Keep rentals or sell and invest

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runningshoes
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Keep rentals or sell and invest

Post by runningshoes »

Hi folks,

Trying to figure out if I should keep a couple of rental properties or sell them and invest the proceeds. The RE market has done well in the area and I could generate a decent return, but it would be at the expense of losing a diversification play and solid stream of earnings for retirement that is not market driven. To help, the details are;

Two 2-flats (so 4 units);

#1: $850k sales value after realtor expenses, monthly rent $5,800, remaining mortgage of ~ $150k and 5 years (15 year mortgage)
#2: $850k - $950 sales value after realtor expenses, monthly rent $6,200, remaining mortgage of ~ $200k and 24 years (30 year mortgage)

Each unit has about $2,000 / month in expenses that would continue after the mortgage is paid off (property taxes, water, insurance, maintenance, etc.), leaving me with $4,000 x 2 or $8,000 per month as the base for retirement. I currently am cash neutral on the units as I use any excess on costs to pay down the mortgage on #2 to try and align the payout date to #1. Of course I have other retirement savings which are mostly invested in the market.

Thanks in advance for any thoughts.
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Watty
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Re: Keep rentals or sell and invest

Post by Watty »

runningshoes wrote: Thu Oct 21, 2021 10:29 am ...but it would be at the expense of losing a diversification play and solid stream of earnings for retirement that is not market driven.
Owning $1.7 million in similar residential real estate in which may be in the same city as where you may own the house you live it my be more of a diversification problem than a diversification play.
runningshoes wrote: Thu Oct 21, 2021 10:29 am Thanks in advance for any thoughts.
One of the reasons that I do not own any investment property is that I do not want to be dealing with it when I am older and may be less financially capable.

My wife sure as heck does not want to deal with rental property if she has to manage the finances someday. If we had rentals and something happened to me then she would likely just quickly sell them without much regard to the price or tax consequences.

Even if you have a property management company you will still need to stay on top of them and occasionally hire a different company. Even if you have a great property management company people will eventually retire, move on to different jobs, or die. It will be kinda hard to hire a new property manager when you are 80+ years old and living in assisted living.

Having multiple rental properties will also make settling your estate more difficult someday and your heirs may be forced to sell the properties in a bad real estate market. You also need to consider how capable your heirs would be with handling the property and if they do not live in the same city that could be a complication.

It would be good to consider how having the rentals fits into your long term plans. If you don't want keep them forever then the current strong housing markets could make this a good time to sell at least one of them.
RoadagentMN
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Re: Keep rentals or sell and invest

Post by RoadagentMN »

runningshoes wrote: Thu Oct 21, 2021 10:29 am Hi folks,

Trying to figure out if I should keep a couple of rental properties or sell them and invest the proceeds. The RE market has done well in the area and I could generate a decent return, but it would be at the expense of losing a diversification play and solid stream of earnings for retirement that is not market driven. To help, the details are;

Two 2-flats (so 4 units);

#1: $850k sales value after realtor expenses, monthly rent $5,800, remaining mortgage of ~ $150k and 5 years (15 year mortgage)
#2: $850k - $950 sales value after realtor expenses, monthly rent $6,200, remaining mortgage of ~ $200k and 24 years (30 year mortgage)

Each unit has about $2,000 / month in expenses that would continue after the mortgage is paid off (property taxes, water, insurance, maintenance, etc.), leaving me with $4,000 x 2 or $8,000 per month as the base for retirement. I currently am cash neutral on the units as I use any excess on costs to pay down the mortgage on #2 to try and align the payout date to #1. Of course I have other retirement savings which are mostly invested in the market.

Thanks in advance for any thoughts.
Tenants are bothersome, the market has done just fine.
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unclescrooge
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Re: Keep rentals or sell and invest

Post by unclescrooge »

I own two rentals. I am in the process of doing a cash out refinance. The proceeds will be invested in the stock market.

The interest rate is 3.5%.
niceguy7376
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Re: Keep rentals or sell and invest

Post by niceguy7376 »

Out of curiosity, which state are these located?
CTinVA
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Re: Keep rentals or sell and invest

Post by CTinVA »

runningshoes wrote: Thu Oct 21, 2021 10:29 am I currently am cash neutral on the units
Yikes! Sell them! That's a lot of principal risk for an investment that pays you $0.

