2021 RE Investments Underperforming... Should I sell?

[Matt Huber]

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?