Selling an investment SF - with 200K Pay off my Heloc or 1031 elsewhere?

Question

I just got tenants out of an aggravating single family I've had for 4 years and fixed it up to sell.   I should net 200K off of this sale.  Property was only netting me $636 a month after all expenses but my interest rate is 3.75%.  Monthly payment $1836.  Rent was $2500 could probably get $3400 now.  I was planning on doing a 1031 into a multi somewhere else but I know I'll be scrambling and with rates where they are I don't know if I'll do much better.

I also have a 200K HELOC balance on my primary residence that I haven't been paying principle at all.  That costs me between $850 a month.  (fixed for a few years).  So this money just feels like it's being thrown away.  If I take the 200K I'll get whacked with capital gains also.

I'm a little torn on what to do here and hoping maybe someone has a different way to look at this?

Andrew Postell · Answer

@Nick Rivers property was ONLY netting you $636 per month?  After expenses?  Every single one of us would keep that profit margin.  I would suggest to stay in that 3.75% rate keep your profits and that incredible rate...and just screen tenants a little better.  In 5 years, you will appreciate having that property.

Eric Fernwood · Answer

Hello @Nick Rivers, Whether you should keep the property is more complex than the current cash flow. Below are some considerations. Income Reliability You stated that you had problematic tenants. This is usually the result of managing your own property. Some people think that the only task a property manager does is to collect the rent, and they do not want to pay for that service. However, a good property manager's most valuable contribution is selecting reliable tenants. A reliable tenant stays many years, always pays the rent on schedule, and cares for the property. Reliable tenants are the exception, not the norm. I've worked with many property managers during the 15+ years we've operated our investor services business in Las Vegas. I only know of two property managers with this skill. I suggest hiring a skilled property manager if you retain the property. Let me know if you (or anyone) would like to know how to select a good property manager. To Sell or to Hold The goal of real estate investing is financial freedom. Financial freedom is more than just replacing your existing income. It's about maintaining your current lifestyle for as long as you live. To achieve this, you need a passive income that meets three requirements: • Rents must outpace inflation • Persistent: You will not outlive the income. • Reliable: The rental income must come every month, even in bad economic times. Whether rents outpace inflation and how long your income will persist depends on the city you invest in. Income reliability depends on the tenant(s). The critical component for financial freedom is rent outpacing inflation. So, are rents outpacing inflation in your city? If rents do not outpace inflation, no matter how many properties you own, you cannot achieve financial freedom. An example will prove this. Suppose you have a property and the monthly rent is $1,000, the rent growth rate is 2%, and inflation is 4%. What will be the rent's present value (purchasing power) at 1, 5, 10, and 15 years? First, I will calculate rents at 2% rent growth. • Year 1: $1,000 • Year 5: $1,000 x (1 + 2%)^5 ≈ $1,104 • Year 10: $1,000 x (1 + 2%)^10 ≈ $1,219 • Year 15: $1,000 x (1 + 2%)^15 ≈ $1,346 Next is the rent's present value (buying power), including 4% inflation. • Year 1: $1,000 • Year 5: $1,000 x (1 + 2%)^5 / (1 + 4%)^5 ≈ $907 • Year 10: $1,000 x (1 + 2%)^10 / (1 + 4%)^10 ≈ $824 • Year 15: $1,000 x (1 + 2%)^15 / (1 + 4%)^15 ≈ $747 So, in the 10th year, the rent is expected to be $1,219, but inflation reduced its purchasing power to what you can buy today for $824. This is the long-term financial trap of buying properties in locations where rents do not outpace inflation. If the rents in your city aren't outpacing inflation, consider using a 1031 exchange to a location where rents are outpacing inflation. Income Persistence You never want to be in a position where you've outlived your income. The only way for your income to persist is if your tenants remain employed at similar jobs. The problem is that non-government jobs do not last. The average lifespan of a company is about 10 years. An S&P 500 company has an average lifespan of 18 years. So, every non-government job your tenants have will vanish in the foreseeable future. Unless new companies move into the city and create replacement jobs, all that will remain are lower-paying service sector jobs. If your tenants have reduced pay, your rent will stagnate or fall. What characteristics attract companies to set up new operations in a city? ✅ Low operating costs ✅ Low crime rate ✅ Low risk of a natural disaster ✅ Pro-business regulatory environment ✅ A sufficient population for economic stability. This usually requires a population >1M. If your city does not meet the above, 1031 should be considered. Properties and Tenants Each tenant segment has specific housing requirements and is unlikely to rent a property if it doesn't meet them. The converse is also true. The characteristics of a property determine which tenant segment it attracts. Are there enough reliable tenants in the segment your property attracts so that a skilled property manager can consistently choose a tenant who will stay many years? Some segments stay longer than others on average. In 2005, when I selected Las Vegas to set up my business, I did extensive tenant segment research. I discovered that there are three major segments, which I named Transient, Permanent, and Transitional. Below is the average length of stay for each segment. • Transient: <1 year • Permanent: >5 years • Transitional: < 2 years We target properties in the $320,000 to $475,000 range to attract the Permanent segment. Above about $500,000, properties attract the Transitional segment. Properties that attract Transitional tenants are often unprofitable due to short tenant stays and a longer time to rent. Below about $280,000, you get into a tenant segment that stays, on average, one year or less. Vacancy costs make properties targeting this segment a non-go. Talk to several property managers. Ask each one about the typical duration a tenant might stay in your property. Also, ask about the time it takes to find a tenant. I would consider a 1031 exchange if the answers are unfavorable. Buy Now Or Later I continue to hear people lament that interest rates are no longer around 3%. They aren't and won't be in the foreseeable future, so we have to deal with the rates as they are. Prices are rising. Since the beginning of this year, the prices of properties in our target segment increased by 9%. What will happen if you wait until rates fall? An example will show the problem. Suppose property prices rise by 8%/Yr, and it takes 5 years before rates fall to 5%. What is the cost of waiting? I will assume a $400,000 property to have numbers to work with. The table below displays the rising market value from appreciation and the accumulated equity. By waiting, you lose a lot of equity growth, which can not be recovered. There is another problem with waiting. In five years, prices will be higher, so buying the same property will cost you more. See the table below. So, waiting 5 years costs you: • Lost equity: $187,731 • Increased down payment due to appreciation: $56,319 • Higher debt service due to higher prices: $251/Mo What would happen if you purchased today and refinanced in 5 years? Also, purchasing today does not necessarily mean negative cash flow. We are still finding properties with first-year ROI between 0% and 1% by putting 30-35% down and or buying down rates. Buying today gets you on the rent and appreciation escalator. So, I see no advantage to waiting. Summary Nick, consider the property's long-term outlook, the type of tenants it attracts, its rent growth rate, etc. Then, decide whether the property can support the goal of financial freedom you desire or if it's time to take action.

