take a dip (even a serious one), but history tells us that the real estate market will always recover within a 10-year time frame. However, the most recent U.S. real estate market crash was so serious that it may temporarily redefine the term “long-term investment.” It is possible that you may need to hold on to your investment a little longer.
Selling Homes with Pre-Existing Renters
If you are selling a home that is occupied by renters, you will definitely have some challenges and will be handicapped in your ability to properly market the home. There are several reasons for this. We show you how to overcome them.
One of the first things to establish is whether or not the law in your area states that a renter’s lease supersedes the sale of the property. In other words, will the new buyer be forced, by law, to inherit your renters after closing? Some buyers may be quite happy to keep your renters so that the flow of rental income is uninterrupted. Other buyers want to handpick their own renters and may not even consider buying a property that has tenants. Still others may want to live in the house and not rent it at all. Either way, it’s important for you to be aware of the state or regional laws.
Obstacles to Selling a Home Occupied by Renters
Most of the obstacles that you face have to do with what is going on in your renters’ lives at the time of the sale, their disposition, how they feel about you as a landlord and the nature of your relationship with them, and how they feel about the fact that you are selling the building or unit. Here are some of the most common challenges from renters:
◆ They fear they will lose their home if you sell.
◆ They feel inconvenienced by showings and might not cooperate.
◆ They don’t seem to care if you get a good sale price.
◆ They don’t keep the rental unit clean.
◆ They don’t have nice furniture or don’t have it arranged well. Even clean, the unit is not staged properly.
◆ They have pets.
◆ They have a baby.
◆ They smoke.
◆ They don’t seem to like you or care about your needs.
Overcoming the Obstacles
There are a few ways to get renters on your team and get them to support your cause. If you don’t succeed at getting them to work with you, renters can seriously affect or even sabotage efforts to sell a property. The following sections discuss some ways to create an atmosphere of cooperation between you and your tenants.
Call a Face-to-Face Meeting
So many landlords call their tenants on the phone, usually at night, to inform them that the property is going up for sale. This is one of the worst approaches possible, for three reasons. First of all, most people are tired in the evenings. Their mood is not likely to be particularly open to receiving bad news. The immediate reaction is often negative.
The second problem with this approach is that the message is being delivered over the phone instead of face to face. There is nothing that feels good or safe about getting a phone call announcing that the building you live in is going up for sale.
Finally, it may be hard to communicate all that you want to, and in the way that you want to, over the course of a phone call. You will be perceived as more caring and sensitive to their needs if you meet with them in person.
Sell to Someone Who Will Continue the Lease
This is not always possible, but, technically, you can make the sale contingent upon the new owners honoring your tenants’ lease. If this is something you are prepared to do, then share that fact with your tenants and they will feel more secure, and will therefore probably be more cooperative.
Involve Renters in Scheduling Showings
Instead of simply telling them—each day—the time that a particular showing will take place, why not set them up as the point of contact for Realtors who want to bring potential buyers into the unit? They may only be “renters,” but your building is where they live. It’s their home and if they feel respected and have a sense of control about the process, it will run more smoothly. However, in exchange, they must make every attempt to allow all buyers to get inside for showings and only deny access on the rare occasion, if at all.
Make a Deal
Sometimes you just have to throw a little money at a problem to make it go away. If your tenants are motivated by dollars, knock 5 or 10 percent off the rent while the home is on the market. It’s amazing how agreeable and helpful tenants are when they feel they are saving money as a result. And if you are selling the building, it’s not likely that a temporary 5 or 10 percent rent rebate will hurt you too much.
However, make it crystal clear what you expect in return for that rent discount. You may simply want the unit kept clean and that the tenants let all potential buyers in as long as they are given reasonable notice. Some sellers get it in writing that the tenants will not do anything that can be interpreted as sabotaging a purchase, such as speaking negatively about the property or about you, the landlord.
