Which is the better strategy when dealing with my rental homes?
I currently have two rental houses. House 1 is worth $40,000, has no mortgage, and is breaking even each month due to repairs and maintenance. House 2 is worth $180,000, has a $205,000 mortgage, and is -$800 per month.
My question is, which option is better: should I sell house 1, take the money and sell house 2, then wait a year and start over by rebuilding my portfolio of rental houses? Or should I sell house 1, take the money and invest it in a better, more productive, rental unit? I could also use the cash flow off of the new unit to pay into house 2.
Hi. The decision to sell the properties should consider your expected appreciation rate of the homes. It looks like Lake Charles homes have experienced a rate of appreciation about matching inflation over the last couple of decades. To gain a better-informed perspective of potential near-term appreciation prospects in the area, I'd look at the level of building permits being granted (supply) against the population growth the area is experiencing (a proxy for demand- households is a better measure for housing demand but population is where that starts). My guess is that near-term appreciation will be modest but you should take a look.
Looking at your situation from a return on equity viewpoint, unless substantial appreciation is expected in the reasonable future, your equity in house #1 should be re-deployed. If satisfactory appreciation is expected, you can still keep the property and better put your equity to work elsewhere in a tax efficient way by borrowing against the free and clear house, although it sounds like your rental rate is unattractive since you're only breaking even with no debt. Regarding house #2, The negative cash flow is not acceptable unless, again, there is enticing appreciation potential. Some things you can consider to remedy the negative cash flow are to consider the potential to refinance your loan for a better rate if you don't already have a good one. Also, a good professional management company is worth its weight in gold. You will, of course, pay them something like 8-10% of collected rents, but they can more than pay for themselves by maximizing rent rate. The key, again, is working with a very good manager.
If you were to sell both properties the sum of the outcome would be basically gaining $800 per month (by virtue of eliminating that negative cash flow). In essence, you would have created $9,600 per year in income with no capital required. That's not a bad option.
To sum up:
- Form an opinion on appreciation potential of your properties.
- Explore ways to reduce/remove the negative cash flow from property #2 while retaining ownership (pending #1 above).
- Redeploy your idle equity in house #1 either by borrowing against the property or selling it (can consider a 1031 exchange here).
- With lackluster appreciation potential for both properties (at least 6% on property #2 to offset the negative cash flow loss) and if the rents cannot be increased, the liquidation of both properties with the net affect of ending with about zero equity but eliminating the negative cash flow is a decent option.
Real estate is a fantastic asset. I've purchased more than 100 homes and we invest in apartment properties for our investors. However, like any asset, it must be bought well for the greatest likelihood of a happy outcome. Don't let this poor experience dissuade you from the benefits of direct real estate ownership. Good luck!
I do not know your age although I have had many clients approaching retirement sell their rental properties because of the experiences you mentioned, as well as not wanting to deal with the three Ts: Tenants, Toilets, and Trash.
If you are looking for an alternative that would save on taxes, I would recommend a 1031 Exchange. Sell both properties then do a 1031 Exchange. The purchase or sale of a beneficial interest in a Delaware Statutory Trust qualifies for tax-deferred exchange treatment under Section 1031 of the Internal Revenue Code ("1031 Exchange"). Investors can sell their existing investment property and 1031 Exchange into a beneficial interest in one or more Delaware Statutory Trusts. They can also sell their beneficial interest in a Delaware Statutory Trust and 1031 Exchange into another DST or into other property selected through the assistance of their financial advisor.
The following sequence represents the order of steps in a typical 1031 exchange:
- An investor decides to sell investment property and do a 1031 exchange. He contacts a qualified intermediary (QI) and they enter into an agreement.
- The investment property is placed on the market.
- An offer to purchase the investment property is accepted and signed by the QI.
- Escrow for the sale is opened, and a preliminary title report is produced.
- The QI sends required exchange documents to the escrow closer for signing at property closing.
- Escrow closes.
- Within the first 45 days after the close of escrow on the sale of the relinquished property, the investor identifies replacement properties as required by law. This is known as the "Identification Period".
- Within 180 days after the close of escrow on the sale of the relinquished property, the investor closes on one of the replacement properties which he has identified. This is called the "Exchange Period". This completes the exchange. No cash – or ‘’boot’’, as it is known – is taken by the exchanger.
The target market for 1031 exchange ownership are taxpayers with a net worth in excess of $1,000,000 who are seeking a monthly cash flow without the headaches of being a landlord. You may also upgrade your real estate to say ownership of a class A office building and receive a monthly check from the DST sponsor. Picking the right property and sponsor with a good track record will afford you better success than you have had and take away all the headaches.
Forgive me for asking this, but based on this experience, why would you want to get back into rental property again? Your situation is a classic case for not having rental properties. My advice is sell both properties, take your cash, and start a nice investment portfolio of mutual funds and ETFs. You could own a ETF that invests in REITs if you are still wanting to be invested in real estate. Such a portfolio would never cause a $800 per month deficit.
The biggest risk to rental property is that your investment is in a small local market and is not diversified enough.