Sell It or Keep It?

Question

Preface: I'm aware that I'm also fighting the emotional bias of this being my first home with my wife so my brain is making some justifications to keep it.

Back in 2006, long before I was smart about buying rental property, I bought a condo for my wife and I at the top of the market on the near north side of Chicago. The condo showed amazingly, had recently been on HGTV - my wife was hook, line, sinker and I was young, with a new, high paying job and said sure. When the market crashed, our condo lost over 100k in value overnight and when my wife and I needed a bigger place to start raising a family, I had no choice but to rent it out. Started renting it out in June 2011 and it's never been vacant - I've been able to find young, professional, low maintenance, highly quality tenants on day 1 ever since. While the condo has come up in value, it's no where near where it used to be. I currently lose about $150/month on it and while that seems bad, my tenants have been paying down over $8000/year in principal on the unit and I'm able to depreciate the value of the unit and my paper losses against my other, better performing rental properties, so while it's not ideal, it's not a complete loser. I've been talking to my accountant lately about selling it to replace it with better performing rental property but with 6% realtor fees and all, I'd have to pitch in about 30k just to sell it. Tonight as I thought about this, I was thinking about how much more would it take to turn this property around into a decent investment and I calculate about another 28k. So for a total of 56k, I could turn this property in a decent investment. I'm able to do this because I have a 1st and 2nd mortgage on the unit and could pay the 2nd mortgage off. Compared to my other rental properties, these numbers downright suck, but there is a part of me thinks there is a silver lining here. Bear with me :)

I could pay 30k and sell it and I:

• Lose $8k/year in principal pay down
• Stop losing $150/month
• Lose depreciation against my other rental properties

If I'm willing to pay an additional $28k and keep it, I:

• Start making about $250/month
• Continue to pay down my principal by over $8k/year which will continue to increase with time
• Continue to depreciate the unit against my income and my other rental properties

This is where my brain doesn't know how to distill my own thoughts. :) Since I planned to sell it for $30k out of pocket, do I consider that part of the pay down for keeping it. Part of my brain says yes, but part of brain says no because if I was willing to pay $30k just to sell it, I would lose all benefits of the property but for an additional 28k, I continue to keep the following benefits:

• The delta between losing $150/month and making $250/month is $400 so my actual benefit is $4800/year
• $8000/year principal pay down
• For a total of $12,800/year
• Plus depreciation of the unit against this income and my other rental properties

$12.8k/$28k = 45.7%

Who in their right mind wouldn't pay 28K to keep an 12.8k benefit and the depreciation in a great, stable neighborhood with professional, low maintenance tenants? Even if we included the 30k in the pay down to keep it, the numbers are:

$12.8k/$56k = 22.8%

Still not too shabby.

Part of my brain says I can't keep the 8k principal pay down benefit in these equations because I still get this benefit today without paying anything down but if I sell, I lose this benefit so part of my brain says keep it in. If the property was high maintenance, I think this might be a easier decision. Can anyone help me better understand how to think about opportunity costs or cost/benefit analysis so I can make a good decision here?

Thanks again,

David

P.S - I'm an engineer by trade so I'm aware that I sometimes over analyze and over engineer things. :)

Orlando Spencer · Answer

David, I'd say you definitely have a great ROI on hand by paying off the $28K to earn $400 monthly. Additionally, it's definitely no guarantee the next property you choose will be so maintenance-free.

Good luck and great job itemizing the scenario!

Jerry Stanford · Answer

@David Gregory...I'm thinking Option 2...Keep it

John Whittle · Answer

It sounds like you its not hurting you that bad losing $150/month. I would do nothing keep the tax benefit, the principal pay down and hope it increases back in value to what it was.  Then it sounds like you still have 56k you could invest in another performing asset.  That could make more than the $150/month you are losing.

Christopher Brainard · Answer

@David Gregory

I'm generally not a fan of assets that don't cash flow, but in your situation, I think I would pay off the second and keep the property. Based on your post, it doesn't sound like you're strapped for cash and you have other assets which are working for you, so taking a hit on a property that sounds like it is in a premier neighborhood won't hurt too bad in the long run.

