I am a newbie to biggerpockets and I have a real estate investment strategy dilemma.
I currently own two single family homes in Tigard OR since 1997. There were new construct at the time and has been rented out ever since. We were fortunate to have the same renters since the beginning with stable rent. Both properties are located in the same neighborhood and is probably worth around 400-450k each. With renovation, I could probably sell for 500k each. Both are also paid off resulting in a net operating income of 29k annually combined.
I would like to continue to grow my portfolio and I have several ideas in mind:
Option 1: I could sell both properties if I put some money in to update both homes as they are both stuck in the 1990s. Since we had stable tenants, we really did not have the opportunity to renovate the properties. However selling them would trigger larger capital gains tax and lose the benefits of passive income.
Option 2 is to do 1031 exchange both into Multi-family homes/apartment. I have been following the PDX market for several months now and it seems the cap rate in PDX is on the low side (4-5%). I was looking at several properties in the range of 800k-1million and I just don’t see a great return on these compared to my existing rentals. Anything more than 1 million would require a mortgage which can greatly reduce cash flow.
Option 3 is to take equity out of my current two rentals and buy new properties. I am not sure on how to go about doing that and whether I can take something like a HELOC to buy additional properties.
Any idea on how to move forward is greatly appreciated!
Real Estate Investor · San Francisco, CA · Member since 2015 · 16 posts · 4 votes
6y
Hi Nick,
I believe my experience in 2019 has some similarity to your situation. I cannot (and do not want to) tell you what to do, because only you know your exact situation, risk tolerance etc. I hope the info below will help you arriving to a decision.
We owned 3 SFH until the end of summer of 2019. We purchased two of them as our homes one as an investment property. We bought the first (A) for 106k in 2000, it was put into service in 2009. We bought the second (B) in 2008 for 413k and it went into service in 2014, we bought the third (C) in 2013 with a tenant in it for 126k. One day, I will summarize the whole cash flow with repairs, mortgage, depreciation etc., and calculate the IRR, but this has to wait until I am done with my 2019 taxes... So here I give just the most relevant info.
We sold house C in Jan 2019 for 210k. We sold B in July 2019 for 675k and finally we sold A (to the tenant in it) for 197k. We employed 1031 exchanges and the proceeds totaled 730k. (Prop. A had no loan anymore, the other two had well below 50% LTV.)
In 2017 when all 3 was still in service the rent was 71k. Actual (real) expenses totaled to 33k and depreciation was 26k. (In 2018 we did a lot of repairs (partly in prep for sale) and had a 3 month vacancy during sale, so 2017 is a better year to look regarding the CF.) (I estimate that equity was between 600k and 650k in that year, with a significant bump in 2018 and first half of 2019.)
We chose multifamily DST-s to invest in with around 53% LTV.We diversified across geography and sponsor. They pay between 4.5% and 6.7% on equity, with an average of 5.4%. That is 39.6k. These are class A apartment complexes. (One of them will reduce distributions starting May to increase reserves in response to COVID-19. Occupancy and rent payment is still in good shape. I expect to get the amount from the reserve later.)
The 38k income in 2017 is not completely representative, because some repairs were delayed (as is often the case with long serving tenants making repaint, kitchen resurface etc. difficult to do). For example, the 2018 NOI was under 30k due to the above mentioned sale vacancy, repairs and selling costs. With this adjustment of delayed costs the DST distributions are not just slightly, but much higher than my prior NOI and the depreciation expense (and saving) will be higher resulting in additional tax savings. Plus, it is completely passive investment. I note here, that I did not employ a property manager. I had good tenants. I had a handy man and I used a real estate agent who listed for rent in MLS for a flat fee ($250). I still had to hustle when a door and a water heater had to be replaced or the plumbing backed up on Christmas day. I am glad I do not have to deal with that anymore or with tenants going through divorce.
The DST-s are for 7-10 years. You can expect capital appreciation, prior sponsor data is encouraging to indicate total IRR over 10% (but no guarantee). Ask me in 8 years how it all went.
I used a fiduciary financial advisor that I never met in person to help me with the DST selections. I also got a healthy reduction of the upfront commission that is otherwise atrocious. He was great. He got paid well, I still feel I got value for my money. And we are staying in touch. However, I am a do it yourselfer and keep learning about investments and moved beyond what he offers.
I am still happy with the investment choices I made. Originally, I considered buying more DST assets using non-1031 money, but then I found other syndicated real estate investments with (much) higher returns (but less tax advantage than DST-s, and riskier). To give you a taste of those, the investors of these opportunities see 10-12% IRR is not really exciting and do not even look unless the distributions are at least 8%. I am also learning about and moving into alternative investments that are supposedly non-correlated with the stock market and real estate market.
