Calculating rate of return on primary property w/ appreciation

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Calculating rate of return on primary property w/ appreciation

Laura M.
Oakland, CA · Member since 2015 · 16 posts · 10 votes

Hi all -

I hope I've posted this in the right area. I've just purchased a second home in Oakland, Ca as my primary residence. I now am trying to decide whether to sell or to rent my current primary residence (also in Oakland). I want to get started being an investor (currently I have only done passive investments) but I want to do this right. 

On the one hand, it would make sense to sell at the peak - my current residence is in a desirable neighborhood. But because I've owned my home for 15+ years the mortgage is low enough that there is a healthy spread between rents and my total expenses on the home (including maintenance, insurance, property taxes, etc.), giving me a good monthly income.

How do I value the buy vs. rent when the property has appreciated healthfully? How does rate of return get calculated? Or at least, how do YOU factor this in - you have a nicely appreciating property that is producing income and you are at the peak of the market? How do you decide to sell vs. keep renting?

Do you just ignore the appreciation and factor that in as covering your exit (i.e. owning in the Bay Area is a safe bet as it's an economic engine and inventory is usually low in more desirable areas)?

Thanks!

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J. MartinPro Member
Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
10y

@Laura M.

It all depends on your circumstances, needs, prospects, and alternative investments, but here's what I like to look at:

Annual Cash Flow / Net Realizable Equity
Net Realizable Equity is the amount of cash you could receive if you sold the property (after commissions, sales costs, capital gains taxes, etc.). If you look at that cash flow yield relative to the amount you could invest in an alternative asset, and still like that yield, given everything else you think about the prospects for your property, you may have a better idea..

Good luck!

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  • JD MartinBusiness Member
    Moderator
    Rock Star Extraordinaire · Northeast, TN · Member since 2015 · 10k+ posts · 16k+ votes
    10y

    It really depends on your long-term goals. If you are doing buy & hold, in a place where units for rent are desirable, in theory you could have a property that you bought at the top of the market go down to being valued $1, and it still makes sense, because in that case all that really matters (assuming you weren't looking at cash-out) is how strong the cash flow is - and you will see that from some pretty smart investors on here, where they are really only interested in the strength of cash flow. If you wanted to cash out, or exit in the foreseeable future, you need to take overall value into account - i.e., it does no good to make $40k cash flow over 4 years if you are going to sell at a $40k loss 4 years from now. 

    For me, I buy at the bottom of my local market, but I am likely to hold until I'm dead or close to it, which means the right cash-flow property will still work for me even if I buy at a market high. 

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  • Leslie Bandy
    Oakland, CA · Member since 2011 · 55 posts · 28 votes
    10y

    I'd talk to a CFP.  There are so many variables in your particular short and long term goals combined with your current and future earnings picture, that it is difficult to give across the board advice.  

    I'm personally a huge fan of passive income, so I love buy and hold strategies. The Bay Area has its own pluses and minuses, however. Rent control and just cause evictions can make getting bad tenants out difficult (though it is much easier for SFR's and quality areas tend to make it easy to get quality tenants). That said, Prop 13 gives property owners their own form of rent control which will forever keep your taxes lower than buying at current market values. Besides your basic rental income vs. expenses spread, there are significant tax deductions available to rental property owners such as those listed here: https://www.biggerpockets.com/renewsblog/2015/05/20/tax-benefits-real-estate-investing-rental-properties/

    I'm a real estate agent and home owner in Oakland.  We are certainly at a market peak and there's lots of talk that we'll see some cooling off by the end of the year.  That said, it doesn't seem like it will be a bubble bursting.  Housing has always been expensive and in high demand in the Bay Area, and seems like it will remain a good long-term investment.

    For calculating returns under various scenarios you can use this: https://www.calcxml.com/do/inv04

    If you have any questions about how much your house would sell for in this market, I'd be happy to provide you with some comps.

    Best,

    Leslie Bandy

    BRE 01990425

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  • J. MartinPro Member
    Rental Property Investor · Oakland, CA · Member since 2011 · 3k+ posts · 2k+ votes
    10y

    @Laura M.

