When to sell vs. when to cash out refi

Question

I own a property in Elk Grove (a suburb in Sacramento) that I'm looking at options to free up capital.  We purchased the property in 2011 for 140k all cash.  We've had the same tenants in place since we purchased the property, and they are model tenants in every sense.

Our current CoC return/cap rate on the property based on the original investment is roughly 7.5%, which isn't terrible.  However, the property is worth a little over 300k today.  If I take my current cash flow and use the 300k buying power number, my return is only 3.6%.  Let me know if this isn't the correct way to look at it.

The Sacramento market has done us well in terms of building equity, but I'd like to start putting that equity to work.  I can either do a cash out refi or sell the property.  What are the factors I should be considering to figure out which option is better for me?

Tobias Falzone · Answer

I run numbers (estimate a total of Cash flow, mortgage paydown, tax benefits, appreciation) and calculate an effective return on whatever equity is left in the property.  I compare that number to the estimate for a different property and see which one is greater.  My goal is growing net worth, and yours might be different.  I ended up selling my property in west sacramento instead of pulling money out after looking at this type of analysis.  I think Sacramento is beginning to see a peak in terms of prices, or at the least is becoming more risky to hold in the medium term.

I generally am able to get better returns on paper from larger properties that are leveraged than all cash transactions.  However, stress test your investment on paper (50% vacancy, double interest rate, etc.) and see how it handles different situations.  Your risk tolerance will determine how far you are willing to go with leverage.  You can make pretty much anything cash flow with all cash.

Ned J. · Answer

@Austin Tam...you are practically my mirror image :)..... my wife and I both have good paying jobs, no debt except the mortgages on our rentals....our house is paid off etc.....

I understand the warm feeling of the "set it and forget it tenant", but if you are well under market rent, then you are making a mistake in not increasing the rent some amount- the current market rent in your area should be the big factor- I understand the concern with losing a "good tenant" and fear that the next may not be so easy. If you increase it some but are still below market, they aren't going anywhere. If the demand is so high in your area, you will easily find another good tenant at or near current market rent....Are the costs of everything associated with the property staying the same? taxes, insurance, CapEx costs?.... probably not....factor in inflation and your profit is slowly going down each year....not up. But there are some that disagree and don't want to risk "rocking the boat" by reasonably increasing the rent based on the market....too each his own...lots of discussion on BP for both camps.....everyone has to do what they feel comfortable with....

Also be careful in heavily relying on the adage "if the rent at least covers the mortgage, we will be fine"...don't forget the Capex that will come up....HVAC, roof, flooring, paint, an eviction, vacancy etc etc.....its not a matter of if...it's when.....if your properties are fully remodeled or new, that's one thing...... but there will be other expenses you need to have reserves for, not just making the mortgage. If you can handle those AND the rent at least covers the mortgage, then you can weather any downturn.....

Obviously no one know what the top of the market will be....but to heavily leverage at the top/near top of the market....and use that equity to buy at the top of the market is exactly what caused tons of people to lose it all when the market crashed. Had several friends that owned multiple properties, lose them all following that plan. That's the rub in CA..... you take advantage of the high equity in CA properties at the top of the market, and then buy other properties at the top of the market in CA...how far ahead are you now?

Obvioulsy the best plan is to sell at the top of the market and use that $$ to buy something/somewhere you can use that cash flows or appreciates even better.

To quote Mike Tyson.....Everyone has a good plan until they get punched in the mouth....

Matt K. · Answer

if you going for bigger properties do a 1031, you can do a reverse where you find the property first. If you're just looking to increase some net-worth/value you could also go OOS. Generally speaking 100k would get you something pretty decent in the Midwest and around 1k mo rent. You'll see people talking about 2% but that's pretty hard to come by outside of warzones now... most time it's around 1%.You could do the delayed financing part too if you wanted and get a good chunk back out if you buy smart.

Gordon Cuffe · Answer

@austin

@Austin TamIf you sell and do a 1031 exchange ,you will want to have an idea of what you want to buy and achieve. You can put 300k down and buy a small apartment in the Sacramento area. You can buy out of state and get better returns. for example buy 2 duplexes in the kansas city area for 300k that rent for 3000.0.  You can do the cash out refi at 200k and buy out of state and do the same thing. The rental demand is so strong that you will always be able to rent out the house in elk grove. Even when prices tanked in 08, people still needed to rent homes. The only thing now is that rents have gone up a bunch since the downturn. For that matter, you can cash out refi, then lend the money and earn 10% . You did the right thing before when you purchased at the bottom of the real estate cycle.

Austin Tam · Answer

Hey Ned, thanks for the response.

If I max out the refi at 75% LTV on a 30-year fixed, my current below-market rental income will still cover the mortgage payment.  We have plenty of room to raise rent, but just haven't done so because the tenants have been pretty much set-it-and-forget-it and we'd like to keep them there.

If I decide to go the refi route, I'm not worried about the market correcting/tanking. As long as the rental market doesn't crash, we can ride through a downturn.  I'm risk averse so I've definitely explored the risks.  My wife and I both work full time with good incomes, minimal expenses  and zero debt (at the moment) so if the sky does fall and I'm not able to rent a 3bd2ba in Elk Grove for at least 1k, we can cover the loan with our paychecks.

But while we are on the subject of over-leveraging, would it be over-leveraging if I were to leverage on top of the refi to extend our buying power further?  So Instead of paying all cash for a 225k property, use the 225k as a dp and mortgage 675k on a 900k property/properties...

Ned J. · Answer

@Austin Tam..... I'm in the exact same boat as you...central valley....got 2 properties that have a ton of equity and moderate cash flow..... and can't find squat in CA anymore that makes sense with the numbers.

So sell, them, and 1031 them into......what?...where?,,,,,,,CA is tough to find something else

Take equity out and buy......what?...where?  again, CA is a tough market...

My one newbie advice is to be careful with how much equity you take out of them....if you go that route....don't max it out and risk being way upside down when/if the market corrects or tanks again..... only take out enough to free up some $$ to buy something else...don't overleverage them.....

Interested to see what the more experienced people say....

Keegan MacNichol · Answer

I think Ned has the right idea. How far below market are your renters? I'm totally on board with keeping "set it and forget it" renters in place, but at a certain point you're incurring serious opportunity costs.

For example, I have a tenant in place that is $25-$50 below market, but I'm cool with it because she is obsessively clean and her place looks like it is staged as opposed to occupied. If she was $100 below market, I don't care how easy she is, that rent is going up. If I had better scalability, I'd increase rent $25 every 12 months on the dot. I only have six, so I'm a bit more conservative; generally a $25 increase is an inconvenience but not something a tenant will move over. Still, I try to increase rents every 12-18mo. Granted, my apartments are in South Dakota, so this market probably commands a greater increase based on the current market.

When to sell vs. when to cash out refi

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