Deciding to Sell Your Rental Property (1031 exchange series - Part 2)
If you’ve been a regular follower, you know that one of my major 2020 undertakings was the completion of a massive 1031 exchange. I sold three properties, then bought three new properties. This process allowed me to defer all capital gains from my sales, plus improve my cash flow by around $1,500 per month.
I completed this process in late October 2020, and now I’m ready to share some details about my experience. Because this is such a massive topic, I’ve decided to break up the talking points into separate articles and group them together as a blog series. Hopefully this will make things easier to digest for you, dear reader, and also make it easier for me to put together.
In Part 2, I’ll outline the following:
- - The market conditions of the middle of 2020 and why it was the perfect time to sell
- - A definition and discussion about the Return on Equity % metric
- - How and why I decided which properties to sell
THE REAL ESTATE MARKET IN MID-2020
In case you live under a rock, 2020 was filled with a lifetime’s worth of twists and turns, ups and downs mainly due to COVID-19. We all had to deal with an upheaval of our personal lives, in addition to multiple political and social crises. All of the changes also had a profound impact on my real estate investing business, and I’m still pivoting to adapt.
March, April and May 2020 were perhaps the most uncertain months. In this time I was dealing with the prospect of a crashing economy and the potential for none of my tenants to pay rent. Ultimately, I decided to double down on real estate and it paid off. We enjoyed little to no competition for good deals from March 2020 through May 2020 and ended up closing on 3 deals in a 6 week time period. When everyone else was fearful we dove in full throttle.
I began to realize things were a little weird in the market in June and July 2020, after COVID lockdowns began to ease. The competition came back, and with a vengeance. I began to get outbid by $30k-$100k on properties that were complete dumps. Consequentially, deal flow slowed to zero for several months.
This was due to multiple factors - too many to hash out in this article - but the reality that was dawning on me (and the local real estate industry as a whole) was that this was an amazing time to be an owner and a seller, and an absolutely horrific time to be a buyer. It was this realization that prompted me to begin reviewing my portfolio for the best properties to sell.
THE RETURN ON EQUITY % METRIC
Return on Equity (ROE) = Yearly Cash Flow/Estimated Equity
One metric that I don’t focus on very often, but matters when considering a sale, is Return on Equity % (ROE). That is, your cash flow (rent minus all expenses) divided by your total estimated equity in the property. I say “estimated” because you are making an assumption on the value of the property. I go off of the latest appraisal (which is subjective) but you really don’t know how the market will react to your property until you get it on the market and it actually sells.
Return on Equity matters because it tells you how hard your equity is working to create cash flow. A higher ROE means that the investment is working out very well and probably shouldn’t be messed with. A lower ROE indicates something is wrong, and you might be able to use that equity to invest in something else that will give you a higher cash flow return. Alternatively, you could do a cash out refinance to lower your equity in a property, thus increasing ROE.
ROE measures opportunity cost - the cost of NOT investing in something else.
ROE is why I do flips. Let’s say I fix up a house and I’m all-in (buy, rehab, closing costs, holding costs, etc.) for $160k, and the house is worth $200k, and I could rent it for $1600. I could either:
a) BRRRR it (Buy, Rehab, Rent, Refinance). I could take out a loan on 80% of the value for $160k, getting all my initial investment back, then rent it out. The rent to value ratio is low ($1600/$200,000 = .8%) so cash flow will be minimal. Best case is I make $50/month, which equates to $600/year. I’d have $40k in equity ($200,000 value minus $160,000 loan). Return on Equity % would be $600 (cash flow per year) divided by $40,000 equity, or 1.5%.
b) Sell (flip) it. Pay $20k in selling costs, pocket $20k, and move on.
ROE tells me option A is not an efficient use of my equity. 1.5% is an abysmal return - I’d rather take that equity and invest it in something else earning 10% or higher.
Of course, it’s not always black and white. For instance, you need to consider the costs of selling to access the equity. In the situation above, selling costs effectively cut my equity in half ($40,000 equity minus $20,000 selling costs). But I’d still rather sell in that situation and invest the remaining $20k in a multifamily building.
ROE typically decreases as time goes by. This is because, hopefully, your equity is growing faster (debt paydown plus appreciation) than your cash flow. I’ve demonstrated this below, making a few assumptions on a theoretical $100k property.
I’ll be reviewing the ROE on my personal portfolio below, and how this metric helped me to identify which properties were the best ones to sell.
MY PORTFOLIO IN MID-2020
As of the end of June 2020, I had 10 properties consisting of 15 units in my personal portfolio (this doesn’t include several properties owned through a partnership). This included 8 single family rentals (SFR’s), a 4 plex, and a 3 plex. The overall portfolio had been doing quite well over an 18 month period, but I certainly had some poor performing properties.
Central PA Townhouse, Indy Rancher #1 and Indy Hipster House were all cash flow neutral or negative. This wasn’t due to a few bad months here and there; these properties were given plenty of time for the numbers to average out, and ultimately proved themselves to be poor performers. There’s many reasons and excuses I could point to, but the biggest one is simple: I made some mistakes in analyzing and buying the properties. These were the 2nd, 3rd, and 5th properties that I purchased, I’ve learned a lot since then, and it’s completely fine to admit that!
Below is a summary of performance by property, including ROE%, as of the end of June 2020.
As you can see, the three properties mentioned are by far the worst performers. Negative/zero cash flow from about $110k of equity, in total. Losers!
I hadn’t considered selling these properties yet for one reason: I didn’t want to take a loss. Up until June/July 2020, I figured these properties had seen little to no appreciation with only a few thousand each in debt paydown. After paying a whopping (anticipated) 8%-15% in selling related costs (commissions, taxes, fees, and repairs), I’d lose tens of thousands if I sold them at (what I believed to be) market value. I was willing to just ride them out, making neutral or slightly negative cash flow, until the time was right.
In July/August/September 2020, the time was right. Mortgage rates were at all time lows, supply of single family houses was at rock bottom, and homeowners and investors were overpaying for everything. Here’s a summary of what my three losers sold for compared to my estimated values (based on previous appraisals and comps):
The combined amount that I made off these sales was almost $43k higher than my wildest dreams.
When all the final numbers were tallied, for the entire life of the investment, Indy Rancher #1 made me $237, Indy Hipster House lost me $732, and Central PA townhouse made me $17,656. And I consider myself very lucky to have exited these investments without posting a much larger loss.
CONCLUSION
2020 was the perfect time to sell some properties, and I was able to let go of my worst performing properties with my equity and dignity somewhat intact.
In my next 1031 series post, I’ll describe the selling process for each of these properties, and what it was like to work with a 1031 intermediary. Stay tuned!
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