If you are a real estate investor that purchased well-located investment properties between 2008 and 2012, you are faced with somewhat of a dilemma.
On one hand, you have watched the value of your property rise significantly in recent years on top of any built-in equity you may have secured at the time of purchase. Not to mention that in this market properties sell in a heartbeat for full asking with multiple offers. So you look at the current market value, then look at your mortgage balance and can’t help but feel that it may be time for you to “cash your chips” and go home. After all, no one ever went broke making a profit…
But on the other hand, rents have also risen significantly and you have enjoyed great returns on your invested capital. If you sell, you “kill the goose” and forget about the golden eggs. Positive cashflow, value appreciation, mortgage pay down, depreciation – they all come to a halt.
So what’s the right call – sell or hold on, cash out or stay invested? To be sure, it’s a good problem to have but a problem nevertheless. Below is a methodical way to think about it.
Goal Clarity Above All
Every decision you make in regards to your investment portfolio has to be aligned with the overall mission of that portfolio. Ask yourself: What’s the principal goal you employed your portfolio to accomplish? Is it income, or wealth accumulation?
If the main goal is income, liquidating an income-producing asset without a proper plan to replace it with better income producing asset(s) is counterproductive. Instead, if the goal is to accumulate wealth, selling an investment property to lock in equity gains makes sense.
But wait – I hear you asking – what if my goal is to accomplish both income and wealth? Hence my emphasis on the word “principal”. If you want to maximize income, you don’t want to arrive at “retirement” with a lot of wealth but no way to convert it into income without cannibalizing your principal or subjecting it to high risk of loss (read: bonds). And vice versa. The principal goal determines how many assets you should own to reach it and subtracting an asset (without replacing it) when you should hold on or add on is not a smart move.
Return on equity vs Alternatives
The next thing you want to do is think past the sale.
Let’s say you sold the property and took home a chunk of cash. What’s your alternative investment plan for this capital? If there is another investment you are considering (i.e opening a business, purchasing other investment properties or securities), what’s the expected rate of return of those investments? In some cases that’s easy to calculate based on prior history or cashflow analysis – in others it’s much more abstract and unclear. But you must have at least an idea of potential scenarios (pessimistic, realistic and optimistic). Then, you compare those returns with the current return on your equity.
Equity = Current Market Value – Current Loan Balance
Return on Equity = Annual return (net cashflow+debt paydown+ realistic appreciation)/ Equity
If your alternative rate of return isn’t significantly better than what your capital is currently earning, you’re doing yourself a disservice by selling, regardless of the profit. Even worse still, if you don’t have an alternative plan for the capital but simply like the idea of selling something at a profit, then you’re really selling yourself short.
Past performance and hassle factor
Secondly, you want to consider how this investment property has performed for you during the time of ownership. Is this a solid investment that rents quickly to long term tenants and doesn’t turn over often? Or is this the redheaded stepchild of your portfolio that you dread every time it becomes vacant? Further still, is this a property that stays relatively repair free or does it break every other day and twice on Sunday?
Past performance and hassle are major factors in considering a disposition regardless of the equity and profit. Or put a different way, if you could go back in time, knowing what you know today, would you have purchased the property in the first place? If the answer is no then it’s time to sell and put that capital to better use.
Long Term Discipline in good and bad times
Mama said there’d be times like this.
When we speak of discipline in a long term portfolio, your mind typically defaults to unfavorable markets. If times get tough you must have the guts to hold one and ride the storm. But, if times are great, you must also have the strength to resist the siren calls of cashing out and keeping your eyes on the prize. So perform the analysis above and determine:
- What’s your portfolio’s principal goal?
- What are the replacement or alternative investments and how do their returns compare to your current return on equity?
- How has this property performed for you in the past? Has it been a pleasure or a never-ending hassle?
The logistics of selling
Now let’s say that after performing the methodical analysis I described above you determine that you will sell the investment property. In that case there are a couple of important logistics you must consider:
- What’s the best way to sell a tenant-occupied property?
- What are the tax implications and how should you structure the sale?
When your investment property is tenant-occupied there are two strategies you can use to sell the property. First you could wait until the lease is up and once the tenants move out get the property show-ready and put it on the market. This strategy will likely make you really nervous because a) you don’t want to pay the mortgage while the home is for sale and b) the timing of the lease expiration may not allow you to bring the property to market at a favorable time of the year. But on the plus side, if you choose this strategy, you could provide full access to the property at any time and to any category of buyer (regular or investor). The second strategy is to sell the property while rented to an investor. For most investors, having a tenant-occupied property is a great plus since they would have no vacancy from day one. That’s especially true if the tenant has been in the property long term and is interested in renewing. The major obstacle with this strategy is that tenants have zero incentive to provide access to the property to prospective buyers. But don’t fret, we have a solution for that, too. On all tenant occupied investment properties we list for sale, we do not allow any showings until a contract has been executed. Since the Buyer is likely to be an investor, they understand why we don’t want to disturb the tenants until the intent to purchase has been put on paper. And there’s a 10 day inspection/feasibility period in which the Buyer can perform all their due diligence and determine if they want to move forward. By restricting showings in such an active market as the current one, you avoid a major disturbance for the Tenant. Instead of asking the Tenant to accommodate as many as 15-30 showings in two weeks, they will simply accommodate a home inspection and appraiser access. Most of our clients are still in acquisition mode, but on all the investment properties we have liquidated in the past 12 months we have employed the second strategy with great results.
Last but not least, you must not forget about pesky Uncle Sam that tends to get really cranky around liquidation time. The major consideration when it comes to taxation at the point of sale is the alternative investment plan for the sales proceeds. If you are planning to use the proceeds to open a business or purchase securities, then simply ask your CPA to calculate your tax liability so you know the after tax proceeds of the sale going in. As with anything else where the government is involved the calculation isn’t as simple as figuring out your profit times your tax rate. So in order to avoid surprises, do yourself a favor and sit down with your CPA. If instead you plan to purchase other investment properties with the proceeds, then it’s time to consider whether a tax deferred exchange (1031 exchange) makes sense for you. In such an exchange, the sales proceeds are never transferred into your bank account but are kept in an escrow account while you line up replacement properties. By structuring the deal in such a manner you defer the taxes you owe on the profit and invest the entire sales proceeds in replacement properties. That’s the short and sweet version and obviously there are many more nuances and technicalities. But no worries, if a 1031 is right for you, we have and can execute it to perfection.
Do you own an investment property and are trying to determine if selling it it today’s appreciating market is the right move? Contact us (or if you’re seeing this in your email, hit Reply) and we would love to sit down and perform the analysis together to evaluate all the options.