Do I have a good or bad rental?

Question

Having trouble determining how to assess my investment returns. My rental property is in Boston where 1% rule is hard to achieve (live-in converted to rental after moving out). Rent is 3300/mo. but after all expenses and mortgage net cash flow is about $80/mo. Property was purchased for $500,000 with 10% down in 2009 ($50k initial investment). It is now valued at about $800,000 10 years later. Mortg. bal is now $355,000 so equity is $445,000.

Appreciation has been the reason for holding on to it, but the ROI appears to be dismal if I calculate it based on current equity. ($960/445,000=0.2% per yr). This does not factor in the appreciation CAGR of about 4.7%. But still makes me think maybe I should liquidate and reinvest into the stock market for 8% returns. Rents in the area do not go much higher than 3300 to 3500.

Am I looking at this right? Can anyone give any thoughts on this?

Patricia Steiner · Answer

A 60% return on investment...that's the math on an investment of $500,000 and a Returned Amount of $800,000.  60%.  This is the stuff of financial genius.

Yes, you could sell and buy a lot of "doors" - as investors like to say - but a whole lot of something doesn't guarantee a ROI that is a whole lot more.  It could actually be a whole lot less. The math matters - not the quantity.

When looking at an investment, we consider the potential for substantial cash flow and property appreciation or either/or.  We prefer appreciating properties that can cover their own carrying costs because the overall gain is greater.

Appreciation and rents are only going one way in your city - just like mine.  I think you've got something well worth hanging onto.

Here's a pat on the back for an investment well-made.

Mike Dymski · Answer

Be sure to check out the Sec 121 tax exclusion for the sale of your primary residence.  If that appreciation occurred while you lived there, your investment returns as a rental have to cover the lost tax benefits before realizing any investment profit.

Whether to keep or sell has more to do with your predictable future appreciation than anything.  Calculate the forecasted IRR as if you were purchasing the property now and compare it to alternatives.

Dave Foster · Answer

@David S., I got nothin other than opinion on the appreciation vs cash flow argument.  But there are a couple things that raise flags in your scenario that you'll want to think about.

1. Like @Mike Dymski says, when you lived in that property is key.  If you just moved out within the last 5 years and can sell it so that you have lived in it for 2 out of the previous 5 then I'd say run don't walk to a realtor.  Because no matter what is happening appreciation wise this is your opportunity to take up to $500K in profit tax free!!!

2. If you haven't lived in it recently then there's a different issue.  You've got a not inconsequential depreciation recapture staring at you if it's been a rental for quite a while.  Your adjusted basis for depreciation is going to be the lessor of your purchase price or what it was worth when put into service.  So it's probably $450K ish without the land.  That's $16K in depreciation that would cost you around $4K/year in recapture in addition to the gains from appreciation - if you just sell and go into the stock market.

So if you decide to sell and if you can't take the 121 exemption then I'd only recommend doing it if you do a 1031 exchange and stay in real estate.  You can either purchase more appreciation property or you can switch to cash flow for higher returns.  The difference between what you would make projecting 8% in the stock market vs 6% in a conservative real estate investment that allows you to continue taking depreciation isn't worth worrying about.  And it's definitely not worth immediately paying a tax of around $80 - $90K plus $4K per year you rented it.  That's a huge dent in your available reinvestment dollars!!!

Mary M. · Answer

I would do some IRR calculations and see how it stacks up. My guess is you wont find anything that will come close - even if it cash flows more per door.

Coming from california i am used to these types of senarios - and those that have gotten (very) wealthy there know to hang on to those high appreciation assets!

Lien Vuong · Answer

I am leaning towards @Patricia Steiner's perspective here. I understand why you did the evaluation the property's value today but the fact is that is not your acquisition price. Currently you are sitting on an insane amount of equity and looks like you bought in the right time.

If you're stuck in the fact that your unit can only get that max rent can you figure out what other other ways you can generate income from the property? Is there a parking area you can capitalize on? Storage in the basement? Perhaps short term rental Airbnb/ 3-6 month term rentals to traveling professionals will allow you more rents.

In addition I think you should actively look at how you can pull out that equity and reinvest it in another asset that would create more passive income for you. The rates are still very competitive - around 4% for residential loans and 4.5% for commercial, you can get a goof competitive edge that way. If tomorrow you sold this property and bought in the current market you'd likely still be in the same low cash flow situation so why not hold onto your asset and accumulate more?

David S. · Answer

Thank you all for the replies and thoughts on this! To answer a couple of questions, we bought in 2009 and moved in 2012 when we began renting it. The value at that time was about $540k. We have bypassed the Sec 121 option based on the view that long term appreciation would outpace the tax benefit of Sec 121. Its in the South End. Time will tell if that was a mistake or not, but down the road we could theoretically move back in there for a couple of years.

I’ve been reading further about how to analyze returns on BP and other websites and it seems I may have missed an important return factor. It seems the repayment of principal should be added to the annual returns as well as appreciation. This makes sense to me because the interest is the cost of the loan, not the repayment of principal. So the components that I should be including in return are:

Cash Flow: $80/mo or $960/yr (this includes P&I and all expenses since they all do impact cash flow).

Principal Pay down: $9,700/yr

Appreciation: $32,000/yr (expected 4% appreciation on $800,000 current value).

So if I use the sum of those figures as my "return" $42,660 divided by equity of $445,000 then the return is 9.6%. If I only compare the annual return to my investment in the property $100k ($50k initial down payment and $95k so far of mortgage reduction) then annual return would be 42.7%. ??

Any thoughts on this new view of returns is welcome as i'm still not sure the best way to analyze things. I'm not certain how to run IRR, but will look into that as well.

Anthony Rosa · Answer

Awesome!!  The massive appreciation is better than making zero on the rent.  It cost you nothing to have the place! This is exactly what happened to me with my MF properties in NYC.  The only reason why i don't sell is because the mortgages are paid off and rents are top dollar.  Appreciation is key...Think about it, the house by itself made 30K per year for just sitting there!

Crystal Smith · Answer

I love reading the responses you've received to this thread. You entitled the thread good or bad rental? My answer- Good rental- Why- You have multiple possibilities available to you because of the value of the asset (i.e. your equity). Any time we have significant equity in an asset we look for ways to tap that equity and purchase other assets that will throw off cash. Naturally, your analysis has to consider the costs to tap that equity, but it's a good problem to have. That asset doesn't have to be a single-family property by the way.

Ben Simon · Answer

@David S.  Where in Boston is the property located? I think that is an important consideration.

John Warren · Answer

@David Slattery with that much capital you should be able to buy a significant property in many areas of the country. Even here in Chicago, which is not a "cheap" market, you could probably pick up a 20-30 unit building with that kind of capital. I would anticipate low double digit COC returns for sure. If I were in your shoes, I would definitely look to reinvest the capital.

Do I have a good or bad rental?

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