“Should I stay or should I go now?
If I go there will be trouble
An if I stay it will be double
So come on and let me know”
Those are lyrics by a classic song by The Clash. Okay, so I admit, I’m stretching a bit trying to be amusing and incorporating those lyrics into a blog post that probably should be more succinctly titled “Should I Sell First, Rent, then Buy?”. Last month, the topic of selling your house first, then renting before trying to buy another house has come up in a conversation I had with a friend and during a recent Coldwell Banker office meeting. Thus, I thought it worthwhile to write a blog on the rationale behind this strategy, the inherent risks and the potential benefits. There are various scenarios on why someone would do this and my perspectives change depending how the reason for doing some and your timelines. The following are two common scenarios.
Scenario 1 – The Empty Nester: couple has owned a larger house for a long time, with adult children
In this situation, my friend has lived in a nice, big house in a nice leafy community for decades and now has grown children, and no longer has a need for a large house with a large yard. He and his wife are contemplating the possibility of “downsizing” their house to a) cash out and take some equity out of real estate while their mid-Peninsula house is at an all-time high, b) move closer and within walking distance of an active downtown area in San Carlos, Burlingame or San Mateo, c) change of scenery of just living somewhere different and d) live in a (smaller) single-story house requiring less cleaning and with a lower maintenance yard.
The conversation revolved around the highly common question of do they sell first then buy or buy 1st then sell; I will tackle this bigger question in a separate blog post. My Peninsula friend then said he’d even consider selling first, then renting a San Francisco apartment for a year or two for fun, before contemplating a purchase. In principle, that sounds like a really cool idea. Long time suburbun couple, cashes out of their house as an empty nester, then rents a hip apartment in the big city SF life for a couple years before deciding where to settle back to. From a financial perspective, let’s look at two rudimentary possible market outcomes:
A) the real estate market remains flat/declines or goes up moderately. In this situation, the strategy above would work out very successfully.
B) the local real estate prices continue rising 10-20% per annum. In this situation, being out of Bay Area real estate would come at a negative financial impact. I use the term rudimentary in above paragraph, as you can include dozens of other variables to really determine “financial impact”. For instance, it would be theoretically possible if one freed up capital in selling off a real estate asset and then reinvested that capital in a different investment opportunity that ended up yielding a higher return than if that person remained in real estate; and if you were to include that possibility, you’d need to incorporate “beta” and inherent riskiness between asset classes into that analysis as well. But let’s simplify thing in this following sample calculation. Let’s say your current (larger) house can sell at $1.8 million in Spring 2014 and the target would be to purchase a smaller 3 bedroom, 2 bath house in San Mateo for $1.2 million which would allow you to cash out almost $600k in equity (not factoring in cost of sale, taxes, etc.). What if you sold your current house for $1.8 million, then rented a super-hip SF apartment for 2 years and then started looking to relocated back to mid-Peninsula again in year 2016. And in this situation, the Bay Area real estate market continued going up 15% per year for these two years. That $1.2 million house in 2014 would be priced at $1.587 million yielding net cash of $213k (from the $1.8 million) as the 3 bedroom house would have gone up by $387k. Additionally, there is the cost of the hip apartment rental in SF which will probably be between $4000-6000 per month for a nicer unit in a hip neighborhood which wouldn’t go towards any mortgage principal at all. Now, we aren’t factoring in impact to tax writeoffs, income earned from reinvestment of the freed up capital and other items, but this simple example seeks to illustrate a financial risk in being out of Bay Area real estate market…..in a potentially rising real estate market.
No one knows what any market will do in the short term whether that is stock market, real estate market, currency market, commodities market, etc., but would you be prepared to “gamble” on being out of Bay Area real estate if you ultimately know you wish to own real estate in the long term as both a financial and lifestyle investment?
Scenario 2 – Young Family: seeks to move into bigger house and are not able to buy 1st then sell, so they wish to sell 1st, do short term rental while looking to purchase larger home.
Why would they want/need to do that? They may not have the requisite down payment unless they sold current house, or can qualify for a new mortgage while owning their existing house/mortgage. They may be able to take advantage of having a larger down payment after selling their current house, and be ready to buy and move into a new house, and not have to put in a contingency to sell their current house as part of their offer. There would be more flexibility to put in an aggressive offer with “cleaner” deal terms with this strategy. And certainly, as (B) above references and with any path, there will be potential risks too. There is no right or wrong way to proceed per se.
There will be implications no matter how this situation is handled. Having the money in the bank and ready to make offers with large down payments and without the complications of selling another house would generally improve the probability of winning in a multiple offer situation. But I wanted to just delineate between scenario 1 where my friend would be looking to temporarily cash out of the real estate market for a period of time just to “have some fun” living in the city for a couple years. He and his wife would be gambling in a situation where he has other options should he wish to pursue them. I would advise them to make sure to evaluate all his various options and just to make sure he knows what the various outcomes could be. Versus scenario 2 for the move-up buyer which is a very different situation with different expected timelines; in this scenario, there is risk, but based on timeline and the high competitive Bay Area market, these buyers have more limited options, but the timeline also is presumably shorter too. Thus, there are ways to try to mitigate some of the risks. But more importantly, there is potential upside in going down this path in terms of trying to buy the larger house.
There is generally a major dilemma with many of my friends and clients who are seeking to buy larger houses from their current place. Do you a) sell 1st then buy, b) buy 1st then sell, c) make contingency offers? Very challenging situation in the hot Bay Area market where many/most properties have multiple offers and some have an incredible number of offers. I will do a future post analyzing the options on this. No easy answers no matter how you disect it.