In this episode of Drinks and Deep Dives, we focused on how today’s market affects the decision to sell a property and trade up to a bigger and better one. We looked at income and rent growth, walked through four scenarios to see if it makes sense to sell, and talked about how to navigate a 1031 exchange. What we found is that there isn’t one right decision on whether or not to sell: it depends on your goals and the best way to achieve them.
- Listen to the podcast “#286: DDD: Should I Sell My Rental? An Analysis of 4 Rental Properties and Two Types of 1031 Exchanges” on the Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
Comparison of Income Vs Rent
The above graph uses data from 50 metro areas around the country to track the growth of income vs the growth of rent. Denver is located in the middle; the median increase in rent is about 2.5%, and the increase in income is 0.7%. We can see that rents are highly correlated with inflation, and historically, real estate is a great hedge against inflation. From a macroeconomic view, we will see both rent and income increase, so investors should keep this in mind as they decide what to do with their properties.
Is now a good time to sell or trade up?
A lot of owners are seeing a sharp increase in equity from their properties as prices keep going up. We get a lot of questions asking if now is a good time to sell and trade up. While the short answer is generally yes, there are certain factors to keep in mind. Before making the decision to sell, there are two key points to understand: determining your goals and understanding the tax consequences of selling.
It is impossible to make the correct decision without having a firm grasp on your real estate goals. Be realistic about your financial goals, job, and assets so you are making an accurate assessment. Know where you are in your real estate career to determine if cashflow or equity is more important to you right now. Make sure to talk to the appropriate people: insurance brokers about annuities, financial advisors for stocks and bonds, and us for real estate. Take everything with a grain of salt, but use the information to shape your goals and strategy for achieving them.
It is also vital to understand the tax consequences of the property you own and the one you want to make moves on. If you’ve lived in a property for two of the last five years, you can exclude capital gains up to $250K if you’re single and $500K if you’re married. If you have a pure rental property, look at doing a 1031 exchange, which will allow you to defer taxes. Before making any decisions, talk to a CPA or accountant to know what your options are and get a full understanding of your tax liability.
Case Studies of Rental Properties
To see these concepts in action, we have four different properties that highlight the range of options. I ran all of these properties through our Return on Equity spreadsheet to see what the best move would be. The spreadsheet analyzes four scenarios: keep the property, do a maximum cash out refinance, do a safe refinance, or sell it. If you would like to learn how to analyze an investment rental property, check out our free Investment Property Analysis Course. Module #3 covers how to use the Return on Equity spreadsheet.
Watch the video (at the bottom) to see the spreadsheet as we discuss the properties.
Property 1: Duplex in Congress Park
This duplex was purchased for $525K and is currently valued at $784K. The annual rents are very strong, and the owners have about $350K in equity. Looking at the different options, selling this property will bring the greatest return. This makes sense because the current return on the equity is only about 10%, which is fine, but not high performing. If the owner is focused on acquiring property, then a sub-10% return is probably not good enough. If he needs more cashflow, however, selling might not make the most sense.
Property 2: House in California
My client bought this house at the top of the market and overpaid at $775K; a year later it was worth $600K. He eventually turned the house into a rental and moved to Colorado, meeting the two of five years occupancy requirement for capital gains. Currently, the house is valued at $1.4M with a $400K loan balance.
The market gave him a huge return via appreciation. His goal was to sell the home and bring that money to invest in Colorado. It’s important to understand what the current performance of a property is to make sure you are buying a better performing property. The current cap rate of the house is 2.5%, significantly lower than the 4% we see as a minimum threshold for holding on to a property.
His preference for properties is to buy single family homes in class A type of neighborhoods, which aren’t great for cashflow but have a high demand and are seeing appreciation. If we assume he wants to maximize leverage and buy multiple properties for 20% down, then the returns will be stronger cumulatively. Keep in mind that your risk tolerance for different types of properties, investing style, and preferences will all play into your decision.
