Long Term Rental Properties

The Fermi Technique: How to analyze investment properties in under 5 minutes

January 7, 2016 By Erion Shehaj Leave a Comment

Over the last decade, I have worked with many successful long term real estate investors. They have different personalities, different professions and often employ different strategies. But they all have one critical thing in common:

Successful long term real estate investors possess the ability to quickly and accurately “size up” a potential deal.

If someone were to call you on the phone to offer you a potential real estate deal, would you know how to evaluate it quickly and accurately within 5 minutes?

If not, the technique I will share with you today will change that. It will allow you to analyze any long term real estate deal in 5 easy steps that fit in the back of an envelope.

The technique was developed by world-renowned Italian physicist Enrico Fermi. He created the world’s first nuclear reactor, has been called the “architect of the atomic bomb” and had a substantial role on the Manhattan project. So, in a nutshell a brilliant fellow. Fermi was known to use his technique to get quick and accurate answers to very complex physics problems on the back of an envelope. Today, I’ll show you how to use the same methodology, to solve a much easier problem: How to analyze a real estate deal in under 5 minutes on the back of an envelope.

Let’s dive right in. Someone calls you and tells you about a potential investment opportunity.

It’s a single family home that would make a great investment property – according to the caller. Here’s how you can run a back of the envelope analysis within 5 minutes.

Collect Information and/or Make Assumptions

To get started with the analysis you need 5 numbers that you can easily get by asking or making simple assumptions: A) Purchase price B) Monthly Rent C) Down Payment D) Loan Amount and terms and E) Monthly Payment. Let’s say you determine that the property is being sold for $170,000, would rent for $1700, you’d put 20% down, borrow $136,000 at 4.5% for 30 years and pay $689/mo.

Calculate key data

• Step 1: Calculate the annual rent – Monthly Rent x 12

• Step 2: Calculate cashflow before financing – Annual rent from Step 1 multiplied by 0.54 (operating expenses typically run about 46%)

• Step 3: Calculate the annual cost of financing – Monthly payment x 12

• Step 4: Calculate cashflow after financing – Cashflow before financing (Step 2) less Cost of Financing (Step 3)

Final Step – calculate critical metrics

There are three critical metrics that will tell you everything you need to determine if this is a good deal: Return on Assets, Cost of Financing and Return on Equity.

Return on Assets is calculated as the cashflow before financing (Step 2) divided by the price of the property. Another term for this metric is Capitalization or Cap Rate. It simply tells you the rate of return the property would produce if you owned it free and clear.

Cost of Financing is calculated as the annual cost of financing (Step 3) divided by the loan amount (your Assumptions). You would calculate this metric so you can compare it to the return on assets figure. If your return on assets is higher than your cost of financing that means you have positive leverage. Put a different way, you using the bank’s money to generate higher returns than what it cost you to obtain that money. You should avoid the opposite at all costs.

Finally, Return on Equity is calculated as the cashflow after financing (Step 4) divided by your down payment (your Assumptions). This metric tells you what your invested capital is earning. When you achieve positive leverage, your return on equity will be higher than your return on assets. Or put a different way, you are earning a higher return by using the bank’s money to finance part of the purchase.

The first time you do this analysis, it will take a little longer to complete until you get used to it. Afterward, it becomes second nature and a powerful skill to make you a better investor.

The technique is especially powerful, after you’ve run the initial analysis because it allows you to quickly evaluate potential scenarios (i.e sensitivity analysis). What if you paid $160,000 for the property instead – how would that impact your returns? What if the property rented for just $1600 instead? What if you could secure financing at lower interest rates?

Run the Fermi Technique and within 5 minutes you have critical information to make better investing decisions and make more money in the long term.

Closing Note

The Fermi Technique is an approximation method that provides some insight whether you should pursue any further, deeper analysis. It is NOT a substitute for the full fledged analysis that we discuss in How to property calculate the return on a long term investment.

5 Critical Real Estate Investing Lessons I learned in 2015

December 31, 2015 By Erion Shehaj Leave a Comment

Today is the last day of 2015. In a few hours, the bubbly will flow and we get to write a new chapter. That’s why this is the best time to reflect back on the year that was, learn the critical investing lessons it taught us and become better investors in the process.

