To rent or sell existing home after purchase of new home in Southern California

15 Replies

I'm sure this question comes up often when people upgrade to a new home but don't need to sell their existing home as a contingency. I'm looking for advice on the following scenario. 

Party decides to buy new home and is contemplating selling or renting existing home. The existing home is worth approx $1,000,000 and has a mortgage balance of $490,000. Mortgage, property tax, insurance, gardener, and pool guy run a total of $3,600/month. The home is turn key having been completely stripped down to the studs and rebuilt 2 years ago. The home is located in a beach community in southern California with higher than average appreciation rates. Based on current amortization schedule the current monthly principle reduction is around $1,100 per month.

The home has some other unique features that are rare in the area such as a private double sized lot. The owner has been told that rents for a home like this could fall into the $3,600-$4,000 per month range living little room for emergency improvements/maintenance etc. Monthly cost for property management company is $150.

For all you buy and hold investors out there would you consider renting a property like this situation knowing that the mortgage is getting paid and where the appreciation trends are at in southern California? I calculated the yearly principle reduction at approx $13,200 which is around 3% of the equity in the property. In researching the average trends for southern California beach communities in the last 20 years I found a 4% annual appreciation on average for the area. 

7% return is not amazingly appealing but I know southern California real estate plays by a whole different set of rules. 

In keeping and renting the property there is also the option of refinancing the loan which will insure cash flow but reset the amortization schedule and of course lengthen the payoff term. 

So what does the community think? Sell or Rent?

Thank you in advance for your investor feedback. 

Correction on the Return calculation. The 4% per year is on the total value of the property so in this case $40,000 or 4% on $1,000,00. This added to the mortgage reduction yearly amount of $13,200 totals $53,200 or 10.5% return on equity of $505K. 

I'm not sure if I'm doing the math right and would love some feedback

In my opinion, refinance to get the lowest payment possible and rent.  

I would also make the tenants pay for the gardener and pool guy just like they should be paying for all of the other expenses as well (with the exception of mortgage, taxes, and insurance of course). 

After a year of renting, consider a 1031 exchange to sell and buy something that produces more cash flow so as to avoid capital gains.

@Matthew G.

 This really comes down to what you think the appreciation rate is going to be over time. It is not a cash flow play. Of course CA in general has very strong appreciation over time but the rate of appreciation varies a lot depending on the area. I'm in the San Francisco Bay Area where appreciation is crazy so I usually tell people that if they can keep something and turn it in to a rental, they will usually do very well here. This isn't the same as buying an investment property with no cash flow and counting on appreciation. You've already taken the risk and own the property. Now it's a matter of what's the best use of the asset. The main thing I would be looking at is your return on equity. You have $510K in equity sitting in the home. Will the expected appreciation give you the return on the existing equity that is attractive to you or can you deploy that $510K somewhere else and get a better return? CA real estate appreciation over the long run is about 5-8%. $50K-$80K per year return on $510K of  equity doesn't look too shabby to me. Of course you can also refinance it and pull some money out to invest somewhere else with rates so low. In any case, I would opt for holding on to it but that's just my 2 cents.

Why not just sell the property now and avoid paying capital gains since it is a primary residence?  Take the proceeds and invest in something with a better return if the party is set on investing in real estate.   

If you (or the party in this case) were to look for an investment property would you consider buying a 1 million dollar home knowing you could only rent it for $3600-4000?

If I had $500,000, I'd buy a multi-family building.

You should expect costs to be higher than you've accounted for.  The monthly fee to the PM won't be all the fees you'll have to pay to them, or for other repairs and maintenance.

It seems to me that $500,000 equity could be making you more money if you bought even a duplex.  Plus, with a multi-family property, if one tenant moves out, you don't lose all income from the property while cleaning, painting, and showing the place to find the next tenant (all of which will cost more with the PM to handle, too).

