To sell or not sell rental property in SF Bay Area

[Chris Meunier]

Hi BP! 

My wife and I are looking for some advice from the real estate community! My apologies if this is not the right place to ask (this is my first post). I'll start with our goal, which is to free up or access about 200k of cash for primary residence improvements and emergency savings. Here is the background:

• We own 3 homes in the SF Bay Area - our primary residence and 2 rental properties that were both former primary residences. 
• Rental A is worth about 550k and we owe 210k at ~3.6% for about 25 more years. It has about $600/month positive cash flow today.
• Rental B is worth about 1.4MM and we owe 550k at ~3.8% for about 27 more years. It has about $300/month positive cash flow. We have a 150k HELOC available to us, at about 5.2%, which we have not drawn on yet.
• We are in our early 30s and have solid jobs/incomes and retirement plans. We only have about 3-4 months of emergency savings at this time

Options we are evaluating: 

1. Continue as-is and use the HELOC to fund our primary residence improvements and any emergencies we have
2. Sell Rental B and collect about 700-800k in cash after taxes/fees. Keep 200-300k in cash and invest the rest in the market or other diversified areas. We are eligible for the 500k capital gains exclusion in this scenario. 
3. Cash-out refi on Rental B and access 150k cash, which would make cash flow go negative, about -$200/month. The reason to do this would be expectation of long term appreciation in the home and higher future rents that would hopefully cover the negative.

Perhaps there are other options we should consider too, but i'm curious to hear thoughts from the community specifically on option 1 vs 2. If I do an annual ROI calculation on our rental income against the equity in the house, it is extremely small (ie. 3600/750000=0.0048). Am I thinking about this the right way? Option 2 would easily give us everything we need and more, but we would lose out on future passive income of course, and a huge nest egg. We are also concerned that all 3 of our properties are in the Bay Area, and a huge natural disaster like an earthquake could wipe us out financially. Selling 1 would allow us to diversify our investments a bit more.

Thanks in advance for your opinions!

-Chris

[Brian Burke]

@Chris Meunier this is a difficult question to answer because it’s such a personal decision and the challenge is finding the right answer for you, which no one on BP can do for you. But what we can do is give food for thought.

At the bottom of the market (2011) I bought 120+/- rentals in the Bay Area and Sacramento and I’m selling. For me it was a trade—just taking advantage of a dislocation in the market that I thought would correct and now that the plan went as expected it’s time to move on. And it was a hell of a great ride!  Your reason for owning isn’t a trade, it’s a long-term investment strategy so what is right for me and my investors isn’t necessarily right for you. But the type of move in valuation we’ve seen as of late is one for the history books.  I don’t expect it to continue.  Nor do I think that there is a sharp drop looming on the horizon.  But if you are attached to these properties because of the past appreciation you might want to really consider if that’s going to continue. 

The new tax law includes the virtual elimination of the deduction of state income tax.  California is one of the highest-taxed states in the country. It’s also one of the most regulated. And near or at the top of most lists of worst states to do business.  And housing costs are reaching the stratosphere. How long will it be before nice weather is no longer a strong enough magnet to overcome all of that adversity?  And when will the big businesses that are driving the housing demand move to friendlier states?  I don’t know the answer, but what I do see are notable corporate expansions in other states amongst companies that had considered, and rejected, California.  Tesla built their battery plant in Reno.  Lucid Motors chose Arizona over Sacramento.  Amazon didn’t even put CA on their list for HQ2.  This might be a trend in the making, so will the rampant appreciation continue?  This could be a bigger threat than earthquakes, hurricanes or tornadoes because the effects could go on for decades if it gets bad. 

But perhaps that doesn’t happen and appreciation continues (but most likely at much slower, sustainable rate). So perhaps you keep rental A. You are getting a 2.1% return on equity. Not great, but appreciation, if it continues, could make up for that. 

But rental B is throwing off four-tenths of a percent return on equity. You could earn that in a savings account!  Perhaps there’s an argument to keeping it but the $500K tax exclusion is a very compelling reason to sell.  Once that times out you’ll lose it unless you move back in for two years. I’d forget the advice to do a 1031 (which is a tax deferral, not elimination strategy).  Instead of being forced to re-invest in like-kind real estate with 45 days to find a replacement property, I’d take the tax-free $500K and pay the tax on any gain gain above that at the low capital gain rate and have the freedom to invest the cash in whatever you want, whenever you want, and keep $200K or so for your home improvements and some extra reserves. 

Then you could buy something else (or several somethings else) in areas where taxes are low and businesses are expanding, or invest in syndications where groups are buying larger properties in those areas (giving you some completely passive opportunities for diversification). The new tax plan is a boon to real estate syndications because 20% of the profits won’t be taxed, so you get a savings that way, too.

That plan gives you exposure to potential remaining upside in CA appreciation via your primary home and rental A, and gives you geographical and asset class diversification plus some cash and higher cash-on-cash return via the sale of rental B.  Seems like a win-win.

Oh, I almost forgot—turning rental B into negative cash flow and going into more debt by using your HELOC for your home improvements? Just go back and read about all of the folks that did that 10 years ago and see how well that worked out for them when the economy moved against them. You've put yourself into a great spot, be careful not to to take one step forward and ten steps back.