Year in Review

Real estate markets across Texas entered 2015 with a lot of momentum from the previous year but one giant “elephant in the room”. Oil prices had dropped by 50% at the end of 2014 and everyone questioned how it would impact the labor and real estate markets. And nowhere were these questions as loud as in our home base of Houston – the energy capital of the world.

In “Why did oil prices drop in 2014” published here in February, I offered my take on the impact it would have on our real estate market. The central thesis of that article was that oil prices would certainly have an impact as expected layoffs would affect housing demand, but it would not lead to significantly lower real estate prices in 2015.

After a somewhat nervous start in January, the Houston real estate market didn’t miss a beat and resumed the “song” it had been singing over the last 24 months. The spring and summer seasons swept in and brought with them bidding wars, multiple offers, rising prices. Move on, nothing new to see here.

On the rental market front, it was the same story. High tenant demand, low days on market and multiple applications.

In September, official stats remained strong with rising sales and prices but in the trenches we started seeing the signs of a slowdown. Price reductions, more room to negotiate, some unsold listings. Major players in oil and gas had trimmed down their workforces by 15-20%, decimated exploration budgets and the inward migration of people coming here for work slowed. As it’s often the case with the oil market, no one really knows what will happen before the fact (although many are “experts” afterward). I suppose that after seeing lower prices stabilize and slightly rise midyear, the market and its players realized we were in for a longer slog and lower prices were here to stay.

In October and November, the official statistics reflected what we had seen for some time. Year over year sales dipped during that period and average prices were lower in November as the luxury segment of the market bore the brunt of the hit. Properties priced closer to the average price mark still posted stronger YOY sales and prices. December numbers won’t be out for another couple of weeks but they’re likely to follow the same fourth quarter trend.

After intensified calls for location diversification, Investing Architect explored the DFW market in October.

Again, the rental market followed a similar trajectory to the sales market. October and November are typically slower than the red hot spring and summer season for rentals but this year we felt it more than others.

Lessons Learned

All considered, 2015 was a fantastic year despite some of the challenges posed by volatility in oil markets. When all stats are done and counted, it will be yet another year of strong sales and rising prices.

There are 5 critical real estate investing lessons I learned during 2015 that I want to share with you now.

Lesson 1: Mama said there’d be days like this

When you invest in real estate long term, for next 10, 15 or 20 years, the one thing I can guarantee you is that there will be volatility. I don’t care which period in time you pick, it will never be a linear, sunshine and butterflies, comfortable ride. You can rest assured that there will be times when the rental market is blazing hot and other times when it’s sluggish, when vacancies are zero and when tenants are harder to come by, when values rise by double digits and when they stagnate or fall.

When things are volatile, the best advise I can give you is to trust the process and stay disciplined. Keep your principal goal front and center and don’t forget it. You will be tempted to sell and get out (when you should stick it out) and worst case you might even feel like you don’t have the stomach for it.

Stay the course. Execute.

Lesson 2: “Moving on up” – Interest Rates

December brought us our first FED quarter point rate hike in God knows how long. It was the first but likely not the last. The FED seems determined to get some “bullets back in their gun” just in case there’s another economical slowdown. After all the economy is doing better but not THAT much better. But if they don’t hike now, they won’t have any room in the principal mechanism they have to stimulate the economy.

So in 2016 you should expect a couple more similar hikes. The question I hear most often is: What effect are these rate hikes going to have on investment property mortgage rates? The short answer is: Rates will be higher but only by a fraction of the actual rate hikes. Typically, mortgage rates rise 0.25% for each 1% hike in FED rates. The first hike had more of a 1:1 impact because it was the first time the FED hiked in many years. Subsequent hikes will likely increase rates only incrementally.

Lesson 3: Value increases = Property Tax Increases

Regular readers of Investing Architect know that we are conservative with numbers. Despite the fact that in the last 36 months property prices have appreciated by 2-3 times that rate, we run our cashflow analyses assuming an appreciation rate equal to the rate of inflation (3%). Still, for existing owners of long term investment properties appreciation is the cherry on the cake also thanks to that beautiful thing called leverage.