Property 3: Townhouse in Denver
My clients lived in this townhouse for a while and converted it into a rental after moving out; they didn’t originally buy it with the intent to invest in real estate. It was purchased for $212K, is currently valued at $320K, but could probably sell for more. They have a $151K loan balance; the current cap rate is 3.7%; and they are making a 10.3% return on equity.
In this case, it makes the most sense to sell and trade up to maximize both their return and cashflow. Assuming they find a property with a 4.75% cap rate and a 25% down payment, their cashflow will increase some, but their returns will almost double to the low-20s.
A key factor here is that the property currently has a tenant who won’t move out until later this year. Generally, it’s not optimal to sell a home with a tenant in place because only other investors will be willing to buy the property. Owner occupied properties require that the owner move in within 60 days in order to get the loan, so trying to sell with a tenant who will continue to live there limits your options. Sometimes the owners can pay the tenant to move out early, but it’s also harder to show a house and make repairs when it’s occupied.
Property 4: Completely Paid off Property in Denver Metro
This home was purchased around 20 years ago for $80K and is currently valued at $650K. What prompted the owner to call me was that instead of the usual $450K range houses were selling for in her neighborhood, a house down the street sold for $650K. That extra $200K changed her perspective enough to look into selling.
Rents for the house are only $23K per year, so the rent to price ratio is not great, but she also has zero interest and loan balance. The current cap rate of 2.3% isn’t great and is again below our 4% threshold. When measuring cap rates, always use today’s rents and values: it doesn’t matter how much you bought it for, only what it’s like now. With a cap rate this low, she could probably buy a better performing property just randomly selecting one off the MLS.
In this case, she could sell her property and get roughly $611K in proceeds that could be used to buy a better performing property. With that much cash, she could look into multi family properties, an apartment building, or a $2.5M house. Buying a better performing property with higher leverage will likely bump up her returns to the low 20s. However, since the property is paid off, she could also hold onto it and keep her cashflow. This goes back to my earlier point: make the right decision based on your personal goals. One decision is not necessarily better than the other here; it depends on which factor is most important to her.
After looking at these properties, we can see how the best decision is based on the owners’ goals and how they can achieve them. Understand the difference between returns and cashflow and how they will help you meet your needs. If you want to buy a new property, make sure it’s better performing with a higher cap rate and that you employ leverage when purchasing it.
What are the two types 1031 exchanges?
A 1031 exchange is a method of selling a property and buying a replacement that allows you to defer capital gains taxes. In order to do this, you can choose either a traditional or reverse 1031. In today’s market, you can sell your property for top dollar, but then you’re in the buying pool and it can be tough to find a replacement. If you’re interested in doing a 1031 exchange, it’s important to have a gameplan in place before selling.
With a traditional 1031 exchange, you have a 45 day window to identify the replacement property. This is a tight timeline, but we can get it done because we do a lot of prep work that will help you move fast. It can be harder to deal with contingencies with this deadline, and multi family properties tend to be more 1031-friendly than single family homes. Once the property is listed and under contract, we go into active hunt mode to find the replacement by reaching out to our network to find out what’s on the market that will meet your criteria. Even with the prep work, it can still be stressful and you run the risk of not meeting deadlines.
A reverse 1031 exchange allows you to buy a new property first and then sell the old property. There are two main considerations for this type of 1031: the fee is higher ($5k compared to around $1K), and you have to have the means to purchase a property before selling the previous one.
There are a variety of ways our clients have funded a reverse 1031: putting a home equity line of credit (HELOC) on their primary residence, using equity from other investments for a HELOC, or doing a bridge loan. Bridge loans are based on credit and net worth to ensure the lender feels safe making the investment. They usually have around a 1% origination fee, higher interest rate, and are meant to be short term.
We are planning on doing a course on 1031 exchanges, so check back for updates.
If you have a property or portfolio you’d like to analyze, reach out to us. We are happy to run different scenarios and walk you through your options. Our main focus is on helping you become more educated, so you can make the best decision for your goals.
Join us for our next Drinks and Deep Dives Live on Wednesdays at noon.