Looking to 1031 out of the California market

39 Replies

Look guys, you know there's inverse relationship between appreciation and cash flow, right ? A market that has cash flow is possible because it doesn't have appreciation, market that experiencing appreciation will not have cash flow because it experience cap rate compression. 

Yes yes, STR is definitely different than LTR. When investing in CA, the appreciation rate is between 6-18%. If you want to sell or 1031, best time is 2023/2024 anyway.

Carlos

Hey @Jason W. , here's a quick sampling from what some of our recent CA clients have been looking at exchanging into. The driving factors seem to always be

- bloated residential prices in every major city (hard to buy)
- uncertainty about office space and other commercial options (not sure if buying is smart)

Assets we've seen considered

  • DSTs
  • Raw land (ranchland and solar fields)
  • Mineral rights
  • passive TIC interests, usually with NN or NNN long-term leases and big-name tenants (CVS, 7-Eleven, Dollar General, etc)
  • cooler residential markets, such as in Indiana, Missouri, and Arkansas

Keep in mind that if you exchange out of CA and into a different state, the California Franchise Tax Board will require that you file CFTB Form 3840 on an annual basis reporting as to the status of the proceeds you used in the 1031 exchange.  If you fail to do this then CA may decide that you suddenly owe state taxes. 

Also for those who want to do 1031 do your money simulation due diligence very promptly. Based on latest research I know CA appreciation is still 5-18% yoy into 2024.

If you invest at DST you may only receive 5% from equity and that's only if sponsor is good.

Panama City Beach, Fl. is in the middle of a gigantic boom with HUGE upward potential as 30A's primary developer just moved to our market. There is still major upside to both appreciation and cash flow here although inventory is short and prices are jumping fast. Happy to chat if you want to learn more.

Crystal Chaillou, Realtor

Corcoran Reverie

205.329.0759

As someone who has 1031'd out of CA here are my thoughts: 

most important - what is your goal? Are you looking for monthly cash flow? or are you looking to grow your wealth over time?

If you are looking for cash flow remember that over time your cash flow should increase as rents increase and your mortgage stays the same....  

also there are very few markets that can beat CA in appreciation. So if you are looking for wealth generation CA is hard to beat. 

What I suggest: create a spreadsheet and assume some conservative data points and extrapolate where you will be with both scenarios in 5, 10, 15 years, etc. 

Also there is a saying you can never go back - once you take your money out of CA it will rarely keep up and you wont be able to purchase a similar property in the future as you will be priced out (see appreciation above) 


This is a question only you can answer as it is a lot about what your goals are.  For example, I left CA as I wanted to go somewhere green (ie that has rain) so I took my funds to OR.....  I will never be able to purchase what I sold. It has already increased in value by a factor over what my OR props have increased in the same time. 

finally, many of the folks posting on BB are selling something so just keep that in mind when you read responses.... 


I don't know your financial situation but assuming this next move is not big enough to replace your day job, if you want to tap into the equity you have on your CA properties but you may want to consider doing a cash-out refinance instead of selling them (1031 or otherwise). That way you can hold onto an appreciating asset and you can invest in some higher cashflow markets.

Hello @Jason W.

Instead of commenting on specific cities or investment strategies, I will describe the process I would use to select an investment location.

So we have a common understanding, I believe every investment property must meet three criteria:

  1. Sustained profitability - The property must generate a positive cash flow today and into the foreseeable future, in good times and bad.
  2. Appreciation - The location must be appreciating at or above the inflation rate.
  3. Investor friendly - The cost of doing business and local regulations and taxes must favor investors.

I will explore each of the three criteria below but first, a comment on selecting properties based on ROI.

ROI is Only a Snapshot in Time

If you anticipate holding the property for many years, what is happening long-term is more important than what is happening today. ROI, and other such metrics, estimate how the property is likely to perform on day one of a lifetime hold. ROI tells you nothing about how the property is likely to perform in the future. See the chart below.

Today, Property A and Property B have the same estimated ROI. However, in the future Property A is returning 8% while Property B is only returning 1%. Market direction is a critical factor in location selection.

Below is another example. Is property A or Property B a better investment? Even though Property B has a higher initial return, Property A is the clear winner over time.

Location Trend

How can you evaluate a location's trend? Determining market trends directly from statistical data would not be easy. However, there are "indicators" and basic metrics that can provide the location selection information you need. I listed a few below that you could use to narrow your search.

Population Size

I would only consider metro areas with a population of at least 1 million. You want a stable economic environment, and small towns may be too dependent on a single company or commodity.

Appreciation

Property prices increasing above the rate of inflation, is a strong indicator that people are moving into the location, new jobs are being created, and household income is rising. And, since rents lag property prices by 2 to 10 years, what is happening with property prices today indicates what will happen to rents in the future. I would not consider any location where appreciation is less than the (actual) rate of inflation.