Let’s say you purchase a property for 170k and you put 20% down. If that property appreciates by 6%, that represents an increase of $10,200 in property value. But you don’t have $170k of invested capital in the property – you only invested $34,000. So that 10,200 increase in property value represents a 30% return on your $34,000 investment. In other words, when you only invest 1/5 of the value of the asset, your return is 5x the property appreciation rate. Like I said, a beautiful thing.

But you know who else notices that your property went up in value? Taxing authorities that rely on property taxes for their revenue. They think to themselves – would you look at that, market values are up, so should property tax values.

And so, your property taxes, the main driver of operating expenses go up.

What are the real estate investing lessons? First, this is exactly why a disciplined long term investor should not engage in optimistic, best case scenario investing. If the analysis was performed correctly, there should be room in the numbers to absorb tax increases when they happen. Second, the disciplined long term investor should always pursue periodical rent increases with their renewal tenants. I know what you’re thinking – they’re great tenants, they pay on time and take care of the place – if I ask for an increase they will walk away and never talk to you again. I get that and the fact is it may not always be possible depending on the market. But it should be the investors ongoing policy to pursue periodical rent increases. Then the decisions on how far that pursuit goes can be made on a case by case basis.

Lesson #4: Greedy when others are fearful

The aggregate behavior of real estate investors is very similar to stock market investors. Both groups tend to invest heavily when the market is comfortable (read: higher) and step back when Volatility brings his old friend Fear to the party. In Buffett’s sage words, be fearful when others are greedy and greedy when others are fearful.

Volatility is opportunity. If properties aren’t selling as fast, you have significantly more leverage in negotiations with Sellers. That presents some interesting opportunities. For example, you could negotiate for the Seller to pay for closing costs thereby lowering your total investment in the property and boosting your return. Or you can make an offer below market and the Seller won’t throw it back in our face like they did 2012-2014.

Don’t sit it out. Adjust your strategy so returns reflect risk.

Lesson #5: Location Diversification

The reaction of the local economy, labor and real estate markets to substantial volatility in global oil markets reinforces our long held belief that Houston remains a strong market for long term investors. If our economy was not diversified, the impact of such a drop in commodity prices would be devastating – similar to 1980s. Having said that, investors with a strong Houston presence in their portfolio should take a look at other Texas locations as well as other similar states to bring some location diversification to their portfolios.

Location Diversification is a major theme for us in 2016. Stay tuned, or better yet (email us) for what’s to come. Hint: We plan to expand our focus to markets across Texas and other similar states in 2016.

Investing Architect explores DFW

October 7, 2015 By Erion Shehaj 1 Comment

Over the years, I’ve been asked by several long time clients about investing in the Dallas Fort-Worth market. At the time, the main reason for their interest was location diversification. While I always thought it a good idea to diversify holdings over markets with different characteristics, I thought there wasn’t a significant difference in location characteristics to achieve any meaningful diversification.

Then oil prices dropped in the $40s and calls about investing in DFW became more frequent. Now the equation has changed from “hey, let’s invest in another city” to “Dallas is Texas growth with less ties to the oil business”. The case for diversification took a whole another dimension. So, I decided to explore the DFW market in greater detail to see if there were any investment opportunities there for our clients. And since nothing beats “boots on the ground” I made the drive north on Interstate 45 and spent a few days exploring different areas, looking at properties and trying to get a feel for the state of the market.

The Process (of elimination)

Before I discuss my findings and impressions of the DFW market, I would like to take some time to explain our methodical process for assessing a new market. This would be very helpful to you if you’re considering investing your hard earned capital in a new market. My process for assessing a new market can be summed up in two steps:

Focus your attention on the areas that fit the criteria
Analyze those areas at a deep level

The first step is crucial especially when you’re analyzing two very large metroplexes like Dallas and Fort Worth. We went about it by being clear about our universal criteria for long term investment properties:

Located in the best school districts
Recently built (10 years old or less preferably)
For single family homes at least 3 bedroom 2 bath 2 car garage and 1600+ sf (it is still Texas after all)
Safe neighborhoods with nice amenities
Decent return on invested capital
Good growth prospects

The first one (school district quality) is the ultimate elimination criterion. We’re just not interested in areas that aren’t zoned to great schools. So the first task at hand was to find out which were the school districts I should focus my attention on. I did look at online data for school quality but nothing beats local knowledge. This is where a long term reader of Investing Architect generously gave of his and his wife’s time to point me in the right direction. Their suggestions matched what I subsequently researched online and it resulted in a much greater focus. Therefore after this all important step was finished, I had focused my attention on areas zoned to a handful of school districts in the North/Northeast suburbs of Dallas and Fort Worth.

