Inherited House in California - Do I Sell?

Question

I inherited a house from my father in 2011. This house is located in Marin County, California (not in an extremely expensive area of Marin). I've been renting out the property ever since and using the rent to pay down the mortgage. I've been paying about $1,000 in taxes out of pocket every year.

Now that I'm 27 and have learned more about investing, I'm starting to analyze this deal from an investor framework. I believe that selling this property and reinvesting in commercial real estate syndications and Vanguard index funds would provide a better IRR.

I'm hoping that I could get some help on my calculations before I jump to any conclusions.

Here is the current information:

• Appraised value (2011) = $600,000
• Annual gross rent = $44,700
• Insurance = $900
• Maintenance (average) = $4,000
• Property tax = $6,200
• NOI = $33,600
• Cap Rate = 5.6%

Mortgage

• Mortgage Amount Remaining = $285,000
• Mortgage Rate = 2.75%
• Mortgage Term= 10

Cash Flow

• Before-Tax = $1,000 (year 1) ==> $12,100 (year 10)
• After-Tax = $-800 (year 1) ==> $7,100 (year 10)

Sale

• Current Zestimate = $900,000
• 10 Year Appreciation (3% per year) = $1,209,000
• Cap Rate at sale (assuming 3% rent increase per year) = 4.0%

Calculations

• Before-Tax IRR = 7.3%

Conclusion

Based on these calculations, a 7.3% IRR is about average. However, am I overvaluing the property appreciation? Because the CAP rate is certainly low at sale.

If this property were to sell for $1,000,000 in 10 years, that would lower the IRR to 5.4%. And if a recession drops the price back down to $600,000, then the IRR becomes 0.5%.

I hope this makes sense. Thanks for helping me through this!

I can link to the spreadsheet I am using if anyone would like to see that.

Kristina Heimstaedt · Answer

Hi @Adam Treboutat!! First and foremost, you have an unbelievable rate on that loan. Congrats to you for getting that. To add to that, to be in Marin County anywhere and look at 5.6% cap rate prior to accounting for your mortgage is spectacular.

Before I give you my 2 cents, let me give you the calculations that we do.

[Annual gross rent - mortgage - property taxes (insurance, maintenance, etc.)]/[cash in property + any capital expenses] This will more or less give you the rate of return on just your cash in the property. I think if you're going to compare apples to apples, it's necessary to determine what the rate of return is on the cash, not the overall property. If you were going to sell and move your money elsewhere, that's the math you'd be doing more or less.

If I were in your shoes and looking at that kind of mortgage rate, I would be inclined to figure out how to increase the revenue on the property. I'm the first proponent to say don't over renovate your property. You won't necessarily see a proper rate of return if you install marble countertops. However, I'm a believer that quartz/granite is more than sufficient to get you a quality price and tenant.

And although I would love to agree with @Soh Tanaka, you gotta know that there is no way you're picking up multiple SF properties with $700k especially not at the 1% rule. To add to the struggle, there are reports (and BP blog posts) that show that rents are actually decreasing in some of the more metropolitan areas as millennials become part of the next wave of suburbanization. Keep in mind that transactions are costly. Whether it's tenant turnover or property turnover, real estate agents and wholesalers get paid for that special skill set.

Hopefully this helps and don't hesitate to reach out if you have any other questions/concerns!!!

Robert C. · Answer

@Adam Treboutat, I wouldn't be surprised if your market value estimation is off. Have you looked at comps in your neighborhood?

Here's the thing, if you sell and don't 1031 exchange, you're looking at a pretty big tax hit in California when you add federal plus state plus depreciation recapture for the last 6 years. It will be a while for you to recover that capital even if you do well with the syndication/index fund strategy.

If this were 2011, I would have told you not to pay down the mortgage, maybe refi on a 30-year and use the cash-flow/cash-out for investing elsewhere. It also seems like you didn't get the benefits of Prop 13 transferred during the inheritance? But since you're already on the pay down strategy, I think you should at least look at some refinance options. If you don't cash out, you may be able to increase your cash-flow. Then, you can take that plus any extra income you have and put it towards other investments. A more aggressive move would be to refinance, and pull your equity back out so that you can invest a larger chunk of money. Doing a 1031 Exchange is an option, but I'm not sure I would suggest that for you given the current market conditions.