If all of the preceding tactics have failed and you cannot motivate your tenants to cooperate, perhaps it’s time to just ask outright, “What do you want in exchange for helping me?” Maybe they want their unit painted. Maybe they want to be released early from their lease—or have it extended in writing before you sell. Perhaps they want more parking spaces, or a washer/dryer installed in the basement. If there is something that you can do for them, legally and financially, do it. It’s worth it in the end.
The Powerful Key to Marketing Income-Producing Homes
Aside from the basic principles of marketing a home, the key to selling an income-producing property is to spell out the income potential for buyers. The biggest mistake that sellers make is to assume that the buyer (or even his Realtor) understands how to calculate it. Even if he does know how to do the math, you must provide the information. Your buyer may be just beginning to invest in real estate, and your building may be his first purchase. Whomever your buyer, if he doesn’t know the income potential, he won’t see the value; if he doesn’t see the value, he’s not buying.
We recommend that you do the math for him! Write out the specific expenses and earnings, both on the listing itself and on paper, that can be forwarded to any buyer who comes through. Remember, buyers of investment properties are motivated by different factors than buyers shopping for a private residence. The income potential is the driving force behind the purchase. It’s your story to tell, and you must tell it clearly and simply.
There is usually a section on a listing where this information should go, but we find so many listings in the MLS’s that leave the entire section blank or even filled out incorrectly.
Once you have told your story about income potential, your home should be marketed as any other following the principles of SALE (discussed in Chapter 9). It should be staged and aggressively priced, you should lead the deal, and you should expose the property to the entire buyer pool.
Trick of the Trade
When preparing your taxes each year, you likely made the annual income from your renters look lower than it really was by deducting certain legally allowable expenses on the property, such as depreciation. As the owner of an investment property, you probably already know that depreciation is a “paper expense,” as you don’t actually pay for it out of your pocket. In fact, it’s a tax law that allows you to offset income from an investment property from taxation each year by claiming wear and tear and physical deterioration on the property—but only on the building, not the land. The law further states that you must take depreciation on residential investment properties in equal amounts every year for 27.5 years (called straight-line depreciation). At that point, the property is “fully depreciated.” What you may not know, however, is that if you experienced losses on the property (real or “on paper”) instead of gains, you may be able to deduct the accumulated losses at the time of sale. You may also be able to deduct closing costs as well. Check with an accountant or tax expert to see what you may legally claim.
Calculating Property Income for Your Buyers
There are three key areas when calculating rental income on a property. They are universally accepted by buyers, lenders, insurers, and appraisers. Some of these groups can take the math to a much more complicated level, but we boil it down to its basic elements. Even someone who has a tough time with math should be able to tackle this. If you haven’t already done the math on your income-producing property, we strongly urge you to do so. It will have a major impact on your ability to get the best sale price—and your ability to attract all buyers, no matter their level of expertise.
The three key areas are based on annual numbers:
GOI = Gross Operating Income (total potential rental income before expenses)
TOE = Total Operating Expenses
Seller Alert
Mortgage payments are not considered to be an expense of an income-producing property. However, for personal tax purposes, the interest on the mortgage is typically deductible.
NOI = Net Operating Income (adjusted rental income after taking out operating expenses)
To calculate your gross operating income (GOI), let’s assume that you have two units in one building and each unit is renting for $1,500. This will give you a combined monthly rental income of $3,000. When you multiply $3,000 by 12 months, your GOI is $36,000.
Total Operating Expenses (TOE)
Net Operating Income (NOI)
Net operating income is figured by subtracting your expenses from your total income on the property: GOI - TOE = NOI.
Trick of the Trade
Some savvy buyers may want to know your rental yield. This is expressed as a percentage; divide the net operating income by the total value of the property. If the property is worth $300,000, then the rental yield is 9.5 percent.
What Really Attracts Buyers to Investment Properties?
As we have discussed, buyers of income-producing real estate are motivated differently than buyers looking for a home to actually live in. These buyers evaluate hard numbers, as we’ve just seen, but they also look closely at amenities and their effect on getting good rents. You may have more amenities than you realize. It’s important to capitalize on them and highlight them when selling.