The next step was to research the local MLS for recently built, 3/2/2+ single family properties to get an idea about prices. Based on our pricing benchmarks from the Houston market, we decided to focus on properties priced from the mid 100s to the mid 200s. In my experience, you will experience diminishing returns and higher price to rent ratios as you move north of those prices.

Next, properties were grouped by area and we drove by each area to assess the overall neighborhood quality and made extensive notes about each neighborhood.

Then, we performed a detailed cashflow analysis on all properties we scouted to get an idea about rent levels, operating expense and price to rent ratios.

Finally, we retrieved and analyzed detailed demographic and psychographic reports to assess growth prospects through population growth, income levels, and psychographic behaviors of residents in the different areas. I will attach a copy of these reports for you at the end of this article

The findings

First and foremost, the understatement of the year is: The DFW area is experiencing tremendous growth. You don’t have to have a PHD in economics or population patterns to figure that out. You can feel it by simply driving through these areas where entire towns are being developed at the same time. While homes are built at a break neck pace, roads are being expanded, grocery stores, schools, fire stations built. There’s a feeling of great momentum and thrust upward. Driving through downtown you see headquarters and Class A office buildings of Telecom, IT, tech, health and oil companies aplenty and you get a sense of the economic engine that’s driving this growth. Now before you point out that these are just “gut feelings” unsupported by data, don’t rush. I will provide plenty of data in the paragraphs that follow. But there’s something to be said about the fact that economic vitality is something that you can feel simply by driving around and observing what’s going on in an area. So, right off the bat, the DFW market had the right vibe for a prospering growth market.

In driving through neighborhoods in Allen, Frisco, McKinney, Fort Worth, Grand Prairie (to name a few) and walking through properties I was impressed by the construction quality and overall neighborhood plans. I saw brick and stone exteriors, granite counters, laminate or wood floors pretty routinely. I also saw lots of neighborhoods with walking trails, parks, lakes, fitness centers etc. Another quality box checked!

The demographic and psychographic reports had even more good news in store.

Dominant_Tapestry_Map_Fort Worth

Demographic_and_Income_Profile Fort Worth (1)

Up and Coming Families – Segmentation

Professional Pride – Segmentation

For a snapshot of the analysis we did for Forth Worth, above are the demographic and income profile as well as psychographic “tapestry” reports for the area. Median incomes between $65,000 and $127,000, robust population growth between 3.84% – 5.5% (depending on radius), and top two psychographic groups being up and coming middle class families and upper middle class professionals is a very good combination for a market in which to invest.

Now for the moment of truth: The numbers. First the good news: Operating costs in DFW are lower than what we typically see in the Houston market. Property taxes in the DFW area were as much as 30% lower than in comparable Houston properties. The typical tax rate before exemptions in DFW was 2.5% while in Houston it would be closer to 3.25-3.5%. Same story with homeowner association dues – Typical annual fees in DFW were $300 a year while in Houston we average $450-550 a year. Finally, leasing fees are lower in the DFW market averaging about 70% of one months’ rent. Now for the not-so-good news: Rents for comparable properties are 10-15% lower in DFW. In the properties we analyzed, the monthly rent averaged about 0.85-0.9% of the purchase price. So essentially, a property purchased for $175,000 will bring in $1500-1600 in rent whereas the same property in the Houston market would bring in $1700-1725.

After thoughtful consideration of the factors at play, a couple of things become clear. First, since the 2008 recession, property values have risen at a faster clip than rents. The appreciation rate is good news for long term returns but not so good news for in-the-meantime cashflow. Second, I wondered what was the reason for this disparity in growth rates. Or put differently, why does a Tenant in Greater Houston pay a higher rent for a similar property than their counterpart in DFW? Logically, your mind first jumps to income levels. So we decided to look at income levels in the submarkets we researched. In some cases, average and median incomes were even higher than those in Houston and in all the cases they were comparable. So if income wasn’t the deterrent, what was? The best educated guess I’ve come to so far is that management companies and leasing agents in the DFW area have been shy to price rent increases into new inventory and have relied on backwards-looking average rents. That could be good news for investors purchasing property in areas with lower inventory levels because there’s a possibility to boost returns and get higher than backwards-looking average rents. But, in the end, the analysis has to be performed with what is, not what could be.

