Author Topic: Is It Time To Sell The Rental Property?: Help With A Quantitative Analysis  (Read 3164 times)

fluoren3

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Long time MM reader, first time poster. I hope you’ll indulge me this rambling.

Much of what I read online regarding rental properties has to do with buying, and valuation at time of purchase. There’s lots of good material out there about it. But the stuff I read about selling is very light on numbers and very heavy on “yeah, do it, dude!” or, “no, man, keep it!” So what I would like is a few knowledgeable people to look over my shoulder and comment on my thoughts--and especially the numbers--and see if I have this right.

Per the suggestion in the sticky for data needed to do a case study (which I’m not necessarily angling for), here are the relevant details:

Market Value: $700,000
Original Purchase price: $279,000
Original Mortgage Amount: Something like $230,000 (in 1997—since refinanced multiple times)
Interest Rate: 3.25%
Mortgage Term: 10 year fixed
Term remaining: Due August 2023, but I’m prepaying it, and should be done sometime in 2021.
Amount remaining on mortgage: $69,000
Gross Rents: $44,000 annually on three units
Principal and Interest (the P&I of your PITI - should match with the above info): $12,223/yr
Taxes and Insurance (the T&I of your PITI): $10,834/yr
HOA costs: N/A
Deferred maintenance notes: Built in 1890 (that’s not a typo). Relatively well maintained, but an unforeseen $5,000-$8,000 expense is normally no more than a few years away with such a building. The boiler could go; the tuckpointing is bad; one of the kitchens could use an overhaul; the basement apartment floods every few years.

Anything else special or unique in regards to the numbers of the property (not the property itself; things such as city assessments, back taxes, special costs due to unique features of the property, etc. etc.): Nothing comes to mind.

Other notes: It’s a hot neighborhood, and has been for a long time, so two of the units are more or less 100% occupied, but the basement unit is probably more like 80% occupied, due to the aforementioned flooding and other issues that just seem to crop up in that unit. Luckily, that unit brings in the least amount of rent. This is a three-flat building, so three different tenants. Rents are at least slightly below market rates right now—I imagine I could raise them by 10% easily, maybe even by 20%.

Gross rents are $44,000 the three units. PITI cuts out about $23,000 of that. Management company costs (I live out of state) are far below what they should be, but combined with maintenance costs and utilities (I pay some of the utilities, though not much), that’s another $7,000 a year. And there’s the odd expense as mentioned above, and the occasional empty unit.

Call that $14,000 of cash flow annually to me. Though principal is “to me” too in the sense of building equity, of course. That’s about $10,000 of the principal and interest right now. Include principal and it’s $24,000 in income and equity.

That’s part of my uncertainty, by the way—how to think about the principal. More on that in a few moments.

As many of you surely already know, an important, basic, big-picture part of investing is understanding the risk/reward trade-off of your investment--and of comparable investments. You don’t sell your S&P 500 index fund and buy Tesla stock with the proceeds and expect the ride (sorry) to be the same. You have much higher potential risk and potential reward with something like Tesla. And if you can find an investment with comparable potential reward to the S&P 500 but with a lot less risk, it should seem pretty interesting to you.

This way of thinking is foremost on my mind in considering whether to get out of the rental market entirely: Is there something I could do with the proceeds of a sale that would be comparable as an investment, in terms of capital appreciation and income? Many of you who are very involved in multiple real estate properties surely do something similar with your real estate investments: Buy low, sell high, and then look for another way to repeat that cycle, possibly by buying in other neighborhoods or towns where property appears undervalued.

Anyway, back to the numbers. I figure my accumulated depreciation is about $115,000, so the adjusted cost basis is around $165,000 in the property, making the taxable capital gain about $535,000. Net proceeds of the sale to me, though, would be something like $581,000: That’s the $700k sales price, minus the outstanding $69,000 mortgage, minus about $29,000 of 25% tax on claimed depreciation, and minus a 3% real estate broker commission of $21,000.

(One parenthetical but important point: my wife and I are pretty low-income right now, with total taxable income in 2013 of about $70,000. This puts us in the 15% income bracket—and capital gains are not taxable for people in that bracket. I almost can’t believe that as I’m typing it, but it appears to be true.)