    It all depends on your circumstances, needs, prospects, and alternative investments, but here's what I like to look at:

    Annual Cash Flow / Net Realizable Equity
    Net Realizable Equity is the amount of cash you could receive if you sold the property (after commissions, sales costs, capital gains taxes, etc.). If you look at that cash flow yield relative to the amount you could invest in an alternative asset, and still like that yield, given everything else you think about the prospects for your property, you may have a better idea..

    Good luck!

    3Reply
  • Laura M.
    OP
    Oakland, CA · Member since 2015 · 16 posts · 10 votes
    10y

    @Jd Martin

    I agree - some investors buy low and then sell high and rent in between (and fix up). Some just hold on to their properties. My first residence will cash flow no matter how low rents drop (they wouldn't drop below my mortgage because it is that low), but I am always wanting to put my cash to it's best use. I guess that it depends on how active an investor I want to be. 

    @Leslie Bandy  

    I think it's a lot easier to get the market low right than the market high. I did not want to buy in this market but I have kids and other considerations and the right property came along and for some odd reason we got it at a good price and no bidding war even though there were multiple offers (saying this after having lost out on other offers because they went into a bidding war). Why do you think there will be no bubble burst? I'd be concerned about the condo market in SF and SFR's in more marginal areas in Oakland. I've heard various scenarios about what people think will happen in this next down cycle, but one thing I'm sure of is that it won't be the same as the last one.

    @J. Martin

    Thanks for your thoughts!  Your formula makes sense but it would also indicate that a home that has a lot of built in appreciation will always give a low return.  Would you agree?

    Thanks for you responses - good to get your inputs~

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  • Chris MasonPro Member
    Moderator
    Lender · CA · Member since 2015 · 9k+ posts · 10k+ votes
    10y

    @Laura M.

    "Your formula makes sense but it would also indicate that a home that has a lot of built in appreciation will always give a low return. Would you agree?"

    REI often use a 1% test in the Bay Area, not a 2% test..

    Implicitly, by doing that, we're saying that it's just as much an appreciation play as a cashflow play.

    Implicitly, they are also saying that any real estate that DOES pass the 2% test is going to instantly get into a bidding war, bringing it under 2%. Which in turn feeds right back into stronger appreciation, aaaand we're back at square one: use 1% because of the appreciation.

    Those places where folks use the 2% test, they are implicitly saying that they aren't going to get a lot of appreciation, so they demand more cash flow.

    I'll tag @J. Martinso he can also offer his response. 

    1Reply
  • David L.
    Kalaheo, HI · Member since 2016 · 58 posts · 10 votes
    10y
    Originally posted by @Laura M.:

    how do YOU factor this in - you have a nicely appreciating property that is producing income and you are at the peak of the market? How do you decide to sell vs. keep renting?

     Depends on what I want to do with the money

    • ... towards another house that will cash flow better?  (otherwise, what's the point?)
    • ... towards another investment vehicle?
    • ... towards my dream home/vacation/etc?
    • ... so I can swim in it like Uncle Scrooge?

    So I guess all I'm saying is, what do you want to do?  If you simply want money to pay your day-to-day, then maybe keeping it as a rental would be best.

    This spreadsheet has been useful for me in figuring out value: 

    https://www.biggerpockets.com/files/user/JasonScot...

      0Reply
    • Leslie Bandy
      Oakland, CA · Member since 2011 · 55 posts · 28 votes
      10y

      @ Laura M.:

      I think the biggest threat to housing prices we have in the Bay Area right now is a tech slowdown.  There are signs that this is starting.  VC is being much more selective in funding and ratings agency are starting to cut ratings on under-performing tech stocks.  Those are very good things at cutting back at some of the frothiness that's been developing.

      For the most part, I've been seeing lots of people driven to buying because of the extremely high rent prices.  They have middle class jobs, are well-qualified for prime mortgages, are often paying with much more than 20% down, and plan to live in the houses for the long-term.  I don't think we have the subprime loans, liar loans, and no-down loans that lead to the 2008 crash (though I've started to see the reappearance of no-down loans in SF - yikes).  Even through the aftermath of that crash, SF got off comparatively easily - in the 5-25% range .  

      See: http://www.paragon-re.com/3_Recessions_2_Bubbles_a...

