Should I Sell My San Francisco Duplex?

Question

I need some RE investing advice as my wife and I are having trouble coming to a decision on whether to sell our SF property given that we are moving.

Background: bought San Francisco duplex in 2014 for $1.45 million (two, 2/1 units, 1150 sq ft each; and 1 unpermitted Jr. 1-bed in-law garage/garden unit - so technically three units). I owe $1.05 million on it with a 30 year fixed at 3.5%; PITI is $7,400. One 2-bed unit is rented at $4,000/month, owner-occupy the other 2-bed (rental value $4,500), and we Airbnb the in-law for about $3,000 a month. My broker just did a valuation and put the current value at $2.05-2.25 million.

Current situation: we just bought a triplex in Oakland for $1.7 million that better suits our needs (large unit for family). We can financially afford to keep the SF property, but aren't sure whether to do so. Under SF law, we won't be able to Airbnb the in-law because we aren't living there, so rent for the in-law would be about $2,000-2,500. If we fully lease the building, it would rent for about $10,500-11,000 and cash flow about $3,000/month assuming no major repairs (tenants pay utilities, all major systems and roof already upgraded, vacancy generally not an issue in SF). But something unforeseen could cut into that cash flow real quickly.

Pros of keeping: (1) SF real estate seems to just go up and up and is tough to purchase - the city discourages and blocks almost all development and so there is a super constrained supply, lots of high paying jobs, and lots of housing demand; we wrote 30 offers to get this place in 2014 and won with a $300,000 overbid. But, at some point the market will level off or slow down (probably when interest rates rise; and there must be a price point when demand falls). (2) The $3,000/month income would be nice, but I suspect we could get the same or more with other investments. (3) If I sold, I'm not sure what I'd do with the pot of money and I'm worried about it just sitting there (probably other RE or maybe index funds). Essentially, the upside is a bet on SF real estate continuing to rise - a good bet over the last 30 years.

Cons of keeping: (1) unreasonable, tenant-skewed rent control laws - master tenants can bring in up to 2 subtenants per bedroom without landlord consent; rent increases of only 1-2% per year max; just-cause eviction law - hard to evict except for very bad behavior, so tenants essentially have a life-estate as long as they pay the rent; if you evict with owner move-in, it "taints" the building for 10 years limiting the option to condo convert, etc.; (2) the building is (10%?) more valuable vacant and I could sell now with two vacant units, but that's unlikely later if I fully lease it; (3) $1 million in equity tied up only making $36,000/yr max (plus appreciation); (4) I could do a Reverse 1031 exchange and take my profit tax free to put into the new property; (5) free up a lot of cash to reinvest somewhere, including the new property.

TL;DR: should I continue to bet on SF real estate rising for my $2mm duplex despite the hassles of being an SF landlord; or should I take my profit and move on?

Amit M. · Answer

I’d keep it.

1- you already locked in a low property tax base

2- you already have a low 30 year fixed rate

3- it’s a prime area that will hold value in downturns, and will always be in demand on the upswings

4- your $36k in income will grow, as the rents will increase, so don’t just assume $36k forever

5- if you want to access your equity you can get a heloc (you don’t have to sell to access equity)

6- for extra credit, you can add value by legalizing the inlaw unit. It’s a bit of a project, but then you’ll turn those sq ft from $100-200 “storage space” value to $800-1200 PSF prime real estate value. Cha-Ching!

7- sound and like the building is in good condition, and with market rate tenants, should be easy to manage

I’m also assuming that since you brought 3 units in Oakland you want to own rental property, and are willing to deal with tenants (it’s not as I Oakland is much better than SF ;). Via experience, you will learn the ins and outs of landlording, namely, choose upwardly mobile tenants that will minimize chance of getting stuck in your units long term. The young tech and biz crowds flooding SF are perfect for that.

It’s nice that you can sell and avoid cap gains taxes. BUT you’ll still pay 6% plus for selling expenses and transfer tax alone. And then you need to find something brilliant to do with the money....