So, with that all set up, here’s the math I keep running through in my head:

If I had $581,000 in cash, right now, I’m comfortable that I could get a 4.5% to 5% yield on it without touching the principal by investing it in various publicly traded investments (a mix of mostly large-cap stocks, REITs, maybe some fixed income instruments). Let’s call that $28,000 in dividend income and distributions, via capital invested in as close to sure things as one can get in the equity markets, and likely tax-free given the income bracket we’re in (dividends, too, are tax free to the 15% income bracket).

Meanwhile, the value of the amount invested goes up, but not as reliably as the income portion. Stock markets go up and stock markets go down, but over the long haul (10 years minimum, though more conservatively more like 20 years), I think I should be able to count on 5% average annual capital appreciation, not that I would realize those gains.

(Another parenthetical: Of course there are investment options besides what I mention above that could provide higher potential returns over the long term. But remember, I’m trying to get this as close to a comparable, existing, income-generating investment as the rental property as possible. There are publicly traded business development companies, for example, that yield 10% or more, but they’re not stable enough for me to consider as comparable for this exercise, except as maybe a tiny part of the overall 5%-generating portfolio. On the other hand, there are plenty of publicly traded companies that have paid a steady or growing dividend for 20, 30, even 40 years that currently yield in the 4% range.)

The giant wildcard here is what will happen to property values in the neighborhood where I hold my place. And I just have no idea. It feels like a bubble, but I would have said the same thing 10 years ago—before the actual bubble of 2007/2008. And values are as high now as they’ve ever been.

So I put that property value question in the too-hard-to-figure-out pile. And that’s no small thing the older I get. I feel like I can count on the rents staying steady or increasing, but I just don’t know if I can count on the capital appreciation. I feel more comfortable counting on that in the equity markets (again, over the long term), because they’re what I know best.

One big thing that has kept making me second guess my thinking on this: At my current rate of prepayment, I should be done with the mortgage in 2021. Then, suddenly, the into-pocket cash flow jumps, as there’s no principal payment anymore, and of course there’s no interest (not that interest is much of a burden at this point). But, in typing that out, I just realized that that change probably should not factor into the equation a ton. Principal payments are “enforced savings,” as they say, as that will be your equity once you do sell. But if the value of your property goes down, and you could have invested that money elsewhere—I don’t know, seems like another too-hard-to-figure-out pile issue.

And so I ask you all:

--What am I missing?
--What am I not thinking about correctly?
--What numbers should I be plugging in where?
--What MM forum discussions should I read covering this topic?

I’m kind of embarrassed because much of my professional career has been spent looking at stock investments and running through various scenarios and valuation metrics, and yet I feel lost at sea in trying to figure this out. I have a spreadsheet forecasting all sorts of things over the next 10-20 years, very detailed, but still don’t feel like I have this nailed.

Now, this is obviously a great problem to have. I don’t want to come off as bragging. I was frugal (living in one of the units for 15 years), and somewhat savvy, but more than anything else I have just been extremely fortunate to have made this investment when I did.

I know this is ridiculously long winded, as I’ve largely been thinking aloud. Hopefully I can help people out with their own questions on this board going forward. I plan to be here for a while.

Thanks for reading!

Another Reader

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Re: Is It Time To Sell The Rental Property?: Help With A Quantitative Analysis
« Reply #1 on: November 25, 2014, 06:40:28 PM »
Your understanding of capital gains taxation is incorrect.  The zero percent only applies up to the limit of the 15 percent bracket.  For example, if the 15 percent bracket tops out at $80k for MFJ. only $10k of the gain would be taxed at 0 percent.  The remainder would be taxed at regular capital gains rates.  IIRC, a portion of the gain may also be subject to the 3.8 percent extra tax.  In the case of MFJ, I believe that tax applies to anything over $250k in income.  You would have a huge capital gains tax bill at the federal level.  You need to look at your state taxes to see how this would be treated as well.  In California, you could be paying around 1/3 of the excess gain in total taxes.

fluoren3

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Re: Is It Time To Sell The Rental Property?: Help With A Quantitative Analysis
« Reply #2 on: November 25, 2014, 08:43:37 PM »
Thanks AR. How embarrassing! I'm not great with taxes, but this is basic. I'll be doing some further research and number crunching. And thanks for the tip on the state return as well.

clifp

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Re: Is It Time To Sell The Rental Property?: Help With A Quantitative Analysis
« Reply #3 on: November 25, 2014, 09:04:05 PM »
Overall I think you are making the correct analysis.