That is a nice problem to have. I am still new so my 2 pesos...double lot in beach community could lead to some great forced appreciation opportunities. When you look at places like Manhattan Beach those double lots became worth millions with forced appreciation.  Perhaps add that part to calculus. If this property doubled in 10 years would you be surprised? When your kids find out Dad sold that back in 2015 ...well you know... You can always tap equity and or sell later if there is no need or rush ....

@Matthew G.

I recommend selling the place because it makes for a lousy rental property.

Even taking @Jeff Trevarthen 's suggestion about the pool guy and gardener, this place makes next to no money:

Monthly Mortgage payment $1,790.31

Taxes $1,000.00

Sewer and Water $-

Trash $-

Heat/Utilities $-

HOA/Legal $-

Cap Ex and Ops $150.00

Insurance $400.00

Mgmt Fee $140.00

Vacancy $324.00

Total Expenses $3,804.31

Total Revenue $4,000.00

Cashflow/month $195.69

Cashflow/year $2,348.31

The numbers are individually made up, but it comes out to your statement that PITI plus pool/garden expenses were $3600.

The vacancy assumes it is empty 1 month per year.  Is that right for that area?  If places like this are hard to rent, this is a serious loser every month.

i think it depends on your personal investment strategy and what you're comfortable with to try and maximize returns. 

Have you thought of using the property as a vacation rental? Without knowing much about the property, I would think, a million dollar So. Cal beach community vacation rental would give you better returns than the regular rental returns. Listen to BP Podcast 114, if you haven't already.

Personally I think most investors, on BP would look at this scenario and either sell the house and put the equity into better returning investments or if the numbers work for a vacation rental, see where that takes you. If vacation rental works well maybe, refinance at a certain point, (seeing what equity you can safely pull out with your numbers still working for the property to pay for itself) putting the equity into better returning investments and hope for some good appreciation down the road.

@Matthew G. I would go for avoiding capital gains as well...I'd you are married, you can avoid the whole gain possibly - talk to a CPA first. That equity could make you a lot more money in the long run.... With down payments on many multi-family units. 25-30% down with 500k to invest! You have to think about where you would want to invest and look at what your returns can get you with that kind of down payment. Maybe 5x the return you are looking at now. 

Thank you everyone for your advice. That's why this forum is so amazing because you get great points of view from a variety of different backgrounds. I discovered another option to renting that could help with cash flow. Keep in mind that historical appreciation is 6-8% per year and it is the consensus with Realtors and brokers that we are in a very good up trend cycle at least in this area.

I had two other options for renting presented to me. 

Refinancing to a low interest 7yr fixed around 3% or interest only for 7 yrs. This could create up to $1k in cash flow (rent comps came in at $3,800-$4k/month) with little to no principle paid down. Assuming the property appreciates for next 3 years at trended rates there can be the expectation of $55k-$66k per year in appreciation? In this vehicle I will essentially be pulling the principle reduction out as cash flow and basing the equity increase on appreciation only instead of combining them in the last scenario without the refinance? Then sell in 2-3 years to avoid cap gains or 1091 etc. I get that this will not look good to some investors outside of southern California. 

The overall return is the same 10-14% but the money is not completely tied up in the property.

Thoughts?

If you are in it for the long term, I would rent it. 

Rents will go up. Value will go up. 

In 20 years, you will look back on the decision and think,  "Why did I even need to ask that question? What there really a decision to be made there?"

Originally posted by @Matthew G. :

Thank you everyone for your advice. That's why this forum is so amazing because you get great points of view from a variety of different backgrounds. I discovered another option to renting that could help with cash flow. Keep in mind that historical appreciation is 6-8% per year and it is the consensus with Realtors and brokers that we are in a very good up trend cycle at least in this area.

This part of your thinking has me worried.  

First of all, ignore what Realtors and brokers are saying.  They are not investors and their job is to sell real estate, not predict the future.  Most economic forecasters whose job it is to predict the future are wrong year after year, so why would you listen to somebody that probably isn't educated in economics and has no consequences for being wrong?