Net of the mortgage, you have about $700k equity in each. You'll pay off the mortgage on the first in 5 years, and the second in 24 years.

Would you invest $700k today in an asset that pays $4000/month starting 5 years from now? The break-even cost of capital on that investment is 5.29%.
Would you invest $700k today in an asset that pays $4000/month starting 24 years from now? The break-even cost of capital on that investment is 1.67%,
Edit: I'm thinking I might have misunderstood how much you still have left on each mortgage. Are these numbers right? If you owe $700k rather than having $700k as equity, it greatly changes the calculations above.

If you're not familiar with this type of calculation, the cost of capital relates to the risk of the asset. In corporate finance, the calculation runs the other way: a company knows its WACC, and uses that to discount the cash flows to see if a project is a good risk or not. In this case, we're looking at the problem backwards: if the actual risk of those cash flows is greater than the percentage given, then the investment is a bad idea (that is to say, the return does not justify the risk).

It is difficult to pinpoint exactly what rate you should use as your weighted-average cost of capital, but I would expect somewhere between 8% and 15% would make sense for a rental property investor. At those rates, both investments have bad risk-to-reward ratios, and you should sell. (Note that my model assumed no inflation and no appreciation--that the $4,000/month is paid steadily from the time the mortgage is paid off until 30 years from now, at which point the property is sold for its current market value--and therefore those are real, not nominal, rates. But I also didn't build in major maintenance like renovating or replacing the roof, or any uncertainty in cash flows.)

The other way to look at the problem, is to ask if you could spend the same money today to generate equivalent cash flows at less risk, or greater cash flows at the same risk. Today, Schwab is offering a $4,000/mo annuity, starting in 5 years and paid over 20 years, for $700,000, which is equivalent to the first building. (I'm not saying you should get an annuity; it's just an easy basis for comparison.) The relevant comparison to the second house, a $700,000 principal investment for an annuity that starts paying in 24 years, yields a monthly payment of $7,277 for 20 years; or a monthly payment of $7,224 for life for someone born in 1981 like I am, or some other options that all sound better than owning the second house. And neither of those are fair comparisons, because the annuities only have counterparty risk and inflation risk, whereas a physical property has all manner of hard-to-quantify risks.

But really, the question is what is your best alternative use of $1.4 million, and is that alternative a better use than this one?
Topic Author
runningshoes
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Re: Keep rentals or sell and invest

Post by runningshoes »

Watty wrote: Thu Oct 21, 2021 10:57 am
runningshoes wrote: Thu Oct 21, 2021 10:29 am ...but it would be at the expense of losing a diversification play and solid stream of earnings for retirement that is not market driven.
Owning $1.7 million in similar residential real estate in which may be in the same city as where you may own the house you live it my be more of a diversification problem than a diversification play.
runningshoes wrote: Thu Oct 21, 2021 10:29 am Thanks in advance for any thoughts.
One of the reasons that I do not own any investment property is that I do not want to be dealing with it when I am older and may be less financially capable.

My wife sure as heck does not want to deal with rental property if she has to manage the finances someday. If we had rentals and something happened to me then she would likely just quickly sell them without much regard to the price or tax consequences.

Even if you have a property management company you will still need to stay on top of them and occasionally hire a different company. Even if you have a great property management company people will eventually retire, move on to different jobs, or die. It will be kinda hard to hire a new property manager when you are 80+ years old and living in assisted living.

Having multiple rental properties will also make settling your estate more difficult someday and your heirs may be forced to sell the properties in a bad real estate market. You also need to consider how capable your heirs would be with handling the property and if they do not live in the same city that could be a complication.

It would be good to consider how having the rentals fits into your long term plans. If you don't want keep them forever then the current strong housing markets could make this a good time to sell at least one of them.
The diversification is not an issue, as rents are much less volatile than the underlying asset value and I own the properties in locations that are upscale and have never had an empty month so that's really not a concern. In terms of the estate, it would first go to my wife, who would likely sell, and if we both go, the direction is to sell to avoid the issues you noted above. The age issue is something I have often thought about and you are correct - it's not a task I want to have on my to-do list when I'm in my mid 70's (but I have some time on that one.. :happy )
Topic Author
runningshoes
Posts: 231
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Re: Keep rentals or sell and invest

Post by runningshoes »

niceguy7376 wrote: Thu Oct 21, 2021 3:11 pm Out of curiosity, which state are these located?
City of Chicago, 2 different neighborhoods that are great for rentals, one more family oriented and the other young professionals.
bloom2708
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Re: Keep rentals or sell and invest

Post by bloom2708 »

If I had to choose between $1.7 million in Total US stock index (VTSAX) or $1.7 in equity in 2 rentals in Chicago, it would be an easy choice.