A year ago I was enthusiastic and told some close friends about the exciting new opportunities of DST-s. Then as I learned about many other real estate and alternative investments, I realized that I still know so little. So I stopped offering advice. I only tell about my experience and typically only when asked by someone I know. (So the above was an exception. :-)
Specialist · New York City, NY · Member since 2019 · 53 posts · 28 votes
6y
@Nick Liu have you considered fractional ownership 1031s? Those can generate cash flow for you, though they will typically not be very aggressive in rate of return. There are also no headaches associated with these as they are 100% passive in nature.
Qualified Intermediary for 1031 Exchanges · St. Petersburg, FL · Member since 2013 · 9k+ posts · 9k+ votes
6y
@Nick Liu, Stable rentors are a treasure to be protected. But many times those long term rentors come with a price - below market rent. If you'r true net operating income is around 29K then you're close to that 5% and would need to look further at your IRR to make an apples to apples comparison with any other type of investment.
A sale and 1031 frees you up to take all of your equity and move it into something that produces better. A lateral into similar returns but maybe greater cash flow isn't a bad thing. Obviously the ideal is greater return and greater cash flow.
The refi is an expense but it lets you keep the properties you have now and lets you take 70-75% of your equity to go into something else. So it really comes down to your thinking about those two houses - do you like em long term??
Another option I'd be looking at with tenants that have been with you that long is a sale to them or a lease option to them if they need more runway to get ready to purchase. You know they love the area and don't want to move. You could save remodel and realtor costs and still pocket some option money. Then you 1031 when they purchase. Meanwhile you keep milking the cow.
Real Estate Agent · Indianapolis, IN · Member since 2020 · 103 posts · 112 votes
6y
@Nick Liu first off, I want to say that you have done a great job with the investment you have made so far, being able to own two properties worth a total of $900k free and clear is not easy and takes patience. As you have determined, now that you have gotten to this point, now is a perfect opportunity to look forward on what to do next.
Based on what I am hearing, you have two properties worth about $450,000 each cash flowing around 3.22% as is ($29,000 NOI/($450,000 X 2 properties))= 3.22%. And you can make renovations and get an additional $50,000 for each property. First off, unless the renovations will cost less then $25,000 per rental, then I wouldn't do it. In the end, you want to make money on the money you put into your properties and if the cost were $50,000 and the net gain from said renovations were $50,000, you would be wasting a lot of energy. Now on the other hand, if you feel like you will need to renovate to simply sell the properties, then obviously I would think about doing the renovations.
As far as your options are concerned, here are my thoughts.
Option 1. Selling and taking a capital gain hit would be very costly in this situation. Since you owned the property since 1997, you have likely depreciated a majority of these properties and the gain on unrecaptured property (top tax rate of 25%) will really eat up your proceeds. Not to mention the actual gains on appreciation that you will likely pay (top tax rate of 20% dependent on AGI), net investment tax (typically 3.8% for some sellers), and state capital gain tax (varies by state). That being said, my first inclination would be tying to do some sort of 1031 exchange if your goal is to continue to build your portfolio. Again, this is without going into in depth analysis of your tax situation, but from experience, this has typically been my suggestion for my clients historically.
Option 2. You mentioned doing a 1031 exchange into some multi family property that are running at CAP rates of 4-5%. Based on you scenario, if you took your net proceeds (selling price minus closing costs and brokers fees) from the sale of the two properties into an investment that had a CAP rate of 4-5%, assuming your net proceeds were $850,000, then your new unleveraged cash flow should be close to $38,250 ($850,000 X 4.5% = $38,250) which is about $9,250 more in annual cash flow then what your investments are producing today. If you want to know my opinion, I think you can find a much better return then 4-5%. Just as an example, I recently worked on a SFH portfolio here in Indianapolis worth of about $1M that had unleveraged cash flows around 10% and rents were below market and the properties were in great locations. I have even worked on single tenant triple net commercial properties that had 10 years leases, no landlord responsibility, and sold for 7% CAPs. Long story short, I think you can find a better returning property but you might have to look a little out of state. You have a really good opportunity to double or even triple your cash flow.
Option 3. You mentioned to refinance the properties and reinvest the proceeds into new properties. Typically, this has been the best choice for investors that love leverage and intend to build their wealth through leverage, which is not right or wrong just a matter of preference. However, I hear two things in your situation, 1) you don't like the idea of more debt and 2) the cash flow return would need to be significant enough to cover the new debt liability. If your situation, with a 3.22% CAP, your cost of capital (interest) will likely be a lot more. If your interest runs at 6%, it will significantly erode at your current in place cash flow at 3.22%. In order to use leverage in a positive way, you would need to have an investment that has a net return (cap rate) greater then your cost of capital (interest). Based on my calculations, if you refinanced on a 30 year fixed mortgage at 6%, you would only be able to pull out $400,000 (about 44% LTV) before it completely eliminated your cash flow, let alone banks typically only let you pull out at a 1.2X-1.25X DSR (debt service coverage). I just don't see this as a viable option in this scenario even without running IRR projections.
