In San Diego- sell 5 unit place and 1031 into larger rental?

Question

I'm new here --we bought a 5 unit rental property in Hillcrest (San Diego, CA) for $411k in 1999. It has a positive cash flow now as we've remodeled and raised rents over the years. I manage the property and we live nearby. This is our only real estate investment property besides owning our house. It has come to a point where we need to spend maybe $100k or more to fix up the two standalone cottages at the back of the property. We are having trouble deciding whether it makes sense to try to buy an 8 or 10 unit place on a 1031 exchange here in San Diego or just keep the buy and hold strategy on this one and undertake the remodeling project. Any thoughts?

We own the property outright but have a large mortgage on our own house (we combined both mortgages a few years back when interest rates were low but it will take us another 20 years to pay it off). Our son will be going off to college in a few years so positive cash flow would be beneficial.

I read on some other discussions here that positive cash flow in San Diego is a dream on any new properties so does our current strategy of buying and holding still make sense here? Any thoughts are appreciated.

Thanks,

Melinda Pajak

Landlord/Owner

San Diego CA

Dan H. · Answer

@Melinda Pajak

Your RE has experienced significant appreciation that, due to prop 13, you are not paying property taxes at its current value.  This needs to be taken into consideration for any CA property that has experienced significant appreciation.

My own opinion, versus the above is simple fact, is that I would keep the RE but use more leverage than you are currently using.  If my equity position is 20% and the property appreciates 10%, I have made 50% on my equity from the appreciation.  However, if I have a 100% equity position and the property appreciates 10%, I have made 10% on my equity from the appreciation.  I would keep the property and keep my prop 13 protected property tax saving and leverage its equity for the necessary improvements as a minimum.  I would likely leverage to a 75% LTV and diversify into either another RE or another investment option.

I would be hesitant to sell a multiplex in a market with the historical ROI of San Diego that has significant prop 13 property tax advantages.  For what better investment?  San Diego historical ROI is near the top in the nation for this century and both locations that are above it have rent control and San Diego does not.  Do you think those locations are likely to stay ahead of San Diego?  Source: Core Logic.

Good luck

Dave Foster · Answer

@Melinda Pajak, Others more conversant with on the ground numbers can chime in but you're in a bit of a dilemma - a good dilemma but a dilemma.  Owning a property like that free and clear in San Diego can give you really good cash flow.  But as a return on the value of the asset it's usually a horrible rate of return.  I'm seeing clients every day on the West and East coasts reporting 2-3% returns on the value of their asset.

But that's where the dilemma comes in .  In order to improve that return on asset you have to either leave the market to go where you can get a better return or you have to leverage.  And of course if you leverage you now have added risk.

I don't know that I'd be looking to trade a debt free property for a leveraged in the same SoCal market.  I'd be looking to go where I could stay debt free and greatly increase my return on asset and cash flow. A 1031 could accomplish that very easily.  But I'm not the bravest soul on the planet.

Melinda Pajak · Answer

@Calvin Lipscomb We were looking at loans about four years ago. The loan we were shopping around for was only for $350k on a commercial property. It was too low for them to fool with. Yes, we need a better tax professional who may be able to help with some of these scenarios and help us walk through the tax ramifications of each one. It seems to get so complicated. And I just worry about carrying around so much debt. Is that old-fashioned of me?

@Kevin Fox Yes, assessment of our property would be a good start. We would like help with that. Can you direct message me your contact information? That would be great.

Melinda Pajak · Answer

@Dan Herschel - Thanks for your response. I will look into local banks and/or credit unions. That's a good suggestion. I'm a little conservative on what I want in a loan meaning I'm a sucker for a 30 year fixed.

@Ellis Hammond - I have never heard of debt from life insurance companies. I would have to do some research on that. Thanks for the suggestion.

Dan H. · Answer

Your question leads me to assume you are looking at keeping your current investment with its prop 13 based property tax rate.  I would have also gone this route.

I have considered jumping into commercial residential and like the scalability but I will not like the commercial loans.  So, unfortunately, I have zero first hand experience at getting commercial loans.  However, I have seen BP posts that suggest creating a relationship with a local bank.  According to what I have read they offer a lot of flexibility.  Equity loans, various fixed with balloon or transition to ARM, potentially interest only with a balloon, etc.  I have even seen investors choose commercial loans on properties that qualify for conventional loans (@Lee Ripma?).

The one thing the commercial loans do not offer is the 30 year fixed at a rate competitive to a conventional non-commercial residential loan.

Hopefully someone with more experience on commercial loans could provide more details.  If no one with more expertise responds with a better suggestion, I recommend you start with finding out what some local banks/credit unions have to offer.

Good luck

Melinda Pajak · Answer

Thanks Dave Foster. Yes, I'm not sure we could find anything in the same SoCal market. And at the same time, I'm not sure we're brave enough to leave the market here to go somewhere we are unfamiliar with.

How would you go about assessing the returns on our rental property? Are you talking Cap Rate or some other equation?

Calvin Lipscomb · Answer

The debt is real.  The key is just management and setting up financial structures that will make you feel a bit more comfortable.  I suggest that you shop around again for a loan.  There are many lending sources now that will provide a loan with a LTV of 50% at favorable rates.

Lee Ripma · Answer

@Melinda Pajak

Well you should try to calculate the value based on a cap rate. Take the income, minus expenses (that is called the net operating income or NOI), then divide it by a 4 cap. So if it generates 100k a year and your expenses are 50k then you'd do 50k/0.04=1.25M. I don't know what your actual numbers are, that's just an example with some easy math. If you want to know your rate of return you'd need to know how much cash you have sunk in the property. Then you can calculate what your return on the cash in the property is. Others will do this by looking at how much income you've got coming in divided by the value of the property. So I'm not sure you did the cap rate correctly getting 9-12%. The cap rate you'd want to use would be the market cap rate. You could also calculate the returns on your cash. If you want to send me some basic numbers I can probably calculate it for you pretty quick. Once you wrap your head around this stuff the math is pretty easy, it's the concepts that can be hard at first.

Yes, I think you'll be able to use this property to buy more properties and get the money you need for renovations, without selling!

Melinda Pajak · Answer

@Lee Ripma Thanks for your input. The value is fairly high. Your comment and the previous ones are opening up my eyes a bit to the possibilities--taking out a 10 year fixed loan and and using the money to invest somewhere else and do the repairs that need to be done. Then refinancing again at the end of 10 years. The rate of 4.5% is great. I calculated our cap rate using the formula with the sale price for the property. Is that correct? If so, I calculated the cap rate yearly for the past three years and it ranges from 9-12%. Is that good? (Can you tell I'm new at this?)

With leveraging out money from the property, I have two questions. Don't we lose profit when we keep refinancing to the bank fees? How do you know when it's still worth it to do so? AND, don't we want to own the property free and clear when we are retirement age so we can just collect the rent to fund our retirement? I thought that was the goal of a lot of investors.

Kevin Fox · Answer

Hey @Melinda Pajak

The refi/exchange dilemma is definitely perplexing for a lot of owners.

As others have suggested, the best step to take before anything else is to assess how your property is currently performing. Looking at several different metrics, the best route becomes much more clear when you’ve defined your current position. That way, you can objectively weigh the risk-reward tradeoff of the various options available to you.

Please let me know if you’d like any assistance  with this assessment. I’d be more than happy to help!

Kevin

In San Diego- sell 5 unit place and 1031 into larger rental?

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