VTSAX and chill.

But, others may choose the rentals. Different strokes for different folks.

You probably win either way, so do what gives you the most joy.
Topic Author
runningshoes
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Re: Keep rentals or sell and invest

Post by runningshoes »

CTinVA wrote: Thu Oct 21, 2021 5:24 pm
runningshoes wrote: Thu Oct 21, 2021 10:29 am I currently am cash neutral on the units
Yikes! Sell them! That's a lot of principal risk for an investment that pays you $0.

Net of the mortgage, you have about $700k equity in each. You'll pay off the mortgage on the first in 5 years, and the second in 24 years.

Would you invest $700k today in an asset that pays $4000/month starting 5 years from now? The break-even cost of capital on that investment is 5.29%.
Would you invest $700k today in an asset that pays $4000/month starting 24 years from now? The break-even cost of capital on that investment is 1.67%,
Edit: I'm thinking I might have misunderstood how much you still have left on each mortgage. Are these numbers right? If you owe $700k rather than having $700k as equity, it greatly changes the calculations above.

If you're not familiar with this type of calculation, the cost of capital relates to the risk of the asset. In corporate finance, the calculation runs the other way: a company knows its WACC, and uses that to discount the cash flows to see if a project is a good risk or not. In this case, we're looking at the problem backwards: if the actual risk of those cash flows is greater than the percentage given, then the investment is a bad idea (that is to say, the return does not justify the risk).

It is difficult to pinpoint exactly what rate you should use as your weighted-average cost of capital, but I would expect somewhere between 8% and 15% would make sense for a rental property investor. At those rates, both investments have bad risk-to-reward ratios, and you should sell. (Note that my model assumed no inflation and no appreciation--that the $4,000/month is paid steadily from the time the mortgage is paid off until 30 years from now, at which point the property is sold for its current market value--and therefore those are real, not nominal, rates. But I also didn't build in major maintenance like renovating or replacing the roof, or any uncertainty in cash flows.)

The other way to look at the problem, is to ask if you could spend the same money today to generate equivalent cash flows at less risk, or greater cash flows at the same risk. Today, Schwab is offering a $4,000/mo annuity, starting in 5 years and paid over 20 years, for $700,000, which is equivalent to the first building. (I'm not saying you should get an annuity; it's just an easy basis for comparison.) The relevant comparison to the second house, a $700,000 principal investment for an annuity that starts paying in 24 years, yields a monthly payment of $7,277 for 20 years; or a monthly payment of $7,224 for life for someone born in 1981 like I am, or some other options that all sound better than owning the second house. And neither of those are fair comparisons, because the annuities only have counterparty risk and inflation risk, whereas a physical property has all manner of hard-to-quantify risks.

But really, the question is what is your best alternative use of $1.4 million, and is that alternative a better use than this one?
Thanks for the detailed response and I think I wasn't clear on my notes based on some of your comments. I'm cash neutral by choice as I'm taking all the excess (plus some variable comp when available) and using it to pay down the mortgage on unit #2 so both units will be paid off when I turn 64 in 5 years. I have a FT job and don't need the cash flow right now, and also use the rentals to help me reduce our tax load. Right now the increase in equity is roughly $50k per year and that number obviously gets bigger until the mortgage is paid off and then I don't have the equity gain any longer. My return on the units, using your examples above are much larger than the calculation you did above since I only invested about $230k in each unit at time of purchase so that is my cost basis (in cash on cash terms). In short, I will have invested about $460k and 5 years from now will have about $1.7MM of equity so a 9% return (with some work in this - it does take time).

