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Lesser of two evils: short sale or tenant?

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Posted: Wednesday, October 1, 2008 10:00 pm

Q: I bought a house about four years ago, and relocated for work last year. My old house has been on the market for almost a year. I thought about renting it, but I really don't want to deal with tenants from a long distance. The place is almost fully remodeled, and people have been viewing it, but my Realtor says I need to lower the price and try for a short sale. The one thing I haven't tried is putting in stainless steel kitchen appliances - the appliances currently in there are newer, but they are black. Should I invest my last few thousand dollars in upgrading the appliances to stainless steel, or should I attempt a short sale?

A: Contrary to popular belief, everyone doesn't love stainless steel appliances. In fact, some folks actively dislike them. Buyers generally want updated appliances; if yours are up-to-date, they are not likely the thing that is stopping your home from selling. Based on your Realtor's comments, my guess would be that your home may be overpriced, which is the single most common circumstance that prevents homes from selling. So, no, I would not pour any more money into new appliances. But that doesn't mean a short sale is your only option, either.

Mindset Management

You may be dismissing a better option than a short sale - renting your home out - prematurely. Now, don't get me wrong, I am not personally a big fan of being a landlord. It runs counter to my personal life rule of minimizing the number of people who can make me have a bad day. However, if I had to choose between having a tenant and selling my property through a short sale, I would pick a tenant.

Generally speaking, in life, what we fear we create. If you fear that you'll have a tumultuous, drama-filled, excruciating experience of being a landlord, complete with late-paying, car-on-the-lawn-parking, hole-in-the-wall-creating tenants, you very well might get exactly that experience. Being a landlord by definition involves putting your tenant in the position where he or she is able to damage your property and impact your monthly finances.

However, there are a number of things you can do to minimize your chances of ending up with The Worst Tenant In The World (note the capitals). Hire a top-notch property manager who is used to handling properties for distant landlords. Have prospective tenants thoroughly screened and background-checked. Follow the landlord-tenant law of your state to the letter. Obtain a fair, but hefty, security deposit. Put a home warranty in place on your home to minimize your exposure to repair expenses.

On the other hand, there's not a whole lot you can do to minimize the badness of a short sale. It has long-term impacts on your credit and your ability to buy a home in the future. Traditionally, the industry counseled buyers that the "hit" to your credit of a short sale was a reduction of about 150 points, about half as bad as that of a foreclosure, which reduced FICO scores about 200 to 300 points. The algorithm used to attain FICO scores underwent a major change last year, though, and the folks at Fair, Isaac & Co. (hence, FICO) now say that a short sale and a foreclosure are equally bad for your credit, both events reducing your FICO score by 200 to 300 points. The "advantage" of a short sale is that you can get a good mortgage about two years after undergoing a short sale, while it takes about five years following a foreclosure.

Also keep in mind that short sales are tough to pull off - your lenders must play ball and agree to forgive some or all of your debt to them to make it happen, which they are statistically unlikely to do. Some real estate industry insiders estimate that as few as 20 percent of short-sale listings actually close - and the ones that close often do so only after months of stressful negotiating with the lenders involved. Many of my buyer clients refuse to look at short-sale listings - they know that the chances are those properties will end up in foreclosure, and they will circle back to them when they are listed as post-foreclosure, bank-owned properties.

It may seem like you are being forced to choose between a rock and a hard place. Rethink whether being a landlord is necessarily as hard a place as it seems. Also, reassess your current situation. You are really not in a position to make any choices or decisions this moment, as you currently have in hand neither an offer to rent nor an offer to buy your home through short sale in place. Don't agonize and torture yourself over what are truly hypothetical alternatives at this point - follow my action plan and position yourself to get some actual, concrete options. Only then does it make sense to agonize and torture yourself over the decision whether to rent or to sell short!

Need-to-Knows

As the foreclosure rate has risen, the resale market has gotten worse for sellers, but all those former homeowners who have lost their homes through foreclosure have become tenants. As a result, the demand for rental housing has gone up, and rents have increased in many geographic markets. So, the more dreary the resale forecast for your market, the more easily you'll likely be able to get and keep it rented, and the higher rents you'll be able to command.

This brings us to one of the most critical inputs to your decision whether to rent: cash flow. Whether renting your home is preferable to selling it in a short sale depends largely on how close the rental income will come to covering or exceeding the expenses of owning the property. To assess the feasibility of converting your home into a rental, you need to compare the projected rental income against a realistic estimate of the expenses, including the monthly mortgage payment, property taxes, hazard insurance, HOA dues (if any), any utilities or services you would pay for the tenant (like landscaping), the property manager's fees, and a monthly reserve for maintaining the place. Ideally, you'd also have enough rental income to set aside 5 percent or so of the monthly rent in a savings account to be drawn upon to cover expenses in the event of a vacancy. After conducting this cash-flow analysis, you can decide whether it might be worth it to consider renting your home out, rather than short-selling it, even if you are slightly cash-flow-negative monthly.

Action Plan

1. Talk with a reputable, local property manager. Ask them to help you create realistic estimates for the rental income your property would command on the local market and for the amount you would pay monthly for property management services.

2. Do a projected cash-flow analysis. Very simply, compare the estimated income and expenses - discuss your analysis with your Realtor and/or property manager to ensure you are not missing any important line items.

3. If you are open to renting it after you have the projected cash flows, put it up for rent and reduce the sale price to a fair market price. You will then be in a race to see which comes to fruition first - an offer to rent the place or an offer to buy it at a short-sale price. Only once you have an offer in hand will you be in a position to make a concrete decision between these alternatives.

If you do decide to rent your home out, discuss this with your CPA - there are tax implications for converting a home into a rental property. And stay open to creative solutions, like a lease-option - you might find someone who is willing to lease, then buy, your home - the best of both worlds!

Tara-Nicholle Nelson is author of "The Savvy Woman's Homebuying Handbook," and "Trillion Dollar Women: Use Your Power to Make Buying and Remodeling Decisions." Ask her a real estate question online.

***

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Things to avoid after being approved for a mortgage

You have done the hard part in the home-buying process and chosen a lender and a real estate agent to work with. You have also gone out and found the home of your dreams! Best of all, your team has done a great job of negotiating the best deal for you.

Posted: September 12, 2014
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