To sell or not sell rental property in SF Bay Area

17 Replies

Hi BP! 

My wife and I are looking for some advice from the real estate community! My apologies if this is not the right place to ask (this is my first post). I'll start with our goal, which is to free up or access about 200k of cash for primary residence improvements and emergency savings. Here is the background:

  • We own 3 homes in the SF Bay Area - our primary residence and 2 rental properties that were both former primary residences. 
  • Rental A is worth about 550k and we owe 210k at ~3.6% for about 25 more years. It has about $600/month positive cash flow today.
  • Rental B is worth about 1.4MM and we owe 550k at ~3.8% for about 27 more years. It has about $300/month positive cash flow. We have a 150k HELOC available to us, at about 5.2%, which we have not drawn on yet.
  • We are in our early 30s and have solid jobs/incomes and retirement plans. We only have about 3-4 months of emergency savings at this time

Options we are evaluating: 

  1. Continue as-is and use the HELOC to fund our primary residence improvements and any emergencies we have
  2. Sell Rental B and collect about 700-800k in cash after taxes/fees. Keep 200-300k in cash and invest the rest in the market or other diversified areas. We are eligible for the 500k capital gains exclusion in this scenario. 
  3. Cash-out refi on Rental B and access 150k cash, which would make cash flow go negative, about -$200/month. The reason to do this would be expectation of long term appreciation in the home and higher future rents that would hopefully cover the negative.

Perhaps there are other options we should consider too, but i'm curious to hear thoughts from the community specifically on option 1 vs 2. If I do an annual ROI calculation on our rental income against the equity in the house, it is extremely small (ie. 3600/750000=0.0048). Am I thinking about this the right way? Option 2 would easily give us everything we need and more, but we would lose out on future passive income of course, and a huge nest egg. We are also concerned that all 3 of our properties are in the Bay Area, and a huge natural disaster like an earthquake could wipe us out financially. Selling 1 would allow us to diversify our investments a bit more.

Thanks in advance for your opinions!

-Chris

Another strategy for option 2 (Selling Rental B) is to do a 1031 exchange and purchase a property (like a small multifamily) that would yield better ROI than a single family home. This would defer all the capital gains not just the 500k exclusion.

Wow, awesome post! We are in almost an identical situation in the Seattle area and have a year to sell before we have to start paying capital gains on our rental. The other factor for us is to invest that money in a location that is much more landlord friendly than Seattle in addition to achieving a better ROE (return on equity). I look forward to seeing the responses!

@Chris Meunier , you're thinking about things correctly. 

Not factoring in appreciation, your rental B with 850k equity earning $3,600/yr giving you an ROI of four tenths of a percent is correct.

This is a very personal question about what path you want to take. 850k equity turning into 700k cash after fees/costs could be put towards a 25% down payment on a 2 million dollar 20+ unit apartment in a lower cost area where you should be able to generate $60k/yr in net cashflow, but there's work involved. 

Or leaving house B as is and it being worth 1.4million and appreciating on average 4'ish% a year would give you a theoretical $56,000/yr in appreciation. 

Most people on BP would say sell right away because appreciation can't be counted on and cash flow is all that matters. All those people would have sold their Palo Alto homes in the 1980's thinking prices have peaked. 

I personally believe the Bay Area will always be one of the most desirable and best appreciating places in the world to own a home, and would not sell. 

You mention that you have solid jobs, how long would it take you to just save the money to complete your improvements? Are you willing to wait that long?  Also I would probably not advise selling one of your rentals until you have thoroughly evaluated a new market that you would like to invest in with the proceeds. because it would be a shame to have the cash sitting in the bank earning next to nothing in interest while you research other markets. 

If it were me I'd use the HELOC to fund improvements if savings from my job were not enough to pay for it in a reasonable amount of time, when done you might be able to refinance your primary residence to pay off the HELOC in exchange for a slightly higher payment on your primary residence mortgage.

Originally posted by @Chris Meunier :

Hi BP! 