I really like the annuity comparison (but not the math behind it) as that is exactly what I was thinking of when we bought the units - being somewhat conservative on the financial side (like most BH's here) I wanted to "guarantee" a certain portion of our retirement needs that was not dependent on the stock market. At the time we ran the numbers compared to annuities and the rentals were a hands down winner (primarily driven by the equity growth and even w/o the added tax benefits) for the simple reason that an annuity basically "trades" your asset value for a stream of payments while the rentals allows you to keep the underlying asset while still providing the stream of payments, and given the low interest rates, the insurance companies who actually underwrite the policies are providing rather low yields.

Having said all that, I'd likely be open to an annuity if the returns went up by a couple of points so that I could buy in at say, $700k for an immediate return of $4k/month.
w5000
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Re: Keep rentals or sell and invest

Post by w5000 »

Well, you could do a more detailed analysis of the return on the properties. But as a rough calculation, $8K * 12 = $96K/year return on $1.75M is 5.5%, so in the grand scheme of things, that's not a great return on real estate. And I infer from your message that you are self managing? (Or at least you didn't say anything about costs for paying a property manager.) If so, how much of your time are you giving for that eventual 5.5% return?

On the other hand, real estate does provide fairly steady income, and both the rents and the property values should roughly go up at the rate of inflation. Maybe it provides diversification against the rest of your assets. But of course you should be able to do better than 5.5% on average and over the long term with a not too aggressive equity portfolio.
Benbo
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Re: Keep rentals or sell and invest

Post by Benbo »

I’m interested in this, as I am in a similar situation. I have a 4-unit rental home in LA that Zillow estimates at $2.4M. I’d like to sell it, both the house and I are getting older and in need of repairs :?
I’d rather move all the profits to a mutual fund, but what’s holding me back is I’d have to do a 10-31 exchange to avoid capital gains, and also due to Prop 13 the tax rate if I purchased another property would be much higher since I’ve owned this home for more than 30 years.
l8_apex
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Re: Keep rentals or sell and invest

Post by l8_apex »

I didn't see that you mentioned if you like being a landlord.

I've got multiple rentals but won't sell because the net from selling is too small due to capital gains, depreciation recapture, and selling fees. That plus not feeling like I would find a good investment for that cash keeps me in the landlord business.

I'd suggest taking a look at ways to get your debt to the lowest interest rate possible. (i.e. read up on margin loans, there are threads here and on the Mr Money Mustache blog/forums). I would also question the need to pay off the debt on the rentals when it's possible to get interest-only loans at low rates.
phxjcc
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Re: Keep rentals or sell and invest

Post by phxjcc »

The RIGHT answer is that it is not correct for anyone to make a judgement based upon the information given.

If you have $M in the market, $C in cash, and $R in real estate AND

--M approximately equals R then ok, you are diversified..

If, however R>>M, then you are overweighted in real estate.
Ditto, the obverse.

Ditto, for C > 0.20 * M.

At least, those are MY rules.
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Watty
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Re: Keep rentals or sell and invest

Post by Watty »

Benbo wrote: Fri Oct 22, 2021 10:38 am I’d like to sell it, both the house and I are getting older and in need of repairs
Considering how the house will age is a good point to keep in mind. If you own a house that is already 50 years old and you keep it for another 30 year you will be dealing with a house that may be past its prime and at that age. At some point it may be more prone to have problems with things like water and sewer mains, foundations, and electrical and plumbing systems, driveways, siding, etc needing work significant just because of the houses age.

Even if your house is well maintained the neighborhood may be past its prime if the other nearby homes are not well maintained too.
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runningshoes
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Re: Keep rentals or sell and invest

Post by runningshoes »

l8_apex wrote: Fri Oct 22, 2021 10:41 am I didn't see that you mentioned if you like being a landlord.

I've got multiple rentals but won't sell because the net from selling is too small due to capital gains, depreciation recapture, and selling fees. That plus not feeling like I would find a good investment for that cash keeps me in the landlord business.

