What should I do with properties with significant gain (Seattle)

28 Replies

I live in the Seattle area, where I have a couple of SFH rental properties which I bought a few years back, now they all have significant appreciation due to the red hot Seattle market, now I'm trying to figure out the best strategy forward.

I don't want to sell because of the significant tax hit; doing 1031 exchange is also problematic since I don't find anything attractive in the Seattle market today; the cap rate on the rental is about 3%, pretty miserable. After years of rapid growth, the Seattle market is also clearly slowing down (although I don't think we will have a crash, probably flat or slow growth for the next few years). 

Any ideas and suggestions? Thanks in advance!

Buddy

@Jason Woods - I would consider the following: 1031 exchange to a vacation home or possible home you may want to retire in the future (eg Lake Tahoe, AsPen, montana, FloridA etc) Have it rented out and managed by property manager for now. OR do the 1031 but buy rentals in other states This year (2018) is almost over but if in 2019 you could make less money (think sabbatical or quitting your job) you could sell one property and your tax basis would be less since you have less W2 income Consult a CPA for the following possIble tax deductIons/advantages: Selling property And... donating money to charity, gifting money to family members, making improvements on your own home, setting up self directed IRA or a Roth IRA

Hi @Jason Woods ,

One thing is for sure, we've definitely seen a slow down this summer but that's not unusual.  IMO what happens at the tail end of summer and early fall (so about now) is where we'll learn what the market will provide in the short-term.  With interest rates rising, it wouldn't surprise me to see the slow down continue.  I'm in the same boat as you, I think if anything, we will have more of a plateau in the market with slower growth in the next few years than the past.

I know of a few local investors who have recently sold part of their portfolios because of this situation and the lack of solid guidance for the future.  They didn't want to hold multiple *newer* properties into a possible slowing or stale market.  However, they 1031 exchanged into other properties, both local and in other states, similar to what @Mike B. mentioned in his response.  In one case, the goal was to AirBnB and in another, to "trade up."  In both cases, each also have properties listed on the market which were flips and are taking longer to sell than expected.  Thus, they are also playing the tax game given the extension deadline coming up in a few weeks.

There are a few options but they really depend on your overall strategy and risk tolerance.

Trade up for income multi-family or apartments.  

Most homes here have at least tripled in value last 6 years. The depressed (then) neighborhoods have a face lift with 4-5X in value cf last 8 years. Reason is same as Seattle. High tech presence. Cap rate right now is not even close to Seattle but many still want to buy with cash. Most expect a double digit appreciation.  Other people have cried out that local homes can not move up more for over 40 years.... What is wrong with $2000/sf argument?    However, many are cashing out. Some just put in the liquid funds or RE notes by retiring earlier.

Originally posted by @Alina Trigub :

@Jason Woods Get a HELOC on your properties and use it to buy more real estate.

Ditto. I'm in a similar situation, but a different market. Cash flow is healthy, CAP rate is good. I've looked at all options and HELOC makes the most sense. Re-activating equity to buy more SFHs.

If you don't want to reinvest in real estate after selling, or if you want to be able to take your time looking for replacement property, then you may consider using a Monetized Installment Sale. With this approach, you defer capital gains tax for 30 years and receive 93.5% of the net sales proceeds in cash, which you can hold or reinvest as you please.

Hi Buddy @Jason Woods , I’d say but depends on your goals. You could either use a HELOC to take some equity out for investing in something else, or keep trying to pay down your mortgages. It sounds like you’re leaning towards further investing. I’d just be sure not to over leverage, assuming the market will go up again (I tend to think we’re looking at a plateau too, but don’t want to bet too heavily on it). I did something similar and Keybank was great to work with for a HELOC.

@Jared Boundy Totally agree. I’ve been burned a couple of times in the past and definitely don’t want to stretch myself too far, leverage works beautifully in a up market, but could really hurt in a down market. My last purchase was in early 2016, I’ve been staying on the sideline since then. But this morning I got a message from a friend, asking me to check out an opportunity, very tempting! We’ll see how it goes, I may dip in again after a long hibernation.