My wife and I are looking for some advice from the real estate community! My apologies if this is not the right place to ask (this is my first post). I'll start with our goal, which is to free up or access about 200k of cash for primary residence improvements and emergency savings. Here is the background:

  • We own 3 homes in the SF Bay Area - our primary residence and 2 rental properties that were both former primary residences. 
  • Rental A is worth about 550k and we owe 210k at ~3.6% for about 25 more years. It has about $600/month positive cash flow today.
  • Rental B is worth about 1.4MM and we owe 550k at ~3.8% for about 27 more years. It has about $300/month positive cash flow. We have a 150k HELOC available to us, at about 5.2%, which we have not drawn on yet.
  • We are in our early 30s and have solid jobs/incomes and retirement plans. We only have about 3-4 months of emergency savings at this time

Options we are evaluating: 

  1. Continue as-is and use the HELOC to fund our primary residence improvements and any emergencies we have
  2. Sell Rental B and collect about 700-800k in cash after taxes/fees. Keep 200-300k in cash and invest the rest in the market or other diversified areas. We are eligible for the 500k capital gains exclusion in this scenario. 
  3. Cash-out refi on Rental B and access 150k cash, which would make cash flow go negative, about -$200/month. The reason to do this would be expectation of long term appreciation in the home and higher future rents that would hopefully cover the negative.

Perhaps there are other options we should consider too, but i'm curious to hear thoughts from the community specifically on option 1 vs 2. If I do an annual ROI calculation on our rental income against the equity in the house, it is extremely small (ie. 3600/750000=0.0048). Am I thinking about this the right way? Option 2 would easily give us everything we need and more, but we would lose out on future passive income of course, and a huge nest egg. We are also concerned that all 3 of our properties are in the Bay Area, and a huge natural disaster like an earthquake could wipe us out financially. Selling 1 would allow us to diversify our investments a bit more.

Thanks in advance for your opinions!

-Chris

 I think your return on property B is too low. Is that a single family ? I would not sell it, but 1031 exchange for a few multifamily houses to avoid capital gains taxes. Explore some out of state markets if yours is too expensive .

Thanks all! 

@Lana Lee - yes it's a single family. The SF Bay Area is likely too expensive to 1031 into better cash flow situation so I would likely need to explore out of the state, which I have not thought about at all yet.

@Aaron Klatt - good call on using the HELOC to fund improvements, and I had not thought of refinancing our primary down the road to help pay off the HELOC. Our cash savings would not reach the level we want for several years probably for us to feel comfortable, hence our desire to unlock some cash.

@Christian Wathne - I had not thought about getting into another property/set of properties if we sell one of ours, partly because we want to reduce the stress and time of owning/managing another rental. However if there are low-risk hands-off ways to do an out of state investment I would certainly be open to it, especially if it provided solid cash flow. Where might I research available options like this?

Chris,

B.t.w., I looked up the properties in question so that I can provide better feedback.


A few things:

- both rental markets are still appreciating

- all rentals are in good areas but rental B market is the more prime one between the two.

- you have a little over 2 years left on being able to take advantage of sec 121 of the tax code (giving you that 500k exclusion)

I'm with you that diversification is a good thing.

There is a way to sell rental A, get cash in hand and still defer taxes (I'm basing that on info provided)

You'd probably end up with about the amount that you're looking for. (PM if you want to know more)

It's always good to know what the plan with the money that comes out of a property but there's some places you could park it while make a very decent return if you're in a situation where you figure out the rest.

I know some folks that do syndication - where you invest with a bunch of folks - where they get good returns. Also, you could invest with some folks in the Sacramento area where the rentals are turn-key with management, etc. already in place.

Seems like have a lot of options so pick whatever makes you comfortable on the many different levels.

Dominique

I suggest stay the course, just focus on saving more in the next 12 – 18 months before you execute on your home improvement project. This I hope will give you enough time to accumulate enough for both the rainy day fund and the home improvement project. Personally I would not sell any BA real estate. It is one of the world’s most valuable currencies, so I’d hold on to it. If you sell you will not be able to get back in. You already seem like you have at least 3 mortgages (unless you own the primary residence outright) and perhaps not a great idea to add another loan on the balance sheet.

Lastly your point on diversification is valid but then who is to predict that. An earthquake in the bay is a scenario that is actually a smaller probability than the hurricanes and tornadoes in other parts of the country. So pick your poison on that one.