I'd suggest taking a look at ways to get your debt to the lowest interest rate possible. (i.e. read up on margin loans, there are threads here and on the Mr Money Mustache blog/forums). I would also question the need to pay off the debt on the rentals when it's possible to get interest-only loans at low rates.
I never really understood this approach (bolded above). What's the point of doing interest only loans as you lose any equity build and are relying on appreciation, which may or may not occur, to provide your returns. The cash flow has to be really strong to support this over the long haul, otherwise why not just buy an annuity as one of the other posters suggested?
l8_apex
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Re: Keep rentals or sell and invest

Post by l8_apex »

runningshoes wrote: Fri Oct 22, 2021 4:44 pm

I never really understood this approach (bolded above). What's the point of doing interest only loans as you lose any equity build and are relying on appreciation, which may or may not occur, to provide your returns. The cash flow has to be really strong to support this over the long haul, otherwise why not just buy an annuity as one of the other posters suggested?
Just as you suspect, the cash flow is very good. $14.5k/mo gross for the six rentals (that's when all are rented, I think mine run about 95% occupancy rate). When I finish the move to IO loans, my loan payments will be less than $2k/mo in total. When I had all conventional loans, I was paying about $6.5k for principal and interest.
babystep
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Re: Keep rentals or sell and invest

Post by babystep »

runningshoes wrote: Thu Oct 21, 2021 10:29 am Hi folks,

Trying to figure out if I should keep a couple of rental properties or sell them and invest the proceeds. The RE market has done well in the area and I could generate a decent return, but it would be at the expense of losing a diversification play and solid stream of earnings for retirement that is not market driven. To help, the details are;

Two 2-flats (so 4 units);

#1: $850k sales value after realtor expenses, monthly rent $5,800, remaining mortgage of ~ $150k and 5 years (15 year mortgage)
#2: $850k - $950 sales value after realtor expenses, monthly rent $6,200, remaining mortgage of ~ $200k and 24 years (30 year mortgage)

Each unit has about $2,000 / month in expenses that would continue after the mortgage is paid off (property taxes, water, insurance, maintenance, etc.), leaving me with $4,000 x 2 or $8,000 per month as the base for retirement. I currently am cash neutral on the units as I use any excess on costs to pay down the mortgage on #2 to try and align the payout date to #1. Of course I have other retirement savings which are mostly invested in the market.

Thanks in advance for any thoughts.
if you sell and generate a return then how much would you pay in the tax?
Topic Author
runningshoes
Posts: 231
Joined: Thu Apr 08, 2021 3:48 pm

Re: Keep rentals or sell and invest

Post by runningshoes »

babystep wrote: Sat Oct 23, 2021 12:53 am
runningshoes wrote: Thu Oct 21, 2021 10:29 am Hi folks,

Trying to figure out if I should keep a couple of rental properties or sell them and invest the proceeds. The RE market has done well in the area and I could generate a decent return, but it would be at the expense of losing a diversification play and solid stream of earnings for retirement that is not market driven. To help, the details are;

Two 2-flats (so 4 units);

#1: $850k sales value after realtor expenses, monthly rent $5,800, remaining mortgage of ~ $150k and 5 years (15 year mortgage)
#2: $850k - $950 sales value after realtor expenses, monthly rent $6,200, remaining mortgage of ~ $200k and 24 years (30 year mortgage)

Each unit has about $2,000 / month in expenses that would continue after the mortgage is paid off (property taxes, water, insurance, maintenance, etc.), leaving me with $4,000 x 2 or $8,000 per month as the base for retirement. I currently am cash neutral on the units as I use any excess on costs to pay down the mortgage on #2 to try and align the payout date to #1. Of course I have other retirement savings which are mostly invested in the market.

Thanks in advance for any thoughts.
if you sell and generate a return then how much would you pay in the tax?
Quite a bit as I'm already in a high tax bracket and next year I'll likely be at the highest marginal bracket assuming the year ends according to forecast. In addition, the depreciation taken over the years really adds to the tax bite. This is one of the reasons I'm considering holding on for a few more years and selling when I retire.
babystep
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Re: Keep rentals or sell and invest

Post by babystep »

Looked into UPREIT?
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cchrissyy
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Re: Keep rentals or sell and invest

Post by cchrissyy »

I don't see the number I would need, which is how much equity you have in each property not just after the realtor and other costs of sale, but after capital gains and depreciation recapture.

That ultimate number is what I compare to simply adding it into my AA.

Agree with other posters to consider if you want the extra work if you become elderly or disabled. And remember as the years go on, the "problem" of capital gains and depreciation recapture may get more expensive.

One idea could be don't sell while you have such high tax rates from earned income but, when retired, sell each in different years.
60-20-20 us-intl-bond
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