Yes the capital gains tax is very important as is the potential obamacare tax  The Obamacare tax is so new and so complicated and potential tax so large (greater than 10K maybe greater than $20K)  that you simply must check with a CPA.

On the other hand, unless you old enough to keep this property until you die and leave them to you heirs you'll have to pay tax eventually. Taking the lower 10K number for Obamacare tax and adding the 80k for capital gains,and picking a number out of my butt for State Tax $30K, that leaves you 460K in cash after subtracting everything. (Your 581K less 120k for taxes.).

It looks like you are getting 24K (plus a modest amount in (deferred) tax savings.) vs taking the 460K and investing it, provides a yield of over 5% plus appreciation.  So strictly from an investment side I'd say you are better off holding unless you are pretty confident the bubble is going burst. 

3 years ago I decide to invest in 4 properties in Vegas, they appreciated nicely and I've got rid of two.  In large part because I don't consider myself to be at all skilled in investing in Real Estate, but at the time the price were so low relative to rent that I thought it was far less risking than the stock market. Obviously both real estate and the stock market have appreciated a lot.  What hasn't appreciated is rents so the cash flow for real estate (especially Vegas RE) is no longer as compelling.  Still on a relative basis real estate hasn't returned to its 2007 levels nation wide while the market is at record highs and the S&P is near those highs even on an inflation adjusted basis.

waltworks

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Re: Is It Time To Sell The Rental Property?: Help With A Quantitative Analysis
« Reply #4 on: November 25, 2014, 11:16:38 PM »
What is the "obamacare tax" and how does it apply to capital gains from selling real estate?

OP: In your shoes, I'd sell. As you've noted, there are tons of things that can go wrong with a building that old and your expenses are probably going to eat a decent chunk of your income. You might be able to make a case that you are getting about the same returns you could in other investments, but those other investments are a lot easier to deal with (I'm assuming you're self-managing?) Make sure you include your time in any analysis like this - if it's taking you 5 or 10 or 20 hours a month, that could really swing things.

-W

sol

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Re: Is It Time To Sell The Rental Property?: Help With A Quantitative Analysis
« Reply #5 on: November 25, 2014, 11:42:54 PM »
I'd probably keep it, though I'm about the least qualified person in this thread so far to be giving advice on real estate. 

There are ways to avoid the capital gains tax.  You could move back in with your spouse for two years before selling it and exclude a half million in capital gains.  You could do a 1031 exchange.  You could do a structured installment sale and spread the LTCG out over multiple years.

But even assuming you take the tax hit up front and the rest of your numbers are good, you're cashing a pretty reliable $24k/year in addition to any appreciation.  In the long run, RE appreciates at about the rate of inflation, maybe 2.5% averaged out over time, for an anticipated additional $17.5k/year.  Even subtracting off the anticipated maintenance costs you mentioned (say you budget $4k/year for repairs) leaves you with a total expected return of $41.5k on extractable equity of about $460k, or about 9% ROE.

That 9% is going to vary from year to year, but it's probably a reasonable long term average.  That's better than I'd expect from the stock market for the next few years.  Since you're paying a property manager the time commitment should be minimal.

You didn't say anything about other investments, but if you have a half mil already invested in the stock market then I'd be comfortable holding the building just for the diversification.  If this is your only investment in the whole world, I'd probably sell it and spread out into more options.

waltworks

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Re: Is It Time To Sell The Rental Property?: Help With A Quantitative Analysis
« Reply #6 on: November 26, 2014, 12:34:36 AM »
Got it. Sounds like the OP doesn't have to worry about that, though.

-W

What is the "obamacare tax" and how does it apply to capital gains from selling real estate?

They are referring to "net investment income tax": http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs

clifp

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Re: Is It Time To Sell The Rental Property?: Help With A Quantitative Analysis
« Reply #7 on: November 26, 2014, 12:45:25 AM »
Got it. Sounds like the OP doesn't have to worry about that, though.

-W

What is the "obamacare tax" and how does it apply to capital gains from selling real estate?

They are referring to "net investment income tax": http://www.irs.gov/uac/Newsroom/Net-Investment-Income-Tax-FAQs


I am not all sure this is the case. I  read this Forbes article twice and I am still not sure if he does or does owe it. http://www.forbes.com/sites/anthonynitti/2013/04/26/overview-of-the-new-3-8-investment-income-tax-part-1/ It was designed to catch people who is primary income is due to capital gains (think Warren Buffett) and with 500K+ gain it sounds like he qualifies.