I don’t know anyone who owned in SF, sold, and didn’t regret it years on.  And yes, I still think SF has at least 1 or 2 more high appreciation cycles left over the next 10-20 years.

my2c

Mark Creason · Answer

@Thor M.

If you have lived in this property for 2 of the last 5 years, you take a partial 121 exemption to take out up to 500k tax free as an owner occupant.  You could also do a 1031 exchange on the rented portion into another property.

Thor M. · Answer

I'm still waiting for hard numbers, but it looks like I could tax defer 1/2 the cash by reinvesting in my new Oakland property through a reverse 1031 and then shelter the remaining amount through the Sec. 121 primary residence exclusion.

David Miller · Answer

@Thor M. Real estate is about lifestyle and then money. We only have one life to live and do not take any money with us. So first assess which plan would give you the best life. Financially every else in real estate is about risk and return, Roi!  So the current market on the coasts is over inflated with 3-4% returns and not making financial sense. I would suggest that you take your profits and getting as much tax free cash as you can then invest the remainder in a higher yield property, something large enough to be professionally managed and don’t over leverage. I’ve been through the crash. So I suggest no more then 70% loan to value.

Account Closed · Answer

The line “It just keeps going up” is making me a bit uneasy here. I wouldn’t hold onto the property based on that assumption. Should you sell the property, how much more efficiently could the capital be utilized in a market that typically cash flows more on a monthly basis?

Amit M. · Answer

@Thor M. yes and no.  Condos will add ~ +10% value max to the two main units. Let’s loosely call that $200k. And the new unit, depending on size and amenities of course, will probably add more value. About how big is it? Can it be 1-2BR, or only a studio? Does it get decent light (for ground floor), or is it a below grade cave? In the future you would sell it as a 3 unit bldg, or, if you vacate the units, you could still sell them off as tic’s to homeowners.

The real question is, if you want to keep the bldg long term, add the unit and max your rents and property value. If you’re gonna sell, do so while it’s vacant (probably will sell for max value as tic’s to two owner occupants) and you can take advantages of the tax laws.

So it’s sort of a binary decision imo depending on your goals.

Thor M. · Answer

Great list - it definitely makes me lean more toward keeping.

If we keep the property we are considering legalizing the in-law. Given that the building is currently a duplex with no eviction history, does adding a legal in-law decrease the value for future buyers because they wouldn’t be able to fast track condo convert?   Thanks!

Joel Fine · Answer

Bay Area real estate scares the Dickens out of me (and I live here). Especially the law's hostility to landlords, but also the compressed cap rates. Only you can decide what risk/reward ratio you are comfortable with, but I decided a while ago to go after the high cash flow in the Midwest even if it means less appreciation. So I invest out of state and not locally. I would sell.

Johnson H. · Answer

Thor, you have an interesting situation here. Pricing seems to be appropriate based on the rents you provided. Pro's of keeping it would be due to prop 13 and your lower tax basis. Pro to selling would be the the partial section 121 exclusion at this time. You could also use the capital gains money into an opportunity zone fund (third party or creating one yourself) to invest so that you don't have to complete a reverse 1031x. I think the biggest question you and your wife have to decide on is if you want to be landlords in SF and would you self manage or hand it off to a property manager. If you don't mind it and believe in the long term potential of the market, then keep it. Also, do you think one day you would want to move back into SF? If there is a chance, keeping it could be also ideal.

You can also complete a cash out refi to get equity out if you don't want so much equity tied up but your rate will be higher as an investment property. However, there are interest only options out there if you want more cash flow. You are definitely correct the vacant units are worth more. If you can buy out the other tenant, you would increase the value further I believe. Finally, there is nothing wrong with having cash on hand to do whatever you want with it. When you have liquidity, you have options. I am a long term bull for the SF market but I understand that everyone's financial situation is different. We just have to make our bets and move on. Good luck!

Theresa Harris · Answer

I don't know the tax laws, but you may want to talk to an accountant to ask.  If you can sell it and not have to pay taxes on all the profit because it was your residence; I'd sell it and take that $1 million and invest it elsewhere.

Should I Sell My San Francisco Duplex?

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