Keep it or sell it?

Question

Hello,

I am brand new member and this is my first post. I currently own a rental that used to be my previous home. Watched the 50% rule video and quickly put together my numbers to see where am I at.

My expenses are at 37% of the rent, excluding the provisions for long-term CapEx items. I'd say, I am pretty ok on expenses side even when factor in CapEx.

The issue is on the debt service side. P+I payment amounts to 96% of the rent. That is because the loan is amortized over 20 years. In the end, each month I am putting approx. $1000 out of my pocket to keep this property, and each mortgage payment adds approx. $1500 towards the equity of the house. So, I am making money each month, just not in my checking account.

In past 4 years, the house has appreciated nicely here in SoCal but now the appreciation seems to be slowing. The only reason I am in dilemma weather to keep this property or sell is because I am not sure if I am missing out on better opportunities with this negative cashflow situation.

Refinancing to a new 30 year fixed is not so appealing as my interest rate would go from under 3% to over 6%.

I'd appreciate different perspectives from readers and gurus on this forum.

Jeffery Griggs · Answer

Have you lived in the house 2 of the last 5 years? If so take the tax free gains and get out now.

JD Martin · Answer

This is one reason I don't like "rules", but my version of the 50% rule goes like this:

Monthly Insurance+Tax+Note Payment+Normal maintenance  <50% of monthly rent.

Sticking to these numbers means I can absorb abhorrent vacancies, or major capital expenditures amortized, without any negative cash flow situations. So when I evaluate whether I want to make an offer on a place, or buy it, or keep it, I plug those numbers in, using liberal estimates on expenses and conservative estimates on revenue, and get some idea how the house works out. Then I factor in the side issues that can impact any of the parts of the equation - the neighborhood for appreciation & ability to rent factors; known capital expense issues, or those known to be upcoming; interest rates; unusual maintenance needs (example: I strongly avoid homes without eaves); local property tax and insurance anomalies; ETC.

In your example I would run from that house like I would from a grizzly. Appreciation and paying down notes are great but not at the expense of financial insecurity. But I can't really speak to your local micro-climate in terms of real estate investments, either.

Franklin Romine · Answer

@Dharmesh R.

If you have enough income from other sources and are not struggling financially, I would keep that property..

Frank

Edward B. · Answer

@Dharmesh R.,

You are not missing something. There should be different rules for SoCal and unfortunately I can not tell you what they are. What I know is that there are investors in SoCal that are making money, but not with these rules. Maybe they are better capitalized, partnering, or investing in different types of properties. They may be investing for appreciation mainly which is a financial form of russian roulette in my opioion but does work for very savvy investors. Others simply choose to just look elsewhere (i.e. midwest), some look in lower priced areas of CA (they do exist), but neither option is without its challenges. I guess 75-85 degree weather and sunshine year round is not without its penalties.

Dharmesh R. · Answer

@Edward B.

Your analysis is right on. There is no way that home can rent for $4700/month.

Just ran some numbers to test the 50% rule viability here  in SoCal. Say if one is buying a property that goes for $2000 rent, that property can have approx. 200k mortgage at 4.5% to meet that 50% criteria (~$1000 PI). Near where I am, any decent property that rents at that price is worth ~350k give or take. Which means, the investor either have to fork out 150k as down payment (42%) or ignore the 50% rule completely as it is not feasible in this market. one can run numbers like this at many rent levels and consistently it just won't work for this area.

Am I missing something? Should there be different rules applied to SoCal?

Edward B. · Answer

@Dharmesh R.,

That might be tough to work. It is often very difficult to make higher priced SFHs work with the numbers. Some quick calculations for you. Assuming no appreciation, principle buy down or sweat equity, all of which would help your case; 75% of $620K is $465k. At 4.5% amortized for 30 years you are looking at a Principle and Interest payment of ~$2,350/mo. So you would need your property to rent for $4,700 in order to meet the 50% rule. If you are no where near that you probably need to cut this one loose and invest in something that performs better.

I'll be honest, I have a few properties that don't meet the 50% rule and over time have been cash out of pocket. BUT, they are not cash flow negative every month and they have been good investments when you factor in the principle paydown, appreciation, and tax benefits. The key though, is that I have enough properties that those that don't cash flow are supported by the others. I also bought those before I had a good handle on this whole REI thing and would probably do it differently if I had it to do over again. My point is, if you get it closer to a cash flowing property, it does not necessarily NEED to meet the 50% rule, which is arguably the most arbitrary rule used here. You need to understand the risks, however, of not cash flowing and ensure you are taking a calculated risk vice just not unloading the property for emotional reasons.

Dharmesh R. · Answer

Loan balance is approx. 520k. The home could be valued somewhere around 620k. It's not too old home and is in great shape already. It's one of those cookie cutter new development home. I am not sure what sort of value-adds that I can do, which may set it apart from other cookie cutter homes down the street.

Jesse Hinaman · Answer

@Dharmesh R. do you have any opportunity for a sweat equity value add? In So-cal a few thousand dollars for interior/exterior paint and baseboard upgrades could easily add 3x the cost of the improvement to your value.

Dana Whicker · Answer

How much equity do you have in this property?

Dharmesh R. · Answer

@Jesse HinamanI like your suggestion that lower debt service on CR will help me greatly with DTI. For the rates you mentioned, I will have to wait out atleast a year so that my current 80 some % LTV becomes 75ish with equity building and may be some appreciation hopefully.

Man I love real estate.