Seems like the rental (property #1) is a marginal performer to me. It's worth at least 400k based on your equity and rents for $3900 so it's not meeting the 1% rule.
$3900 rent - $3300 PITI leaves 600/month for management, cap ex, vacancy, and profit which you'll probably find isn't very much.
You've probably seen great appreciation in the value of the property in recent years. Why not cash that out and just sell the marginal rental?
This is a good question. Your estimates are close to the mark. I bought Property#1 for $600K in 2017 with 10% down. I put in another ~$100k in repairs (60k materials estimated 40k of labor from me and my wife, unpaid). Today it is worth ~900k. So effectively that is $160k investment that is worth 400k three years later. Let's call the margin on the rent negligible, as I've made some repairs, and some upgrades. This is a 36% CAGR. Over the same period VTI has gone from $115 to $141 (though it hit a high of 171). Neglecting dividends this is a 7% CAGR (If you sold at 171 then it would be 14% CAGR). So yes, it has outperformed the market, and I have more equity in the house than I anticipated.
I'm not selling Property#1 because:
A) I need to leave my current situation (Property#2) and if I can't buy another house (Property#3) then I'll move into the one I own (Property#1).
B) This has beaten the pants off the market, and gives me tax deductions for depreciation, and the margin on the property will continue to increase as rent increase will outpace PITI increase. Additional appreciation is speculative, but in this city it is more likely than not.
I want to pull cash out of the property because I don't like having so much equity in on place, and because I will still capture 100% of appreciation if I have 1% equity or 100% equity.
For this reason I want to pull cash out and buy a new house to meet my new needs. We have a very modest lifestyle and expenses, but we do need a place to live. Seattle is a VHCOL environment, so a ~20% down payment is a lot of cash.
I will buy Property#3 to occupy until we retire, then I'll rent or sell, and move to a LCOL location.