At the current moment, based on our findings, the DFW market offers cash on cash returns of 5-6% and internal rate of returns of 15-17% for well located, recently built properties that employ a self management system with 20% down payments. If we have to account for professional property management, cash on cash returns are in the 2% range (so basically, break even) and internal rate of returns of 10-11% (assuming 3% annual appreciation). The compensating factor is that appreciation is likely to average much more than 3% so actual returns will likely be higher once it’s all said and done. But again, we analyze for what is erring on conservative side – not best case scenario investing.

To conclude, I was very impressed by what I saw in DFW – I think the market has excellent potential for growth. So I am keeping a keen eye on the market for any opportunities I can pass on to my clients both in the single family and small multifamily space.

P.S As heartbreaking as it is for this Houstonian to admit, I had the best brisket ever at this place in Deep Ellum called The Pecan Lodge. It was so good, I think they should classify it as a dangerous substance. 🙂

What to expect when you are investing – Houston 2015 Edition

September 3, 2015 By Erion Shehaj Leave a Comment

Consider the following scenario: You are a successful professional and through hard work and living beneath your means you have managed to set aside some capital. Thus far, your career has been fine but you want something more. You wonder what might be possible if you were to invest the capital you have managed to save in real estate. Would it be possible to create enough of an income stream to achieve financial independence? Or put a different way, can this investment lead to an income stream that would give you the freedom to invest your time how you want, rather than how you must? You start reading and researching and after a while you are overwhelmed with different strategies pulling you in a thousand directions. Good old paradox of choice. But then you take a step back and look at the big picture: You’re not a gambler, or a speculator and you don’t like excessive risk. You want to invest your capital in real estate but don’t want to invest all your time (i.e don’t want it to turn into your full time job). Therefore you eliminate all forms of investing that don’t fit well with your investment personality and risk aversion. You come to the right conclusion that the best strategy to achieve financial independence is a long term investment strategy. Then one day, you read one of my posts on BiggerPockets or stumble on an article from Investing Architect. And it all seems to make sense. It’s a Lego-perfect fit. At which point, you dive into our archives and read until there are no more.

Sound familiar? Read on.

After reading “How to create a six figure income with real estate investing” (one of our most popular articles) you look through the illustration of the Domino Strategy at work with nine investment properties. And you get really excited. But wait a second – this case study describes the purchase of nine properties priced at $105k each! A quick look at Houston listings for sale reveals that the properties in that price range don’t match the characteristics of properties I describe in these articles.

The source of your confusion comes from the fact that all case studies I’ve written about in the past reflected the property parameters at the time. The Domino strategy Illustration I mentioned above was prepared nearly four years ago when those property prices were available. Needless to say, things a changed a bit since then…

That brings us to the main question of this article: What should a long term investor expect when investing in the Houston area in 2015?

Property specs and price spectrum

First a quick recap of the property characteristics of the target investment property:

Located in a great school district
10 years old or less (unless well maintained)
At least 3 bedroom, 2 bath, 2 car garage
Between 1600-3000 square feet
Better than average finishes (think tile vs linoleum, laminate vs carpet, hard countertops vs formica etc)
Safe neighborhood with attractive amenities
Easy access to highways and employment centers
Offers a fair return on investment (more on this in a bit)

In the current market, properties that fulfill the above criteria fall in a price spectrum between $160,000 and $215000. Those are the outer price “borders” but most properties we are sending to our client’s inboxes these day fall in the $170,000 to $190,000 range.

Cashflow numbers

I know you can’t wait to see the cashflow numbers so I won’t take anymore time. Let’s look at a property I just sent to client before I sat down to write:

Asking Price: $178,900
2300 sf, built in 2002 (well maintained), 3/2/2
Projected Annual Rental Income: $21000
Annual Operating Expenses: $6837 (34%)
Annual Debt Service: $8830
Annual Cash Flow: $3407
Invested Capital: $39500
Internal Rate of Return (10 year hold): 19.64%
Cash on Cash Return: 8.66%

Obviously, not every property will fit those parameters exactly but this should give you an idea about what to expect when investing in single family investment properties in Houston in 2015.