Population Growth

Increasing or decreasing population is a strong indicator of taxes, crime, cost of living, jobs, quality of life, and many other things. If the population is increasing, a lot of things in that location must be right, and prices and rents are likely to rise due to increasing demand. If the population is decreasing, prices and rents are likely to fall due to decreasing demand. Here is a list of metro population changes between 2010 and 2019.

Job Quality and Quantity

An investment property is no better than the jobs around it. Said another way, if your tenants are not working, they are not paying rent. When you consider jobs, there are two aspects: job quantity and job quality. The quantity of jobs is important but not sufficient; you must also consider the quality (pay rate, benefits, location, etc.). Also, it is not just the jobs the tenant pool has today. Most small businesses' life span is about ten years, and even S&P 500 companies only last on average about 18 years. So, most of the jobs your tenant pool has today will likely be gone within the next ten years. Unless new jobs are being created to replace the existing jobs that pay at similar levels and require similar skills, your tenant pool will either move away or take jobs at lower pay. If your tenant pool moves away or accepts lower-paying jobs, rents will fall accordingly. You need to consider the economic direction of the location. One of the best indicators I know for economic health is median household income growth. The St Louis Federal reserve site is my go-to place for such information.

Crime

While crime is everywhere, crimes occur in some locations much more frequently. Properties in cities with high rates of crime are unlikely to do well over time for three reasons. One, few people will move to a location perceived as a high crime area. Two, people who can afford to do so will move away from a high crime area. Three, jobs do not stay in high crime areas, so people move away to where the jobs are. NeighborhoodScout maintains a list of the 100 most dangerous cities in the US. I would be very hesitant to invest in any city on this list. High levels of crime and long-term growth do not go together.

Urban Sprawl

In most cities, areas that were once the best place to live are now distressed. The pattern where people with higher incomes move to newer areas is commonly referred to as urban sprawl. The people who remain typically have lower incomes and cannot afford to move. As the median income of an area falls, property prices fall. Sales taxes and property taxes largely fund city services. If the tax base declines, city services decline and crime increases. As crime increases, the remaining population with sufficient income leave the area. Over time, the only jobs that remain are low-paid service sector jobs, which results in a spiral of declining prices and rents.

The easiest way to detect urban sprawl is to watch a time-lapse aerial view of the area. Below are a few examples.

  • Memphis
  • Atlanta
  • Indianapolis
  • Phoenix
  • Las Vegas - Las Vegas is fairly unique in that it is surrounded by federal land and there is very little non-government land left for expansion. So, Las Vegas has almost no urban sprawl.

Cities subject to urban sprawl share some common characteristics, including:

  • Existing home prices rise slowly or even decline (after adjusting for inflation).
  • As the household income in older areas declines, prices and rents fall to match.
  • Generally, home prices will be significantly lower than metro areas with expansion limitations.

Investor Friendly

You could buy what appears to be an outstanding property only to have operating costs eat all the cashflow. Below are a few factors to consider.

  • High Taxes - People are fleeing high tax states like California, New York, New Jersey, and others. I would not invest in any of these states because their economies are declining.
  • Property Insurance Cost - Property insurance rates are based on the probability of a natural disaster occurring in that state. The higher the cost of insurance, the higher the probability of a major disaster. The problem is not the cost of repairs, which can be covered by insurance. The problem is the loss of area jobs and population. People and businesses will leave a disaster area so they can resume a normal life. The likely result will be declining property values and rents. Value Penguin has an excellent comparison of insurance cost by state. I would not consider states with high insurance costs.
  • Regulations - I talk to many people considering using a 1031 Exchange to move their investment to Las Vegas. The most common reasons for moving their investment include:

    • Anti-investor regulations including rent control and similar abuses of property ownership rights.
    • Permits & occupancy regulations - In some cases you will need to get occupancy permits just to rent the property.
    • Cost and time to evict non-paying tenants. For example, in some states, you cannot evict tenants during the winter. In other states, it can take up to a year or more to evict a wily tenant. Note I view such nightmare evictions like I view cancer. The odds of your getting cancer are relatively small, but if you do get cancer, it is devastating and "odds" mean nothing.

The Process I Would Follow

I would eliminate locations based on the following criteria, which is sorted into the order of the easiest to hardest to evaluate.

  • Population Size
  • Property insurance cost
  • Crime
  • Population Growth
  • Job quality and quantity
  • State income tax rates
  • Urban sprawl
  • Investor friendliness

Final Consideration

A number of skills are required to make money with real estate. You can either provide all these skills yourself (you can't) or you can work with a good investment team. Below is a chart showing the needed skills and who is most likely to provide these skills. Unless I could find a good investment team in a location you are considering, I would look for another location.

Jason, I hope the above helps. If you have questions, feel free to reach out to me.