How should I diversify my SFBayArea tilted portfolio?

Question

Hi,

I am looking for some advice on how I might go about diversifying my assets, specifically around real estate. I feel that I am not diversified enough - and looking for opinions here.

Currently, my real estate consists of about 36% of my assets, a big portion of it is a single-family home rental (which used to be my primary residence) in the San Francisco area.  Breakdown looks like this:

• * San Francisco: $750K equity (About $1.1M estimate with $350K mortgage, bought it at $500K).  Current cashflow is about $1K / month ($3.7K rental - mortgage/taxes/expenses).
• * Texas: $150K equity (About $200K estimate with $50K mortgage, bought it at $150K).  Cashflow at about $300 / month ($1.7K rental - various_expenses)

Other than “pure” real estate:

• * Crowdfunding real estate: About $200K in various (core, value-add, opportunistic).  Just started this year.
• * $800K of stocks in taxable account.  Mostly diversified into VTI
• * $600K in 401k, in some miscellaneous combination of FFNOX and a few others.
• (No bonds.  Not much in cash other than emergency reserves)
•

Top of my mind right now is whether I should do anything about the San Francisco rental home.  Should I keep as is?   Should I 1031 exchange and buy a property (or two) elsewhere?  Liquidate and put into high dividend stocks/ETF (although with sky-high stock price yields are low...)?

I’m about 40 years old, and do have a reasonable normal(salary) income of about $200K, but looking to hopefully semi-retire in a few years if I can, although need a few more sources of passive income as of right now.

Disaster scenario in my head is… stock markets crash(loss of stock equity), along with the tech scene here in California collapse (loss of job/rental price decline or vacancies increase), and adding icing to the cake with perhaps some earthquake affecting my real estate here (we are long due for a big one).

Feeling a bit paranoid but would rather intentionally decide what to do, whether to keep or to diversify.  Any suggestions from fellow investors & readers on what you might do?

Thanks,

John

John Corey · Answer

John,

Warren Buffett is reported as saying that 'diversification' was invented by sales people on Wall Street so they can sell you stuff. He prefer to focus on opportunities where he can create alpha (apply what he knows to gain an advantage) rather than trying to reduce his upside to the market averages.

There is a lot of friction to selling a property you already own (taxes, transaction fees, an asset you already know vs the unknown).

Given your age, you have a 'long runway' before you need to live on your savings. As SF is bounded by water on 3 sides and hills on the fourth, values there will be fine long term.

Grow your knowledge, consider other investments and keep the rental occupied. I would not be in a rush to exit the property. And I would not be in a rush to drain all the equity from it. The logic there is you can lose the property to the bank if you over leverage.

I lived in SF for a while and was there for the 7.1 earthquake. Look into the insurance options rather than sell the property. You do not need perfect coverage to largely protect the asset. There were fine choices for insurance in the past. I expect there will be some now. Note: Insurance companies will close access to new policies for 90 days after an earthquake. Most people fail to think about insurance until after a big one. Get it sorted now and rest easier.

Two other things. Earthquakes are a big risk yet they are not that often. Other risks exists. Review your coverage so you are well protected. A lawsuit might be a bigger risk than an earthquake. Second, you can do things to improve the resiliency of a building to earthquakes. Bolting the house to the foundation, bracing if there is a garage below the house, etc. Nothing too complex. Lots of info out there.

John Corey · Answer

A good summary.

One more factor.

The Financial Times (FT) used to run a comparison every January about UK real estate vs the UK stock market. Both were close to each other in terms of annual performance. Then the FT did a piece about why the annual comparison was closer to a mistake than reality. The fact that most people purchased shares with all cash while most people purchased real estate using debt for leverage made the real estate a hands down winner. Assuming the debt was funded by rental income, the holding costs could be zero.

So, hard to compare asset classes. And the local knowledge element does favor real estate given most of us do not run companies.

Amit M. · Answer

Ask yourself this: how many people sold a decent property in SF/prime Bay Area and have not wished that they kept it 10 years later?

John Clien · Answer

Thanks for the continuing input.

