Upgrade location even with less cashflow?

Question

I own 7 properties (8 doors) in southwest Pennsylvania free and clear.  I cash flow about 7k a month after expenses.  These are in C locations but my places are on the nicer end of what is available in those locations and my rent is also on the high end.  Haven't had any problems with tenants yet.  I have about 800K of untapped equity.  These places will not have a lot of appreciation.

I am considering cashing out 3-4 of these properties and using those funds as the down payment on homes in better location - B/A-.  This will better diversify my portfolio and let me add some places that should appreciate nicely.  If I cash out three of them, I can get six other places.  Unfortunately, this will actually bring my cash flow DOWN due to the interest rates.  Take equity out of one property will cost me about 1K a month and with the mortgages on the new purchases, I will probably only cash flow 200-300 per home.  So if I refi three and buy six more - than I lose about 3K in cash flow and only add 2400 in cash flow from the newer places.  This will get better once interest rates come down and I can refi.

What would you do?

Dave Foster · Answer

Along with what @John Litz is saying, doing a 1031 exchange on the lower performing properties to buy in areas with more growth potential, would give you that diverse potential for greater cash flow.  And get out of the properties that have more cap ex risk or potential problems.  If you're concerned with interest, you could do a consolidation exchange and  purchase fewer properties for cash using the proceeds of several old properties sold for cash  without taking out a loan and let those work for you till interest rates are in your favor.  This concentrates the equity so it will be easier to access when you need it.

If you want a true picture of what borrowing does to your return you have to look at the Internal Rate of Return.  Cash flow will go down.  But the factor helping you is the amortization of the loan (principle paid down on the loan  by the tenant).  Having mortgages does reduce the amount in your bank account at any given time.  But The amortization factor really boots your return.  You just don't get to touch it until you next refinance.

John Litz · Answer

Could you save your current cash flow to do additional investing in a better area? Could you sell the least performing unit and 1031 into a better area? You could refi to pull equity but does that turn a performing property into an alligator?

Better areas with appreciation are where wealth will increase more and faster. However higher cash flow is allows you to sleep well at night because your not stressed about you daily expenses.

Alecia Loveless · Answer

@Karolina Powell Have you considered a refi or a HELOC on any of the existing properties that would only take some of your equity and still allow for some cash flow? You wouldn’t be able to buy as many replacement properties but you’d get 1-2 and still have the original units plus the new ones.

Jay Hurst · Answer

Just a piece of advice if you do elect to pull some cash out is to stay at 60% loan to value. 60% loan to value for most products will get you the best combo of rates/costs on the loan.  Sure you can go to higher loan to value but you will pay more in fees and have a higher rate for a relatively small amount of money. Not everyone has this luxury because they have existing financing but owning free and clear this is the loan to value that would maximize your funds.

AJ Wong · Answer

This is a great problem to have..congrats on the success so far. Maybe you can approach with a combination of selling the lowest performing or least desirable asset(s) and utilizing some for cash out towards reinvestment? I'd be hesitant to break what is working on properties with a low base just to increase units..can/will rental rates increase on the currently owned units? Mortgage rates will eventually come down and also improve cash flow for any potential refinance for capital accessed now. Good luck.

Drew Sygit · Answer

@Karolina Powell so you want to trade cashflow for appreciation?

Which one will increase at a higher percentage?

Jeremy Taggart · Answer

@Karolina Powell I always like to look at the end goal and the timline and work backwards from there. At the end of the day the goal should be to make enough to give you an optimum lifestyle but not go overboard and cause yourself more work/hassle if you don't actually need the additional income that comes from it.

Increasing the quality of the area/properties should make it easier management wise and if you don't necessarily need the cash flow now could end up ahead in overall return compared to the lower end areas, especially if you use leverage.

I think it depends on your source of active income as well and how long you want to continue doing that for. Like for me I have a business I enjoy that produces active income I don't see myself stepping out of anytime soon, so I am prioritizing the nicer areas/properties that might not cash flow as much right now but will in the future and provide me with good depreciation to offset active income right now.

Just such a personalized thing that doesn't have a one size fits all approach.

Alan Asriants · Answer

this is a great example of the cash flow vs appreciation debate

If I could find some cash flowing properties in A/B areas that have much higher appreciation growth, I would pick up a few of those to have for appreciation growth, even if it means my cash flow could go down a bit.

It's hard to give up $7k/m in cash flow, that is just great income, but long term, having appreciation is very important too.

Don't over leverage yourself, and try to retain as much of the original cash flow as possible while picking up an asset or 2 in a higher appreciating neighborhood.

Im not sure where that is in the pittsburgh area, but Im sure it has to be closer to downtown.

Kyle Joseph · Answer

Depending on whether you manage yourself or hire property management, your return on equity seems very strong for having no debt on the properties. If you are paying a property manager and still generating $84,000 cashflow on $800,000 equity, your return on equity is over 10%.

If you think that you can generate a lot more cashflow relative to the amount of equity in other investments, then I would consider selling and doing a 1031 exchange into larger property(ies). I just did this with a duplex and bought a 6-unit property in my market. Long story short, I had $150K equity in the duplex (due to appreciation) and was cashflowing very little - $5,000 per year. So my return on equity on equity was 3.33% ($5,000 / $150,000). I sold the duplex and bought a 6-unit property that will generate over $15,000 per year in cashflow, which is over a 10.00% return on equity ($15,000+ / $150,000). Even with the higher rates, I am able to generate a lot more cashflow from that same amount of equity.

Upgrade location even with less cashflow?

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