You'll still be negative cash flow, if you account for vacancy, capex, repairs, etc, but I think its making the best of a bad situation. I don't account for principal pay-down in my calculations (since I assume that I'd invest in a different property and have similar pay-down), but your $28k can earn $400 a month, which is something like a 17% return. The $30k you're under water is ~17 years worth of negative cash flow, and I'd hope that long before that 17 years would pass you could recapture 30k in appreciation. Paying off the second seems to be the best ROI (to me) in this situation...

-Christopher

Curtis Yoder · Answer

Use the 56K to purchase a small rental. With 56K you should be able to cash flow a smaller rental anywhere from 400 to 600. This would easily offset your 150 drain and you would be able to keep the tax benefit as well.

Joshua Springer · Answer

Not really a big deal but if you pay the 28k you're not getting 8k in paydown anymore...unless it's an interest only second, or you didn't include that in your annual paydown for option 1.

Opportunity cost and your current situation dictate your next move.  If you want cash in your pocket do option #2.  If you are in networth building mode I'd stay put and find a good place to move your 28k to make more money.

Steve Vaughan · Answer

If you have the funds available, $400/mo is an awesome risk-free/hassle-free return on $28k like @Orlando Spencer points out.

Also, when my reserves are reduced, I tend to work harder to build them up again!  Please keep us posted with what you decide to do @David Gregory!

Brian Moore · Answer

@David Gregory

I agree with the advice above not to sell the condo and take a $30k loss. This is especially true because you are in an appreciating market. That would ONLY make sense if you foresee a protracted downturn in the value of the condo (not likely at this point). Your $8k annual mortgage pay-down will put you positive in 4 years ($32k principal paid). Plus in the meantime you will be raising rents to overcome that $250 monthly deficit.

Now, between the other options of paying off the 2nd or doing nothing we will need more information from you. It comes down to comparing the rate you are paying on the 2nd mortgage to the rate you could be earning on your capital that you would use to pay off the 2nd.

If you have the $28k in cash sitting in a bank account you are making a miniscule savings rate so using that money to pay off the 2nd mortgage sounds like it makes sense. However, you could also use that $28k to invest in real estate with a return expectation of 8-20% (known as your opportunity cost). You need to decide if you have a good chance of investing that capital in a way that will give you a clearly higher return than the 2nd mortgage interest rate. It must be higher by several percentage points because you must take risks to invest in real estate and paying off a mortgage is risk-free. If the risk-adjusted rate of return on another real estate deal (or financial investment) exceeds the mortgage interest then do that investment.

If you are borrowing the $28k then your interest rate to borrow must be less than the 2nd mortgage which will save you money on your total borrowing costs. Again, having access to that capital at (I assume) a low interest rate begs the question: why don't you invest that money in a higher return vehicle.

If you are pulling the $28k out of an investment you should consider the expected return you will give up from that investment (or other alternatives) and compare it to the 2nd mortgage rate.

In a nutshell, if you have the opportunity to invest the $28k and make a higher risk-adjusted return than the 2nd mortgage interest rate you should do that.

Gilbert Dominguez · Answer

Honestly, I do not see where you will lose more money than selling the property. I would keep it. Pay down the second if you can. If its in a good area in time it should appreciate more and coupled with your yearly pay down on the mortgage in time you should come out ahead. The tax write you are getting against the income from your better performing rentals plus the depreciation outweighs just being able to get into another property for the sake of it. I say keep it, pay down the second or pay it off.

David Gregory · Answer

I guess another option I should have included was to do nothing and just keep the property and pay nothing down because this maintains most of the benefits with nothing out of pocket. From this angle, it makes the two above scenarios look pretty bad. The fact that I don't make any money month to month compared to my other, better performing rentals makes me immediately think I need to get rid of it but perhaps that's the wrong conclusion to jump to? IDK. Any insight here?

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