In the end, remember this. Although property prices, interest rates, down payment requirements may (and often do) change, the investing principles and strategies remain the same.

—

In case you may not know this already, I am a guest author for BiggerPockets Blog and write there on a pretty regular basis. In the weeks to come, subscribers to our email list will begin to receive those articles as well as they’re published.

The fascinating paradox with long-term real estate investors

August 19, 2015 By Erion Shehaj 2 Comments

There is this fascinating paradox I encounter regularly in our real estate practice. The overwhelming majority of real estate investors I have the privilege to help, fall on the conservative end of the investing spectrum. They are driven by unbiased logic, need empirical evidence and have a long term focus. If you haven’t left this site yet after reading an article or two, you can probably relate.

But with all that focus on logic, numbers and the “long game” they still succumb to doubts that run counter to all those things. See, we like to think of ourselves as rational beings driven by unbiased logic but the truth is we are hard-wired to respond to certain impulses and fears.

Let’s look at two related misgivings I hear frequently from our clients:

1. “I wish I had met you in … (2008, 2010, 2012 – you name it) so property prices would have been more favorable.”

2. “Shouldn’t I wait to acquire investment properties since we’re in a Seller’s market and prices are high?”

These statements indicate valid concerns but they’re paradoxical in that they run counter to the very core of the conservative long term investor.

Silly Rabbit … Market Timing is for traders

Real estate prices in most markets (Texas included) were substantially lower in 2008-2013 than they are now. Furthermore, most investors that purchased during that time were able to lock in quite a bit of equity and very favorable price/rent ratios. That’s especially true if you consider the increase in rents during the same amount of time. Those are facts that no one can dispute. But our investor clients forget a couple of critical issues when they express the wish to have invested earlier.

First, investing in 2008-2013 seems like a given now that we know “how the movie turned out”. However, at the time, it didn’t seem as such a no-brainer to most investors. I know because I was on the phone with them trying to get them to see it. When the whole nation was curled up in a fetal position waiting for financial Armageddon, it was hard to think about investing for even the most visionary of investors. When you drove into a neighborhood and saw 15-20 foreclosure signs back to back on the same street, it was hard to imagine the time when they would be worth so much more.

But most importantly, that wish disregards a critical truth: The long term investor is fundamentally not an opportunist.

A long-term investor invests to achieve financial independence regardless of the market he’s dealt. That doesn’t mean that a long-term investor cannot or should not take advantage of an especially advantageous real estate market. They absolutely should. However, they should NOT invest only when there’s “blood on the streets” and “going out of business” banners are aplenty. So ask yourself this essential question: Are you a long-term investor or an opportunist and then act accordingly.

Seller markets come with the territory

The average Blueprint plan we devise for our clients entails an investment timeframe of 7-20 years (depending on the resources and goals). Take any 7-20 year period and look at the market conditions over time. It’s not only highly likely that market conditions will change over time – it’s to be expected! As a matter of fact, a scenario in which market conditions remain the same over a decade is almost implausible.

But there’s another fear at work here – no one wants to be the sucker that invests at the top of the market only to ride it downward. That’s understandable. But did you know that the Houston area has been in a “Seller’s market” since the Spring of 2012? What if the investors that purchased properties during that time had succumbed to the same fear and waited for a price drop? They would find themselves wishing they had invested in 2013 when prices were lower. Sometime in the future, investors will speak of 2015 as the ideal time to have purchased because conditions may be less favorable then (read: interest rate hikes).

As long as property valuations are supported by economic fundamentals and we are not in a real estate bubble, the long-term real estate investor keeps her focus on the main goal (financial independence) and executes her Blueprint plan regardless of the market. Sometimes the market is extra favorable, other times it is not. Over the long term, the market will do what the market will do and our goals are still there for us to accomplish. So accomplish them we will.

Should you sell your investment property? A comprehensive guide

August 12, 2015 By Erion Shehaj 1 Comment

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.

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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.