Recommendation. The good news is that you currently have a very safe investment with very reliable tenants. The downside to that is that it sounds like you don't have much upside. My recommendation would be to look more into a 1031 Exchange and really consider looking into something with higher yield. If you truly like the multi family value add aspect, then it might be hard to find something in OR.
Real Estate Investor · San Francisco, CA · Member since 2015 · 16 posts · 4 votes
6y
Hi Nick,
I believe my experience in 2019 has some similarity to your situation. I cannot (and do not want to) tell you what to do, because only you know your exact situation, risk tolerance etc. I hope the info below will help you arriving to a decision.
We owned 3 SFH until the end of summer of 2019. We purchased two of them as our homes one as an investment property. We bought the first (A) for 106k in 2000, it was put into service in 2009. We bought the second (B) in 2008 for 413k and it went into service in 2014, we bought the third (C) in 2013 with a tenant in it for 126k. One day, I will summarize the whole cash flow with repairs, mortgage, depreciation etc., and calculate the IRR, but this has to wait until I am done with my 2019 taxes... So here I give just the most relevant info.
We sold house C in Jan 2019 for 210k. We sold B in July 2019 for 675k and finally we sold A (to the tenant in it) for 197k. We employed 1031 exchanges and the proceeds totaled 730k. (Prop. A had no loan anymore, the other two had well below 50% LTV.)
In 2017 when all 3 was still in service the rent was 71k. Actual (real) expenses totaled to 33k and depreciation was 26k. (In 2018 we did a lot of repairs (partly in prep for sale) and had a 3 month vacancy during sale, so 2017 is a better year to look regarding the CF.) (I estimate that equity was between 600k and 650k in that year, with a significant bump in 2018 and first half of 2019.)
We chose multifamily DST-s to invest in with around 53% LTV.We diversified across geography and sponsor. They pay between 4.5% and 6.7% on equity, with an average of 5.4%. That is 39.6k. These are class A apartment complexes. (One of them will reduce distributions starting May to increase reserves in response to COVID-19. Occupancy and rent payment is still in good shape. I expect to get the amount from the reserve later.)
The 38k income in 2017 is not completely representative, because some repairs were delayed (as is often the case with long serving tenants making repaint, kitchen resurface etc. difficult to do). For example, the 2018 NOI was under 30k due to the above mentioned sale vacancy, repairs and selling costs. With this adjustment of delayed costs the DST distributions are not just slightly, but much higher than my prior NOI and the depreciation expense (and saving) will be higher resulting in additional tax savings. Plus, it is completely passive investment. I note here, that I did not employ a property manager. I had good tenants. I had a handy man and I used a real estate agent who listed for rent in MLS for a flat fee ($250). I still had to hustle when a door and a water heater had to be replaced or the plumbing backed up on Christmas day. I am glad I do not have to deal with that anymore or with tenants going through divorce.
The DST-s are for 7-10 years. You can expect capital appreciation, prior sponsor data is encouraging to indicate total IRR over 10% (but no guarantee). Ask me in 8 years how it all went.
I used a fiduciary financial advisor that I never met in person to help me with the DST selections. I also got a healthy reduction of the upfront commission that is otherwise atrocious. He was great. He got paid well, I still feel I got value for my money. And we are staying in touch. However, I am a do it yourselfer and keep learning about investments and moved beyond what he offers.
I am still happy with the investment choices I made. Originally, I considered buying more DST assets using non-1031 money, but then I found other syndicated real estate investments with (much) higher returns (but less tax advantage than DST-s, and riskier). To give you a taste of those, the investors of these opportunities see 10-12% IRR is not really exciting and do not even look unless the distributions are at least 8%. I am also learning about and moving into alternative investments that are supposedly non-correlated with the stock market and real estate market.
A year ago I was enthusiastic and told some close friends about the exciting new opportunities of DST-s. Then as I learned about many other real estate and alternative investments, I realized that I still know so little. So I stopped offering advice. I only tell about my experience and typically only when asked by someone I know. (So the above was an exception. :-)
Love the 1031 exchange idea, or even a sales deferred trust, both great ways to defer taxes into a better/larger cash flowing asset.
But as a fellow investor living in Oregon - I do not recommend investing in OR. The landlord laws on top of the returns and price point just do not make sense when compared to what you'll find in the South East or Midwest. Look at markets with positive Job, rent and Population growth as well as low unemployment. My 2 cents.
Additionally, HELOCs are a great tool. And usually better than refinancing a home as the fees are better. And I say usually because right now things might be different with the lower mortgage rates, just need to do your research on that. And then weigh that against your current mortgage rate - is it worth it? But with a HELOC the fees are lower and you can typically get 80-100% loan to value for as low as 5%, although things may have changed due to the whole Covid response. Again, you'll have to check into that.
Turn key provider · San Jose, CA · Member since 2010 · 4k+ posts · 3k+ votes
6y
@Nick Liu if you were to sell, I would recommend doing a 1031 exchange, however, I would always be reluctant to see a performing cash cow that has a long history of success. Personally, I would favor option 3.