@Jason Woods  , Yep Seattle's tough.  But both @Jake Alger and @Mike B. are correct. Your 1031 exchange does not have to be limited to the Seattle area. The United States is your oyster. You are free to exchange any kind or investment real estate in any location in the United States for investment real estate any where else in the US (or a couple of select territories). 

Originally posted by :

You are free to exchange any kind or investment real estate in any location in the United States for investment real estate any where else in the US (or a couple of select territories). 

The phrase like-kind refers to the use of property - is the intent of ownership investment? You are familiar with SFH market, but you can redeploy your capital into retail, multis, office space, even royalties and water rights. There are also turn key portfolios that can be used in an exchange to help match every dollar.

I would be locking in gains from Seattle and finding areas with greater upside. 

As a real estate investor or any investors consider your Return on Equity (ROE) as a means to evaluate the highest and best use for your capital and to be able to make adjustments to your portfolio over time.

The saying “buy and never sell” will work but “buy and evaluate your ROE prudently” will yield high returns and safer capital preservation.

There are many metrics that Investors use to quantify the quality of their investments. COC, ROI, ROE, are to name a few.

Cash on Cash Return on Investment (COC Return)

The pre-tax year-end cash flow divided by the actual amount of original investment you have invested.

COC is used to compare your investment with other options excluding factions such as the use of leverage (mortgage), taxes, appreciation over time, and mortgage paydown over time. As time goes along and your investment goes well due to your tenants paying their rent as they should and the home going up in value due to inflation and market appreciation, COC becomes less relevant.

For example, if you purchased a property with $22,500 down payment, $5,000 in closing expenses, and $2,500 for some touch-up paint and new carpet, you are all-in for an original investment of $30,000. If at the end of the first year with your rental property in operation that you are able to profit $10,000 from cash flow after all operational expenses and debt service were paid, your COC return would be $10,000/$30,000 or 33%.

Sophisticated investors compare COC with other investments to determine the highest and best use for their liquidity going into an investment whereas ROE is used once the investment is owned. COC for mutual fund and stock investments have been known to have been in the 8-10% COC range.

Annualized Return on Investment (Annualized Return)

Annualized return is used to evaluate an investment’s performance over time. Real estate is not a get rich scheme and many times if rehab is done to the property it will require a few years to complete the construction and stabilize the rents for the next buyer to feel comfortable and pay a higher price for the investment.

Annualized return takes into account the cash flow returns received during the hold of the property and the sale or refinances of a property that takes place at the exit. The annualized return is often used to compare syndications (private placements) with different business plans but similar lengths of ownership.

For example, if you received a 8% COC return for 5 years ($8,000 per year on a $100,000 investment for each of 5 years = $40,000). And then you exited the property via a sale at end of year 5 for a gain of $60,000. Your annualized return would be a total of $100,000/5-years or 20% a year. This is calculated with $40,000 in cash flow plus the $60,000 due to the general appreciation of the property.

Return on Equity (ROE)

One of the few downsides of real estate investing is that your investment is illiquid unless you sell or refinance the asset.

As you hold on to investments you are increasing you equity position over time via the following:

  1. Mortgage paydown
  2. General appreciation from the market
  3. Forced appreciation from any property improvements

Say you had a great investment kicking off 20% COC a year. Your return on equity shortly after purchase on a $100,000 home that you used $20,000 to acquire is making you $4,000 profit a year. In this case, your ROE would be 20% ($4,000 divided by $20,000).

Great!

But say a couple years go by and with a hot market the property is now worth $160,000. You return of equity on the $160,000 home that you used $20,000 to acquire is now making $5,000 profit a year. In this case, your ROE would be only 6.25% ($5,000 divided by $80,000). Note: This does not include mortgage paydown.

For the minor headaches rental property ownership brings 6.25% would not be worth it. I personally believe that when you ROE dips lower than 10-15% you need to look to make a change in your portfolio via 1) Cash out refinance, 2) 1031 exchange or, 3) simply selling the asset.

There is one intangle metric that we did not talk about here which is your Return on Time (ROT)

Sell, sell, sell. Markets are at a peek, SFHs are subject to home buyers whims and are a very high risk to hold as rentals at this time (any time for that matter). 

Now is the right time to liquidate SFH rentals and reinvest in something more stable.....multi units purpose built as rentals. Your equity is in jeopardy in a SFH at this time.