Eric Fernwood · Answer

Hello @Bryan Harvey,

You've raised a valid point. I hadn't considered the impact of losing the depreciation deduction after 27.5 years. Accurately predicting future tax regulations and market conditions is indeed challenging. Additionally, I hadn't accounted for the fact that most mortgages are paid off by year 30. It's fair to say that predicting anything beyond yesterday is speculative. Nonetheless, you've made an excellent point.

In response to your question, "How do you find the data to know if your rents are outpacing inflation over time," you would likely need to consult an investment realtor who can provide the necessary historical rental data. Even if you've acquired the data, deriving property segment rental performance against inflation over time isn't straightforward. I'll outline the issue and our approach to solving it.

The Problem

You can usually obtain historical metro rental data. The problem with such metro averages is that they combine dissimilar properties together. For example, $1M  properties have different rental characteristics than $300,000 properties. Condos, townhomes, and single-family homes each have distinct rental characteristics.

Because metro data averages encompass varied property types, the resulting data has little relevance to any specific property segment within the average. Below is an excerpt from an article I wrote about the issues with using average metro prices to evaluate a sub-segment of the averaged properties.

Imagine you followed the prices of ten properties for one year. The table below shows how their market values changed.

Based on metro averages, prices fell by 5.8% over the reporting period. While mathematically correct, the result is invalid. A more accurate statement would be:

• Properties priced at $300,000 rose by 6%
• Properties priced over $1M fell by 14%
• Proeprties priced at $100,000 fell by 10%

My point is that the metro average of a 5.8% decrease does not apply to any of the properties.

How We Solved the Problem

I developed software that calculates the average monthly rent growth for our targeted property segment. The data is sourced from downloaded MLS historical rental data. The software filters properties that align with our targeted segment and calculates the average monthly $/SF. This allows me to compare the inflation rate for a particular month with the rent growth.

I didn't suggest a method to determine if your rents are outpacing inflation over time. The only solution I can offer is to consult with an investment realtor. They can provide the historical rental data that you need.

Bryan H. · Answer

@Eric Fernwood, this is a great analysis. I’m wondering how you would factor in holding vs selling  a property that meets all these parameters, yet is fully depreciated after 27 years - losing some of its benefit to hold. Also, how do you find the data to know if your rents are outpacing inflation over time?

Huy Nguyen · Answer

@Eric Fernwood  Very good advice n analysis. Tks.

Nick Rivers · Answer

Thanks @Andrew Postell Yeah it's worth 600K and I owe 280K on it.  Just put about 50 into it.  I just cant help but feel like that amount of equity could be levered into something better or more doors.  Could be wishful thinking though

Selling an investment SF - with 200K Pay off my Heloc or 1031 elsewhere?

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