The factors that they consider include some or all of the following:
◆ Rental income history
◆ Future potential income
◆ Proximity to public transportation
◆ Proximity to shops and restaurants
◆ Proximity to local or regional universities, hospitals, or business centers
◆ Availability of parking
◆ On- or off-site laundry
◆ Separate outside building entrances for tenants
◆ Condition of the building
◆ Safety of the neighborhood
◆ Bylaws about pets (for condos and co-ops)
◆ Accessibility for persons with disabilities
Many renters do not have cars and must walk or use public transportation to get to work, school, entertainment, or laundry facilities. Landlords often rent their units to students, medical residents, teachers, and transplanted business people. It’s important to include information about the close proximity of your rental units to services, entertainment, and academic or business hubs. This will allow potential buyers of your property to quickly see that they can keep the units occupied and at higher rents than other buildings.
Trick of the Trade
Share with potential buyers any research you may have already done about ways to increase the value of the property, such as creative ideas to expand parking or possibly convert the attic to another rental unit.
On-site conditions and amenities are also important. Having private parking, laundry in the unit or within the building, a doorman, health facilities, or common rooms can be important for rental income. If the building has more than one entrance, tenant privacy is enhanced and the building is worth more. If you have made upgrades to the structure and the units during your ownership, describe them. All of these issues impact the value of your building and should be highlighted.
Attached Rental Units, Mother/Daughter, and Boarder Apartments
Selling a private home with an attached rental unit, carriage house, mother/daughter layout, or boarder apartment is trickier than selling a straightforward rental property. For one thing, the rental unit may not be legal. Mother/daughter layouts imply that there is another wing or section of the home, often with its own entrance, where extended family may reside. But creating a lease for it and taking in rental income may not be legally allowed in your neighborhood. A boarder apartment may be legal, but perhaps only as long as you do not have certain appliances within it that constitute a fire code violation, such as a kitchen stove. If you market the property as having legal rental income and it turns out to be illegal, you could find yourself in a difficult position with your buyer and you may lose the deal altogether.
If you did not check the legality of the unit with the local zoning board at the time you purchased the rental unit, you should do so now. You may not hear what you want to hear, but it’s better to find out now that you’re violating a code or ordinance than to find out after you have spent time and money marketing the property and having gone into escrow with a buyer.
Showing Rental Properties
As we said earlier, it may be easier on everyone to allow your renters to be the direct point of contact for showings. If you make yourself the contact, then you will be the constant go-between, receiving calls from Realtors and then calling tenants to get permission for every single showing. If your tenants have been properly motivated by you, they will do the right thing and let buyers in whenever possible. To be sure that your tenants are granting access, put a note in the MLS listing itself that instructs Realtors to call you if they have trouble getting an appointment to see the unit.
You can also get creative in other ways if you have problem tenants. For example, if your building has two identical units and one tenant is more flexible or at home less often than the other, see if the buyers are willing to view just one of the units. If there is strong interest, then schedule another showing to see the other unit. It’s not ideal, we grant you, but it may be your best option when dealing with difficult tenants. It’s the same principle as a new condo development that takes all buyers through one model unit. If a buyer expresses keen interest, then another showing is scheduled to see the other units.
The Least You Need to Know
◆ Income-producing real estate is a valuable long-term asset, and the decision to sell should be carefully weighed.
◆ It can be challenging to conduct showings of units occupied by renters. Incentivize them to get their cooperation.
◆ To demonstrate potential income to buyers, subtract the property’s operating expenses from the rental income to come up with net operating income.
◆ To calculate the percent that represents rental yield, divide the annual income by the total value of the property.
◆ Key factors that buyers will use to evaluate your property include proximity to public transportation and business centers, as well as amenities such as on-site parking and laundry facilities.
◆ Before putting it on the market, check to be sure that your rental units are legally zoned—especially carriage houses, boarder apartments, and mother/ daughter layouts.
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