      The fourth quarter Fitch Ratings' Sustainable Home Price Report says that Bay Area homes are now, on average, 16% over-valued.  The sustainable valuation is based on coupling incomes to housing prices.  Very strong income growth since the last housing peak (44%) and since the post-recession low (18%) have meant that housing prices have been coupled with income until quite recently.  

      http://media.bizj.us/view/img/8513612/us-rmbs-sust...

      A cooling off of the market by 10-20% would just cut into the overbids for most listings at this point.  That seems healthy enough.  There will likely be larger price drops for properties in areas that are more iffy or prone to speculation.  Who knows, maybe I'm way off base here....  If only I had a crystal ball...  

      In any case, if you're still reading, Laura, I know way too many good people looking for rentals in good neighborhoods.  It's a tough market for the renters out there.

      0Reply
    • Laura M.
      OP
      Oakland, CA · Member since 2015 · 16 posts · 10 votes
      10y

      @ Chris M.

      Thanks for your input. I get that the Bay Area in particular is an appreciation play - hence buying when the market is down and then capturing that appreciation is key. Because I've held my primary residence for so long (15 years) the cap rate is quite a bit higher than 2% looking only at my loan value.  But it seems fairly evident that the best idea to optimize rate of return (I have yet to crunch numbers on this) is to sell when the market is clearly overvalued and then buy in cheaper neighborhoods when the market is low to capture that appreciation as well as high rents in Oakland in general. 

      Small houses are commanding high enough rents now that renting out a bigger house is not necessarily going to give me that much more marginal rent/house value.  That's my thinking - I'll see if the numbers agree!

      0Reply
    • Laura M.
      OP
      Oakland, CA · Member since 2015 · 16 posts · 10 votes
      10y

      @ Leslie Bandy

      Thanks for that extra bit of information! I agree - it's a tough market for renters as well as buyers. I can't tell you how many awful homes I have looked at in the last 2 years that sold for too much. There just aren't a lot of great options in Oakland - inventory has been super tight for a couple of years now.

      0Reply
    • Account Closed
      Investor · Singapore · Member since 2013 · 1k+ posts · 3k+ votes
      10y
      If you can hold on to the house just keep it. Asa wealth building asset a good Bay Area property held long enough will make you wealthy. My wife and I kept both our homes when we moved in together to a new home and like you since we bought earlier they positively cash flow and appreciate also. The cash flow increases every year due to rent increases. The only argument to sell now would be that you could get the gains tax free. So if you plan to sell anyway in the next 5 years then may as well sell now. If you can hold indefinitely then keep the home. Don't get swayed by paper ROI calcuations on cheap properties. They never factor in the risk. The Bay Area home is a solid long term investment
      0Reply
    • Victoria S.Pro Member
      Investor · Miami FL / DMV · Member since 2016 · 70 posts · 27 votes
      9y

      @Laura M. How is are you now? I am curious as to your search an analysis / choice(s) at this point. 

      I am (somewhat) new to the REI space, and am thankful for your post!

      0Reply
    • Laura M.
      OP
      Oakland, CA · Member since 2015 · 16 posts · 10 votes
      9y

      Hi Victoria -

      I have rented out the property. My decision came down to not having alternatives as to where to put that money and to work against my inclination to always sell at the 'high' vs. long term strategy. I'm going to see what land lording is like and then evaluate later if it's not for me. The house is a really nice property in a solid neighborhood (not one of the highly coveted neighborhoods, but those have higher crime than my neighborhood so I'm okay with that) so I know I can always find renters, even if I have to drop rent from time to time.  It's so hard to imagine that the property will ever be worth more than it is now at this peak, but I'm okay with that (i.e. no appreciation) as the rental income is just really nice and I imagine that will bump along a bit over time.  I don't have the stomach for a lot of risk and I only want to deal with A+ tenants so this seems like a safe easy investment with a good return. It's a solid asset that throws off cash and won't have wild swings like the stock market. I also fixed the property up really nicely as I don't want to deal with hassles and want the tenants to know that I care about the house and so I want tenants who will too. In fact my current tenants applied for our house because of the fact that we cared so much for it (there are many unresponsive property management co.s and landlords). I decided to follow Anish's advice to do my analysis and then kind of ignore it.  Higher returns really do encompass more (often unstated) risk and I think one has to have a 'win some, lose some' mentality to survive with those deals. That's not me- peace of mind and quality of life matter too much- but we'll see how it goes!

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