2021 RE Investments Underperforming... Should I sell?

Question

In 2021 I purchased a couple of single-family rentals. After nearly 3 years of operating history, I'm concerned that the properties are not performing well enough to warrant continuation of the venture, and I'm considering selling. This venture was originally expected to have a 10 year horizon, with the goal to maximize IRR in that period. I'm curious to hear feedback from other investors on the question: should I hold or sell?

Here are some basic facts:

Initial cash invested: $120k

Year 1 Cash Flow: $12.3k

Year 2 Cash Flow: $8.6k

Year 3 Cash Flow (YTD, 3 months left in year): -$4.5k

Current equity estimate (net of expected selling costs): $102K

Mortgage rates at or below 3.75%

CapEx uncertainty: HVACs will likely require replacement within the next 5 years and one of the roofs is nearing 20 years old.

Market is the Huntsville, AL area.

Underwriting hurdle when acquiring these properties was 10% CoC return annually.

With a 10% CoC return after Year 1, I felt good about this investment. Year 2 had some large expenses, including some CapEx items (water heater, roof). Year 3 we achieved a 10% rent increase across the portfolio, but have incurred high turnover and vacancy costs. (The rental market is strong - these costs are largely due to a problem tenant who recently left the property.)

Both properties are rented to Section 8 tenants and professionally managed. I believe my property manager does a good job and keeps me informed. (We discussed the "problem tenant" situation above, and I believe it was an anomaly and not necessarily due to poor tenant screening.) So, these properties are probably as close to "mailbox money" as one could get with direct REI. Given current rents and historical expenses plus some cost escalation, I believe stabilized cash flow of $12k/year is a reasonable expectation excluding any major CapEx. Due to the likelihood of needing to replace AC and/or furnaces in the next 5 years, there will probably be another year or two of near zero cash flow at some point.

When I bought these houses, the neighborhoods had a lot of rental homes, but were still desirable affordable neighborhoods. Today almost all houses in these neighborhoods are investor owned, with a high proportion of Section 8 tenants. Nearby new build 3/2 SFRs start in the mid-200's, and there's a lot under construction. Because of this, I believe the market for selling my houses is likely limited to other investors. If this is true, I believe they will not appreciate with the SFR market at large, but rather appreciation will be limited by the ability to increase rent. In other words, I expect low, if any, appreciation over the next few years.

A similar investment in the S&P 500 would have yielded a 25% return if sold today. (Net of capital gains tax and NOT including dividends.) By comparison, liquidation of these properties today would yield a slight loss. I'm leaning toward the decision to sell, as the expected rewards do not seem worth the risk (or opportunity cost).

But what am I missing? Is it worth it to hold onto these properties? Or should I sell and move on?

Michael S. · Answer

@Matt Huber - if you bought in 2021 in Harvest, you should have seen some decent appreciation - however, if you bought these as turnkeys, that may explain some of the lack of appreciation you are experiencing.

Yes, the market here right now has been really tough, and trying to sell your properties to other investors with section 8 tenants will likely be fairly problematic at this current time. Given your low interest rates, your best move may be to sit tight for a while until the market here improves.

Travis Biziorek · Answer

I would caution on comparing these returns to the S&P 500.

Real estate has been pretty much flat the last 2-3 years while the S&P has been on a great run.

It's human nature to sell the lows and buy the tops. What's that mean?

There's a high chance that you are feeling FOMO from the returns in public markets, sell your houses for a loss, pile into stocks, and then see mediocre performance while real estate heads back higher again.

I see this, and similar actions, play out over and over.

Personally, I'd stick with the real estate rather than selling it.

Matt Huber · Answer

@Adam Michael Andrews

The catalyst for this discussion was my concern about the location. I believe that Huntsville/Harvest is a good area - but I'm afraid the neighborhoods I've invested in will continue to experience decline of quality. This, I recognize, is a consequence of my decision to go Section 8 versus other avenues.

But you're right; other than that, the operating fundamentals area still reasonably good, and the capex isn't really surprising. Thanks for taking the time to share your view; it helped me to get my own view into focus.

Matt Huber · Answer

Thank you for the replies so far! It's helpful to see other points of view and go through these questions.

One of the reasons I decided to make direct RE investments was to provide a hedge for volatility in our portfolio. But to your point, the risk adjusted return does not seem adequate. (This, of course, depends on one's assumptions about future appreciation; the prospects of which I have my doubts.)

@Michael Smythe To answer your questions:

In the first couple of years there was some appreciation. However, I believe it has deflated a bit recently due to the current interest rate environment, increased inventory of nearby new homes at a low(ish) price point, and the neighborhood turning to mostly investor owned homes.

I do have mortgages; the tenants are paying these down.

@Basit Siddiqi The area is Harvest, AL. If the existing mortgages were at current interest rates, the P&I would be about 30% higher and the pro forma cash flow would no be much more than break-even. I believe this limits the price that investors are willing to pay.

To clarify my assumption about current equity: most transactional activity in the area has been new construction and established neighborhoods of "better" quality. I've tried to be conservative in my assumptions and based on the best available comps have valued the properties using the 1% rule for this analysis.

Basit Siddiqi · Answer

What is the area that you invested in?The thing is there was a lot of appreciation in 2021 and parts of 2022.Real estate didn't appreciate(in general) much from Summer 2022 to start of 2024.In general, the investment, while lagging behind the stock market return, is not a bad investment.You got 10% cash on cash return in year 1 and 8% cash on cash return in year 2.It was negative in year 3 but that is okay if you beleive it to be around 10% going forward.A lot of investors are starving for cash-flowing deals so I am surprised these properties didn't appreciate much.

Michael Smythe · Answer

@Matt Huber well laid out!

Why has the market not appreciated in the last 3 years?

How are the performances different than your projections at purchase?

Did you pay cash for these or are the tenants paying down your mortgages?

Regarding the new construction, often this attracts more homeowners. A percentage of them may not be able to afford the new construction homes, so may instead buy in your neighborhood. So, that may lead to appreciation eventually.

Jonathan Bock · Answer

@Matt Huber I think you know your answer already

Direct real estate ownership should compensate you appropriately why else be in the alternative space.

Matt Huber · Answer

@Adam Michael Andrews Thank you for the feedback. I have considered that a 3 year lookback might be insufficient for a complete analysis; but it's what's available right now. And shouldn't one periodically review investment performance and compare it to one's goals? Also, the historical data tells me that 3 years of underperformance means that future performance must improve substantially in order to meet the IRR goal for the investment. That's useful for informing decisions.

With respect to the interest rate: I do have a sense that borrowing at such a low rate can be viewed as an asset. But what difference does it make if the leveraged portfolio earns an insufficient risk adjusted return? After all, the interest rate (high or low) is just a number on a spreadsheet.

Please help me understand the perils of this view.

Adam Michael Andrews · Answer

You need to do a full useful life look through on your capex items. If you spend a couple years of cashflow on a new roof, that means you should be free and clear for a couple decades. I don’t think a three year historical lookback is sufficient.

Unless the market fundamentally changed, I would just sit tight. You have the management piece figured out, revenue side looking up, and the area is good. Remember that you can’t get your rate again today. You are sitting on a big unrealized gain with that mortgage and if you prepay it you’re paying them back at par.

2021 RE Investments Underperforming... Should I sell?

2021 RE Investments Underperforming... Should I sell?

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