Secondly, I think your numbers for historical appreciation are way off.  I'm a Huntington Beach native and also own property there.  I have many relatives that have owned in Huntington Beach since the 1970's-80's... parents, aunts & uncles, cousins, etc.  Their home values have not gone up by 6-8% over the long run.  My mom bought two miles from the beach in 1987 just before the late 80's bull run for $250k.  According to Zillow, her place was worth $800k last year.  So compounded over 27 years, the appreciation rate is more like 4.4%.  And that's with buying just before a strong bull market and counting through the end of the recent strong appreciation from 2012-2014.  If you were to calculate the compounded appreciation at the bottom of the market, it would look even worse.

Since we just concluded a few strong years, I think you should forecast below average appreciation in the coming years and see how it affects your calculations.  Personally, I would take the tax free gain and put it towards something more productive.  There might be a couple more years to this bull market, so consider letting your money ride just long enough to still qualify for the capital gains exclusion and then move on.

Originally posted by @Brent Seehusen :
Originally posted by @Matthew G.:

Thank you everyone for your advice. That's why this forum is so amazing because you get great points of view from a variety of different backgrounds. I discovered another option to renting that could help with cash flow. Keep in mind that historical appreciation is 6-8% per year and it is the consensus with Realtors and brokers that we are in a very good up trend cycle at least in this area.

This part of your thinking has me worried.  

First of all, ignore what Realtors and brokers are saying.  They are not investors and their job is to sell real estate, not predict the future.  Most economic forecasters whose job it is to predict the future are wrong year after year, so why would you listen to somebody that probably isn't educated in economics and has no consequences for being wrong?

Secondly, I think your numbers for historical appreciation are way off.  I'm a Huntington Beach native and also own property there.  I have many relatives that have owned in Huntington Beach since the 1970's-80's... parents, aunts & uncles, cousins, etc.  Their home values have not gone up by 6-8% over the long run.  My mom bought two miles from the beach in 1987 just before the late 80's bull run for $250k.  According to Zillow, her place was worth $800k last year.  So compounded over 27 years, the appreciation rate is more like 4.4%.  And that's with buying just before a strong bull market and counting through the end of the recent strong appreciation from 2012-2014.  If you were to calculate the compounded appreciation at the bottom of the market, it would look even worse.

Since we just concluded a few strong years, I think you should forecast below average appreciation in the coming years and see how it affects your calculations.  Personally, I would take the tax free gain and put it towards something more productive.  There might be a couple more years to this bull market, so consider letting your money ride just long enough to still qualify for the capital gains exclusion and then move on.

 Thanks for the insight. In recalculating at 4.4% it still yields a return of $48,400 per year on $600k equity which is an 8% return on investment? That coupled with $13k per year in principle reduction brings it to 10%. Perhaps that is not a good return for this type of investment.

I'd love your thoughts on what you look for as something that is more productive. 

Originally posted by @Brent Seehusen :
Originally posted by @Matthew G.:

Since we just concluded a few strong years, I think you should forecast below average appreciation in the coming years and see how it affects your calculations.  Personally, I would take the tax free gain and put it towards something more productive.  There might be a couple more years to this bull market, so consider letting your money ride just long enough to still qualify for the capital gains exclusion and then move on.

This is very possibly true. Because the history of CA real estate is periods of falt to even slightly negative appreciation followed by periods of appreciation at roughly a 45 degree angle. I guess if he wanted to sell, now would be the time to do it. But I would rather capture more 45 degree angles.

@Matthew G. @Mark Whittlesey

The main reason I would think of selling is to lock in the tax free gain.  You could sell this place and buy the one next door if it's such a great investment, and save up to $125,000 in cap gains taxes (Federal + State, and possibly more if subject to 3.8% Obamacare tax).

The 10% return is banking on long term appreciation which may not show up for many years, so personally, I would rather not count on that.  If it does show up, then you have a return comparable to the stock market, but with more responsibility.  That might be fine if you want the diversification.  Part of the decision depends on your goals.

I hope all goes well whatever you decide!

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