Account Closed · Answer

If you have the W2 income for it, do a cash out refinance for an investment property. The rates are higher but you have access to your equity which IMHO is worth it. At 70% LTV you can pay off your loan and still have $345K left assuming the market price is $900K. Local banks around the area are offering 4.25% to 4.375% as recently as last week. I know because I just got rejected after going through their executive review due to no W2 income (my properties are also bay area).

The benefits are that your cash flow increases due to the 30 year term versus the 10 year term even though the interest rate is higher. You get to keep  the property and bank on future Bay Area appreciation. You also bank on potential rent increases. Those things you don't give up. Plus you have $345K untaxed money to do what you please whether it be index funds or syndications. Have your cake and eat it too! For that last part, just make sure you know what kind of investments and risk you are getting yourself into.

BTW, I would not pay down the mortgage. At 2.75% it's a waste of capital. Even at 4.375% I would not pay. Oh also, the 4.375% is a 7/1 ARM 30 year amortizing, which is not as good as you got but still not bad.

Kristina Heimstaedt · Answer

@Adam Treboutat there are lots of posts around the site with different strategies on how to increase rents without completely scaring off your tenant. We do 2-5% increases every year to account for the increase in property taxes as well as market rents. At this rate, tenants still typically stay below market and get used to the idea that their rent is going to go up every year. If you have a quality product, they will beg for their lease to be renewed every year even though they know their rent is going to increase. Also, usually 2-5% isn't burdensome enough to want to make the effort to move. It's typically more expensive to move than to take a $50-$100 hit to increased rent.

Robert C. · Answer

@Adam Treboutat, Scanning craigslist or other rental sites for rent comparison is still a good option. At least you know where the competition is at and how to price so you get a lot of traffic.

The more I think about your situation, the more I would slow your roll on the idea of selling (sounds like you've already reconsidered). You're in a really enviable position. You might have already read some of the other BP threads where people are desperate to just have a small anchor in the Bay Area. Lots of people are priced out!

Sigh... this is gonna make me sound so uncool, but you're still on the younger side when it comes to being proactive about this investing stuff. I was 29 when I started, and remember feeling like I was still ahead of the curve (I'm still only 37 now!) - mostly because people around me are very preoccupied with their W2 jobs. My point is just that you have the luxury of planning long term, and more time to make mistakes. I get the feeling from your original post that you were hoping to make a big move to maximize returns. But just by juicing this one property, and investing the proceeds thoughtfully you can be in a whole different arena compared to your peers in the next ten years (probably sooner).

Kristina Heimstaedt · Answer

I'm with @Robert C.. Hang on to the property until the next little hiccup/correction in the market and refinance and take the funds to fund your next deal. I might even be more inclined to look at a second mortgage of some sort. I'd say HELOC, but I'm apprehensive to say that they'd give it to you on a non-owner occupied property.

Larry Turowski · Answer

@Adam Treboutat First, forget Zestimate.  Figure out what the house is really worth.

Then figure your cap rate based on the actual value of the house, as though you were buying it from yourself, as @Soh Tanaka said.

If you are completely confident in 3% appreciation, then add that to the cap rate. (I don't like to bank on appreciation.). That'll give you a better picture of how this stacks up against other investments.

But on first blush, yeah, sell.

Soh Tanaka · Answer

While I did do the calculation for all the scenarios, since the market is, if anything, hot right now, I would sell it, and buy multiple SF properties in an area where the houses are more affordable, and the RV (Rent to Value ratio) is better than 1%. I think you have too much money tied up in this house.

One question you can ask is, if you didn't have this house and had $615k ($900k value - $285 mortgage) cash in your pocket, would you buy this? You are having a good problem.

Just my thought.

Aaron K. · Answer

@Adam Treboutat  One vacancy should not worry you especially if your property is in a nice area, which it sounds like it is.  If vacancies and unsavory tenants worry you then multifamily is not the way to go.  In my experience tenants like to live in single family homes much more than apartments or other multi families if they can afford to do so.  If the property is priced correctly, which in this case is anywhere close to market rent you should have little to no problem finding a qualified tenant in the bay area where so many people who would otherwise own are forced to rent.

Aaron K. · Answer

@Adam Treboutat  ask a local realtor or better yet a property manager to pull some rental comps for you another good tool is Rentometer.com, also the old fashioned way of just looking at what is on the market for rent currently on Zillow.

Inherited House in California - Do I Sell?

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