Look at the numbers. Would you buy those buildings at the prices they are worth today and get that little cash flow for that investment? If the answer is no way (and it should be) then you should sell and re-invest elsewhere. You could sell the 2 rentals and 1031 exchange tax free into another market and buy many buildings or 1-2 apartments or some NNN lease properties. You could sell and 1031 into a DST investment or you could sell and pay the capital gains and invest in syndication's. Either way you look at it, you have very little cash flow with a ton of equity. Your money(equity) is making very little ROI.

@Chris Meunier this is a difficult question to answer because it’s such a personal decision and the challenge is finding the right answer for you, which no one on BP can do for you. But what we can do is give food for thought.

At the bottom of the market (2011) I bought 120+/- rentals in the Bay Area and Sacramento and I’m selling. For me it was a trade—just taking advantage of a dislocation in the market that I thought would correct and now that the plan went as expected it’s time to move on. And it was a hell of a great ride!  Your reason for owning isn’t a trade, it’s a long-term investment strategy so what is right for me and my investors isn’t necessarily right for you. But the type of move in valuation we’ve seen as of late is one for the history books.  I don’t expect it to continue.  Nor do I think that there is a sharp drop looming on the horizon.  But if you are attached to these properties because of the past appreciation you might want to really consider if that’s going to continue. 

The new tax law includes the virtual elimination of the deduction of state income tax.  California is one of the highest-taxed states in the country. It’s also one of the most regulated. And near or at the top of most lists of worst states to do business.  And housing costs are reaching the stratosphere. How long will it be before nice weather is no longer a strong enough magnet to overcome all of that adversity?  And when will the big businesses that are driving the housing demand move to friendlier states?  I don’t know the answer, but what I do see are notable corporate expansions in other states amongst companies that had considered, and rejected, California.  Tesla built their battery plant in Reno.  Lucid Motors chose Arizona over Sacramento.  Amazon didn’t even put CA on their list for HQ2.  This might be a trend in the making, so will the rampant appreciation continue?  This could be a bigger threat than earthquakes, hurricanes or tornadoes because the effects could go on for decades if it gets bad. 

But perhaps that doesn’t happen and appreciation continues (but most likely at much slower, sustainable rate). So perhaps you keep rental A. You are getting a 2.1% return on equity. Not great, but appreciation, if it continues, could make up for that. 

But rental B is throwing off four-tenths of a percent return on equity. You could earn that in a savings account!  Perhaps there’s an argument to keeping it but the $500K tax exclusion is a very compelling reason to sell.  Once that times out you’ll lose it unless you move back in for two years. I’d forget the advice to do a 1031 (which is a tax deferral, not elimination strategy).  Instead of being forced to re-invest in like-kind real estate with 45 days to find a replacement property, I’d take the tax-free $500K and pay the tax on any gain gain above that at the low capital gain rate and have the freedom to invest the cash in whatever you want, whenever you want, and keep $200K or so for your home improvements and some extra reserves. 

Then you could buy something else (or several somethings else) in areas where taxes are low and businesses are expanding, or invest in syndications where groups are buying larger properties in those areas (giving you some completely passive opportunities for diversification). The new tax plan is a boon to real estate syndications because 20% of the profits won’t be taxed, so you get a savings that way, too.

That plan gives you exposure to potential remaining upside in CA appreciation via your primary home and rental A, and gives you geographical and asset class diversification plus some cash and higher cash-on-cash return via the sale of rental B.  Seems like a win-win.

Oh, I almost forgot—turning rental B into negative cash flow and going into more debt by using your HELOC for your home improvements? Just go back and read about all of the folks that did that 10 years ago and see how well that worked out for them when the economy moved against them. You've put yourself into a great spot, be careful not to to take one step forward and ten steps back.

@Chris Meunier , You've done a fantastic job of balancing your choice occupation with some very wise real estate moves on the side.  I love the way you've laddered your primary residences to now. Implementing strategies for tax free moves is huge and particularly in CA where taxes on investing were onerous, are now made worse with the tax reform bill, and follow you even if you take your investment real estate outside CA.

So given my proclivity for tax advantage I'd look at your situation and say you need to sell asset B while you can still take advantage of the primary residence exclusion.  This gives you the greatest tax advantage and the greatest freedom of choice.  The one argument against this would be that the greatest strength of CA real estate has always been appreciation.  So if you anticipate continued appreciation offsetting taxes and opportunity cost then you may think about holding it.   But as an investment asset for cash flow it's pretty grim.  What is that return on equity - .5%?  