@John Corey - good point on the leverage.  Some people talk about how in stock market you can use margin accounts which would be the equivalent of getting mortgage & leverage.  But at least personally to me using margin accounts feel much more risky due to margin call... it's like if the real estate market prices decrease, suddenly the mortgage company can ask you to put down $100K more or they will forcibly sell your home even if you are paying the monthly payment... that's crazy (p.s I don't personally have margin accounts so this might not be accurate - just my understanding).

@Bernard Reisz - it does make me feel a bit better... and realistically 2 years moving back is hard enough, no way will I move back into the house for 5 years.  Which leaves me with the 1031 exchange option if I were to sell (which majority here doesn't think is a good idea).  I guess one option if I were to sell would be opportunity zone investments, but not quite an expert there (or any real experience in that).

Thanks for the advices.

Bernard Reisz · Answer

@John Clien

If it's of any consolation... Although moving back into the property for 2 years will have some tax value, it would not get you back to having the full 250k/500k exclusion. Appreciation would be prorated to periods of qualified and non-qualified use and anything allocated to rental periods would reduce the exclusion amount.

John Clien · Answer

Thanks for the insight and perspectives.  It looks like right now the general advise seems to be keep the property and do the appreciation play and not focus too much on cashflow.

@John Corey - great reference on Warren Buffet.  You're right - his perspective was that diversification is for ignorant people, and that he preferred to understand a particular industry/company really deep, and make bets based on knowledge and research.  With real estate being very local (even hyperlocal), that quote does have a lot of relevance.  SF is indeed land-constrained like you said.  As long as more people come in than leaving, you're right that it might be better to keep the property and use insurance and other means of de-risking for some black swan events than selling the property.

@Amit M. - I think your point on people who didn't hold the property 10 years ago might depend on what they did with the proceeds.  In a somewhat biased view, if they bought S&P ETF at the bottom in 2009 (i.e. 10 years ago) with the proceeds, they would have seen an even higher growth on stocks (2X - 4X, depending on when in 2019) than they would have seen with SF real estate prices.  However, if they simply cashed out and did nothing (or invested in things that didn't appreciate as much, including buying property in areas that saw less appreciation), then most certainly they would have regretted it.  We can't really time the stock market and right now the stock market is all time high, so that stock comparison might not be valid.  I think you do have a point as with John that if we are purely talking about real estate, then keeping the SF property might be a good idea for the appreciation plan.

Thanks for the perspectives!

John

John Clien · Answer

Hi Dave,

Thanks for the response!  You have good point on the home sales capital gains exclusion.  Unfortunately I've been renting this out for over 5 years so I unfortunately can't take advantage of that.  Also for me taking it back from tenant and living there myself for 2 years isn't quite realistic, so it looks like my only option is 1031 exchange.

Yes, $12K/year for a $1M asset is pretty horrible... Not sure how much more appreciation I can expect here, with Uber/Lyft/Slack/Pinterest/WeWork all having a miserable IPO (WeWork didn't even make it to IPO).  Longer term though, like with most real estate in US, it should appreciate, but short term looks dicey.

Thanks for the suggestion.

John

Dave Foster · Answer

@John Clien, You mentioned that you had previously lived in that SF home.  If you moved out recently enough and have owned it long enough so that you have lived in it for 2 out of the 5 years prior to sale then you can take either the first 250K or the first $500K of profit tax free.

That would be my first vote.  Even if you want to stay invested in SF I'd sell that because the profit is tax free.  Get it off the table while you can. The maybe use some of the gain to buy back into SF if you want the appreciation play.  Or put it anywhere you want in real estate or not.

Since it sounds like you actually may be pushing that $500K limit you can always take the first $500K in profit tax free and 1031 the remainder.  When you convert a primary to rental and sell within the right time frames you get to do both!  And that would be huge in getting you the flexibility to shape your portfolio as you want and when you want but tax free.

If won't have lived in the property for 2 out of the previous 5 then you're right, the 1031 is still an option.  But the preference of it isn't clear.  On the one hand making $12K/year cash flow on a million dollar asset is horrendous.  But the flip side is what the appreciation has been.

I'll let the rest of BP argue the merits of that either way.

How should I diversify my SFBayArea tilted portfolio?

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