Others will have a opposing opinion but do you want to take the gamble of holding if you already know that you have likely maximised your appreciation for the foreseeable future and risk a market/equity drop. You need to know when to make the right business decision and I believe now is the time to capitolise on your investments.

I took the opportunity in this last peak to sell my rental SFR that I considered to be in a less desirable location. My ROE was hovering just over 1%, which I only justify by 12% YOY appreciation I got since 2015. I considered HELOCing the thing, but I just didn't like the location (sub-market of south Everett) so I closed escrow on the sale in Sept. I think I squeaked it by, because now inventory has shifted higher and my market is very dependent on demand to get top dollar. I read a report that said 1 in 4 houses listed in Snohomish county saw a price reduction in Sept. Everett is getting a lot of attention from plans to start private airline service from Alaska Air and others. Seattle needs another major airport beside SeaTac and Everett is an obvious choice. All that to say, I definitely plan to return to that market.

As for strategy.  1031 all the way, and I plan to parlay into multifamily elsewhere. I looked in markets where cashflow is not analogous to Sasquatch. This is certainly not a shoot from the hip strategy.  I have been planning this pivot since February and now that I am actively exchanging I still finding areas of due diligence where I should have better prepared myself.  

I think our market is strong and I do still expect some growth next year in desirable locations.  I suggest waiting this seasonal slump (my opinion) and meanwhile educate yourself a ton on the 1031.  Consider ending your leases in April and get listed on market next May with intent to exchange into higher cap market. 

  @Jason Woods - I have watched the Seattle boom with family in B.C. and friends in Seattle - with a little emerald city envy - of the apprecaition! Yet - my cash flowing investments up here are doing their job - paying me monthly and paying down my principle. I'd suggest considering Alaska as a market for some in your shoes - as we have not had noticeable appreciation in the past few years - and optimism has returned to AK. Cap rates on multifamily can range from 6-10 here  - and without, in my experience/opinion, the concern for a downturn in equity. Anchorage in particular is between ocean and mountains - leaving land at a natural premium. Another play I've been navigating for investors is in different area in our state that has much better cap rates available, sometimes even on new construction. 

Exiting in hot market cycles is inherent in a value play strategy...or the strategy is to hold very long term and ride the cycles up and down.

Some investors are re-deploying capital from value plays to cash flow plays.  It's hard (and fun) work finding investment alternatives but simply part of the strategy that was in place from when the value plays were originally purchased.  The alternative of exiting value plays in a down market does not sound like fun.

Many options, I guess it comes down to your strategy and your risk appetite.

If you have seen significant growth in this market, and the rental yields are not attractive, one option would be to sell out and reinvest into another market with higher rental returns, alternatively  1031.

Another option access the equity and plough the funds into another asset class with higher returns. … ie stock market?? 

Also look at perhaps ways to increase income on these properties ie Airbnb.... OK this is not passive investment, but looking outside the square.

Reducing debt and increase cash flow is not a bad strategy. Sell 2 pay off 1. Yes, not sexy, but it does reduce risk

@Jason Woods

There are a lot of good options listed above. To give you a good answer I need to know how much gain we are talking about and what tax bracket you are on.

- 1031: you can get into any type of investment real estate, it doesn't have to be SFH or Multifamily, it can be a golf course, it can be a theater, commercial property, anything you choose as long as it is investment real estate.

- Monetized Installment Sale might or might not be a good option. Keep 93.5% of the cash and defer the tax 30 years.

- Deferred Sales Trust: Again might or might not work. Depending on how liquid you want to be.

- Opportunity fund: Defer the gain portion of the proceeds and keep the cost basis (your investment in the property). You can also create your own OZ LLC.

- Pay the tax: depending on the amount of the gain and your tax bracket, this might be a good option as well.

Hope this helped you :)

@Hector Bilbao This is a great summary, a couple of them I haven’t looked into. Thank you! For my situation, I have a couple of SFH properties each gained ~$500k, I’m already in top tax bracket, so it won’t make sense to sell and pay taxes.

Jason,

A MIS might be a good fit. I can run the numbers for you if you like. No charge.

If so I need: 

Sale Price

Basis (cost plus improvements)

Prior depreciation taken

Estimates are ok.