Again, it appears that you're more into your jobs and using real estate as an add on to your life rather than making real estate investing your whole life.  Nothing wrong with that at all.  So if that property is stable and you anticipate continued appreciation and you can withstand any down turn and you like where your life is now then keep it - but no way should you put yourself into a negative cash flow position.  If you want to improve your current house then sell the asset.  The income is tax free.  It gives you the freedom to reinvest however wherever and when ever you want.  And you'll be very pleased with the options you do have for reinvestment that are safe stable and ever so much more lucrative from a cash flow position than your current.

One additional thought - If the gain from the sale of B would actually exceed the $500K max you can combine that and do a 1031 exchange on the remainder and defer the rest of the gain and the recap on depreciation.

1031 B into something that has a good return, then raise the rents or something else that would increase it's value, then pull out 210k of it maybe through refi or whatnot and pay off A.

Then you'll have a better performing asset that can still appreciate AND house A is paid off in case something happened you'd have something free and clear. You could even take more out to bump up your savings...

@Chris Meunier Selling Rental B and taking the Tax Exemption seems to be logical at face value. I would check with an accountant/tax expert (that's not me) and clarify the gains exemption.

Once liquid maybe you then invest in a market like Phoenix, AZ where you can buy solid rentals for under $200,000 all day long. Have the property managed by a professional as an out of state investor and you are good to go again with a reason (deduction) to visit a nice warm spot once in a while.

if you’re both working full time jobs, and aren’t trying to become active RE investors, I’d stick with option #1 and stay the course. Here’s why:

1. You already know these properties well. And they are near you, so easy to manage. 

2. You already locked in your property taxes at a low rate. 

3. You already have long term financing at a low fixed rate. 

4. Sounds like the second rental is in a prime area, but both homes will see nothing but continued appreciation over the years. 

Just use that heloc for the emergency fund, and decide how much to put in home renovations from the heloc vs saving it going forwards. $150k isn’t an insane amount to take on, and the home improvements will add on to the value of your home too. 

Extra credit: if you want to get more ambitious in RE investing, you could leverage and make another purchase, or 1031 the expensive home into 2-4 units in the Bay Area. That'll give you a better return, but a lot more work. Don't trip out too much about the low return. It's only low because of the killer appreciation you got! What would you prefer, a 5% return and then the home is worth a fraction of what it actually is now? Owning 3 SFH's in the Bay Area is a luxury. I wouldn't change a thing.

Wow, I am amazed by all the responses! Such great advice and different perspectives I had not considered. A few additional points to add, based on what many of you have said or asked about:

  • For Rental B, we still have until 2020 to use the 500k capital gains exclusion, given the 2/5 rule
  • For Rental A, we can't use the 500k exclusion
  • Generally speaking, a 1031 exchange is not a good option for us because we do want to pull some cash out with whichever path we choose. I would hate to pay extra taxes if we do a 1031 exchange for less than our current property B is worth, leading to taxes. If someone knows of a way to do this without paying taxes though, let me know!
  • Right now we are leaning towards selling Rental B in 2018 or 2019, pocketing the proceeds nearly tax free, and then possibly doing an out of state investment with 200-300k of our money

@Chris Meunier  

In reference to your last question -  are you aware that you can combine your owner occupant $250k/$500k capital gains tax exemption in addition to the 1031? That could be the ticket...

@Chris Meunier  

I am in similar situation as you and trying to decide if I should sell one of my properties next year . If you look at the last boom and let us imagine we are like 2004 in the last cycle where there is 20% more appreciation left . Somebody who bought in 2004 and went only to have his rental appreciate by 25% lets say 1 million went to 1.25 and then in 2009 went back to 900k (30% corr) . so why should be even buy anything now ?  I know its really impossible to predict if we are close to the peak but I seem to agree with Brian Burke . You buy as much as u can when real estate is down and stop once the recovery is well underway .

Going my historical bay area standards , it has never appreciated by more than 7 years which is the assumption I am using to say that we are close to the peak . sell and have plenty of cash available to then pull the trigger when u want it . 

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