Own 2 Seattle-area SFHs. Best way to move forward?

Question

My husband and I have what we think is a good problem.  We own two houses in Kirkland, WA with a fair bit of equity. Both can be considered tear downs and are in terrific locations. Property values are increasing by double-digit percentage points annually, and builders and home sales are going crazy in the area.  Consensus seems to be we aren't at the end of the boom quite yet.  We see our houses as opportunities to further our goals of early retirement,  because although we love the area, we want to lower our COL.  We are having trouble figuring out what option(s) make the most sense both in terms of minimizing debt / maximizing cash flow when retired, but not getting in over our heads.

The two houses are:

1.  Rental that was our original residence; 100% equity, short walk to expanding Google campus. Very old and tiny 2/1, but no major upkeep needed in short term as roof, water heater and furnace are all newish.  Tear-down across the street recently sold last summer for $565K and ~3500 sq ft, high-end, new constructions nearby are selling as soon as they hit the market for ~$1.5 million.

2.  Our current residence; view property; we owe $290K, and it has some deferred maintenance required in the next year or so (e.g., roof).  Tear downs in our neighborhood are currently selling for ~$1 million give or take.  New construction next door just sold as soon as it was listed for $2.2 million. Investor reportedly made ~10-15% (he purchased the tear-down almost two years ago for $850K).

Some of our options for each house include:

Rental house: Long-term tenants would happily buy from us and we could do owner financing, or we could tear down and build, or just keep renting it out (tenants prefer to stay).  If we built a spec house we could either sell when finished and take the tax hit on gains or 1031 exchange it, or live in it for two years (before or after construction) and qualify for the full capital gains exemption because we lived there for a few years before it was a rental.  We are also considering building for us long term which means we would build with an ADU so that it generates income (could get more than the current house rents for).

Residence house: Sell to a builder or investor (we get multiple letters a month looking for property in our area), or tear down then build spec home as investors, or keep it as a rental and either sell while we could still qualify for the tax credit or wait and 1031 exchange it down the road. (Note: rent would cover PITI with $2K going to P and an additional couple hundred to spare per month not accounting for maintenance.)

Obstacles/Questions: no construction experience and builders are currently asking top dollar; not sure if partnering is an option (not a request, just wondering if it is a valid option); what might be the financing options of whatever route we choose (e.g., HELOC on our current house, construction loan, etc.) with goal of being in a decent cash flow position preferably in a couple of years.

If anyone has ideas as to how you might move forward from this point, I would be much appreciative to hear and I'm sure it would also be educational.  We have some ideas, but would love unbiased opinions.  Let me know if there are any blanks I need to fill in.  TIA.

Ryland Taniguchi · Answer

We're developing 25 projects locally here in Seattle right now. Couple of thoughts.

1) We're expecting a slowdown in the near future similar to 2000 (not 2008). One option is do your survey, site plans and pre-submitted all conference then check to see where the market is at. Better to pay for these "soft costs" out of pocket so you don't have to build if the market is not doing so well.

2) Kirkland is an extremely hot neighborhood and you would probably be okay in a down market. If the market slowed down in 2016, there are still housing shortages in Kirkland. On the other hand, properties over $1 million can sell slower than under a $1 million in a market slowdown. Always have a back-up plan.

3) You own the rental free and clear, correct? I am assuming that is what you meant by 100% equity. I would start with this rental project. Permit it while keeping the tenant in the property. The ethical thing would be to let your tenant know what you are planning to do. If you have the money to pay cash on the ADU, I might build that first and then rent out the ADU prior to tearing down the main house.  First I would find if the market supports adding a ADU

Without having all the numbers on your seller lease option, I would guess that you could probably get a higher return by developing the lot.

4) Be careful using a bank loan (though they have attractive low interest rates) because in 2008 when the banks shut down they were calling construction loans in full. Based on this experience, I prefer hard money loans through Empire Financial Services LLC on a two-year term. The points and interest is high (12% and 4-5 pts) but I actually think is safer then a bank that wants to collateralize all your assets including your primary home and can call your loan at any time for no fault on your part.

If you use a lender, talk to Columbia, Coastal or Whidbey. I would be careful with WAFed. Again, I prefer hard money. Experience is often necessary for these bank loans (and you probably need to work with experienced people for any loan).

5) In development, experience does matter but it will definitely help if you hire the right team of architects. They will usually know the good engineer, etc. Lower price is not always better.

6) We can build a high-end finish home between $100 to $145 a sq foot for vertical construction costs depending on factors such as dirt and slope. Expect to pay between $40 to $60 a sq foot for development costs including engineering, architect, surveyor, permits, utility hookups, etc. Find out if the city of Kirkland will require for things like underground utilities, retaining walls, sidewalks, paved roads, etc.  These areas are where experience helps and matters.

7) Don't do two or three development projects at the same time. Start with the ADU if it is market feasible, learn from the small projects. Finish the ADU and rent before moving onto tearing down the house. You can get surveys, site plan, and permits prior to tearing down the house but don't build two projects simultaneously.

8) Because you own the land free and clear on the rental, a lender like the one I mentioned will be willing to give you a loan for the "soft costs" like the survey, site plan, etc. I wouldn't take it if you have the cash. The risk in development when you have loans and the holding costs. It is less risky to use your own cash till you get permits and then take a construction loan out when you get the permits approved. Also, we like to get two years from the construction loan so that we have an extra year and a half to sell the home. That buys us time. If you rent the ADU, the cash flow can help offset the holding costs. If you don't take the loan for "soft costs" it is easier to wait out the market if it slows down.

Christine Sykes · Answer

@Cathy McNair, great post! I have property in Seattle, and found you post very interesting. Sounds like you've got some fantastic property!

@Ryland Taniguchi, thanks for all the great information! I am still educating myself about REI, so all of this is very useful.