Leverage Current Equity or Sell and purchase multiple properties?

Question

I'll try and keep this as clear as I can.  I'm fairly new and my market is Lawrence, Kansas.  For those who don't know this is a college town that has approximately 50% of it's residents as renters.  I am not looking to target the college market at this time but more interested in the SFH and little higher quality tenant.

Here is my current situation.  I have one investment property and am an"accidental landlord".  I've come to find out that this is an investment strategy that makes a lot of sense to me.  I have the opportunity to tap into the equity of my former primary residence or to sell it and purchase multiple other properties.  I'm ready to grow beyond one investment property and am trying to decide which is my best route.

The rental is under a 3yr lease and was my primary residence prior for 5 years.  That would mean my home meets the requirement of primary of 2 yrs within the last 5 to avoid capital gains.  I realize that I will have to pay realtor fees if I go this route.

I struggle with the HELOC because I feel like I'm financing 100% and our market doesn't support properties cash flowing after expenses when financed at 100%.  The concept is tough for me to grasp but I do understand the leverage.  Paying back the heloc would be similar to me saving for my next down payment.  I guess it's a "mental block".  I'm not willing to invest outside of Lawrence at this time because that's my comfort zone and the market I understand.

Basically am trying to find out if it's worth it to sell after the 3 yrs of a tenant and save capital gains taxes... it also would allow me to bypass the 1031 struggle of buying multiple properties.  Or should I keep it and tap into my equity?

Current Value-  $245k and was built in 2010.  Low maintenance finishes.

Current equity is- $90-95k so I would have access to $76-$80k in equity via the HELOC.   Yes I was quoted at 85% HELOC from my lender.  My lender however can not offer interest only.  I will be looking for interest only.   With a little of my cash I could probably buy 3 SFH.

A really good deal is meeting the 1% rule in my market.  I have a great realtor who is experienced in investment properties.  A recent great deal and similar to what I'm looking for was a home for $140k (Actual value was $152-155) that was rent ready and rented in a few weeks for $1325.

Details and analysis of current property.  It's a high end rental for my market and cash flows very well for our area.  It's a slab home that's 3/2 and should be fairly low maintenance due to it's age.

continuation of spreadsheet

Dave Foster · Answer

@Andy Krzanowsky, You're looking for a better class of tenant - you need to move your market about 70 miles west :).  Sorry, a little college humor from a Wildcat!

The 1031 will always be there as an option if and when you choose it.  Leverage is what is is whether on one or several properties.  Seems to me there's two real issues you need to stay laser focused on.

1. Tax free vs tax deferred.  Although the 1031 will always be an option to defer in the future.  Now is the opportunity for you to take profit off the table tax free.  That's probably 15 - 20K in tax that becomes yours to do what you want if you sell using sec 121 primary residence exclusion.

2. The quality of this rental.  Look at it on it's own merits.  Not just as a vehicle to finance another rental.  If it works for you then keep it.  If not then sell it.

One other option would be to use your equity in it to finance another purchase and within the next three years while you still qualify, you sell this new one.  It reduces your portfolio but gives you three years of double rents along with the advantage of being able to evaluate later and still potentially take money off the table tax free - either to reinvest or do something else.  If you play this one right you could actually end up with a free and clear rental plus tax free cash from your current one.

Rich O'Neill · Answer

@Andy Krzanowsky is really on to something. Based on the numbers it looks like you will either need to put a little cash down or take a small note on the new property in the next 3 years. If good deals are going for $140k and you can leverage $80k then you need $60k to cover the rest. Once you sell the old primary then you can pay off the heloc, existing mortgage, put $10k into the new prop and end up with a 30ish% LTV on the new property. By no means risky.

In my opinion, with a tenant that is that good on a 3 year lease, they may want another 3 year lease and you are already making money. I think you hold on to it regardless of the tax advantage. It could make you much more than the money you will save in taxes. I said in the other thread that I am a buy and hold guy so take that how you will.

Maybe you take take $30ish out of the line to put your 20% down on a new prop and take the rest out in a mortgage. Assuming the $140k purchase on the new one here is how numbers look:

New prop:

$140k purchase

$112k mortgage

$28k down payment (paid out of HELOC)

Old Primary:

$245k current value

$150k existing mortgage

$28k HELOC

Total portfolio:

Value: $385k

Debt: $290k

Total LTV: 75%

Take your payments for all three of those notes and take your combined cash flow and see if it makes sense.

If it does, I would go that route personally. If it does not then I would sell and go Dave's route.

Hope this helps!

Dave Foster · Answer

@Andy Krzanowsky Hey my mom was an ambulance jockey and she would put a whuppin on me if I said that!

Of course so much depends on appreciation and the market etc.  But I was kind of envisioning something like the following

1.  Keep this property through the 3 year lease but make sure and sell when you can still qualify for the profit to be tax free.

2. Use a heloc during this time to purchase a new rental for cash or use cash flow from both properties to pay the note off quickly.

3. At the end of the lease, sell your current.  Even though it is highly leveraged there would still be some cash left which would be tax free.  All the profit in it should be tax free under sec 121.  No need to 1031.

4.  You take that and now you have a free and clear rental and a little cash in your pocket free and clear.  Basically you've taken your money off the table and you can enter the game again but this time with only the bank's money  Finance the new property or just let it generate cash flow while you save lives.

You can certainly adjust this model to fit your taste for leverage but that is what I was referring to.

Account Closed · Answer

If you are requiring equity to be income producing then how do you distinguish equity that is your money into the property vs  equity that is a gain through appreciation?  Seems under you mindset that appreciation gain should be counted as income.

Thomas S. · Answer

I believe you have possibly underestimated your expenses on you current investment property and should raise them to at least 40% to be more accurate.

In addition, unless I am wrong you have not allocated any value to the equity you have in the property. Equity return is the primary reason all investment properties must cash flow at 100% financing otherwise they are not a good candidate as a income property.

In your case with $95K in equity at a conservative return of 5% you need o subtract approximately $400/month from you present cash flow numbers to be more accurate.

rent ($1700) - 40% expenses ($680) - mortgage ($752) - 5% return on equity ($400) = (-$132)

Your property will likely show a negative cash flow of $132/month long term or worse.

Leverage Current Equity or Sell and purchase multiple properties?

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