Estimating Rental Property ROI in deciding to hold vs sell?

[TheGipper]

I know there have been many threads on this and I also know there are many fancy methods to attack this such as cap rates, etc.....

Here is my simplistic way of thinking about it, correct me if my logic is way off.

Annual rental income $31,200 (tax free as completely offset by depreciation and expenses)

Total annual Expenses: $18,000

This includes condo association fees, maintenance, average annual repairs, landlord insurance, mortgage interest, property tax escrow, and percent of annual accumulated depreciation that will eventually need to be recaptured.

Annual profitability (excluding any increase in property value):  $13,200

Annual mandatory and extra principal payments ($43,000; seems irrelevant to this calculation)

Rental RoI (excluding any property appreciation):  $13,200 annual profit / $225,000 (Adjusted equity based on estimated current value, depreciation recapture, capital gains tax, and passive loss carryover) = 5.87%.

Rents have been rising on average $1200/yr.  Future property value appreciation tough to predict, but good city location.  Possibility of future costly special assessments.  May need a kitchen renovation before selling depending on the market.  Variable interest rate has drifted up from 2% to 3.5% but in no rush to refi due to investment property surcharge.  Could easily pay off remaining mortgage in a few years if needed.

Despite having some difficult tenants and more than my share of headaches the last few years, it seems a good long term hold, no?  Would others assess differently?  If I can stomach holding until retirement, I can potentially avoid paying any capital gains tax.  Or I could 1031 exchange into something lower maintenance or even rental properties for my kids while at college or grad school.  Or I could just cut bait now as i clearly don't enjoy being a landlord.

Thoughts?

 

 

[ENT Doc]

I wouldn't look at things from a ROI standpoint.  I would look at things from a post-tax cash flow perspective and then assess your annualized rate of return.  Presumably there was an up front investment.  If this has purely been a rental property then you have an investment at time 0 followed by a stream of after-tax cash flows.  I would not add back anything from depreciation as an expense, as this is a non-cash item that shelters you from tax (negative cash flow) now but will need to be accounted for at time of sale (at a 25% rate).  I would also definitely include the annual $43k in principal payments, as this is a negative cash flow.  It seems you actually have a stream of negative cash flows, or "investments".  For your sale price now make sure to get good comps and take off 6% for realtor fees.  You seem to have a good handle on what needs to be adjusted to determine the basis but keep in mind the depreciation is taxed differently.  So then you have an initial investment, the other yearly investments, and a big cash flow at the end.  Calculate the IRR.  That will give you an understanding of your annualized return to this point.  You can project future cash flows to see how that will look moving forward.  For the sale/hold decision this depends on what alternatives you have, the risk you're willing to take, etc.  Gets a bit more hairy.

[TheGipper]

Appreciate the input.

In my mind the hold/sell comparison really comes down to:

A) Lets say I sell today and realize $225,000 (after depreciation recapture at 25% and payment of capital gains after passive carryover loss offset). If I dump this into index funds in a taxable account, at my desired AA, I might expect an average 6% annual nominal return. There will be minimal tax drag, so say 5% nominal return as a conservative estimate. That's $11,250 this year and compounding going forward. Also free of landlord hastle.

B) If I hold the property (ignoring voluntary extra principal payments), I'll net about $13,200, free of tax this year, increasing about $1000/yr with rent increases and slight decreasing mortgage interest. The property will also appreciate slightly on average each year, but the amount of total depreciation subject to recapture will also increase. If I wait to sell until a low income early retirement year, I likely can avoid any capital gains tax.

Which would you prefer?

[Zaphod]

I also am not enjoying being a landlord, and the property management company hasnt been very good and basicalliy is skimming at this point.

The money is comparable to what I could earn in the market, if not lower, and there is considerable headache and liability.

Unless something changes when this lease is up the house is being sold.

[StarTrekDoc]

Headache factor reigns supreme. Real estate can be extremely easy in your investment portfolio like a reit fund. If you want management, reward needs to outweigh passive investment significantly unless you have a spouse willing to take it on or an interest in re as a hobby or second job.

That's factor but.ber one to decide hold or sell. Everything else is simply about tolerance and margins.

To that, my litmus test foremost is low pain tolerance. We have two properties with higher returns but lower ses so higher pain issues so those get a management company to handle matters. Like a good coding billing company, a good manager is worth their weight in gold.

The higher the income earner, the better the deal on real estate. So those 40% , finding a cash flow property that's neutral and low pain can effectively shift taxation from depreciation/recapture savings by 15% easily on that alone.

[ENT Doc]

My suspicion is that your return is going to look fairly ugly given the principal payments you're doing.  If you can stop those and let someone else pay off the home then things might look better that I would keep it.  I think the best real estate investments are ones of short duration (15 year loan) and where the rent pays for everything.  You'll find some sweet returns in there.  If you can't stop the principal payments I'd probably get out.

[TheGipper]

The extra principal payments are voluntary which is why I exclude them from the rental analysis.

They apply more to the age old argument of "invest vs prepay mortgage principal", for which I am in the split the baby camp with today's equity valuations, especially if one is comparing prepaying principal vs bonds.

[Complete_newbie]

Your returns are better than the market. I would keep the investment.

IRR vs r (your risk free rate va you can get that return and you know so) is the best way to compare these things for buy sell decision IMHO. Ofcourse within that "r" the time you out in/headache that you may call it also should be baked in.

[Zaphod]

Im sure some of the issue is my current rental just has a painful tenant and terrible management company.

However, the returns are lower than I could get in the market with a lot more hassle in general. I'll see what happens when the lease is up, but for now I'd rather have the money in the market.

I will wait until next tax season maybe, 15% would be pretty sweet and possibly worth it.

[FIREshrink]

TheGipper wrote:

Appreciate the input.

In my mind the hold/sell comparison really comes down to:

A) Lets say I sell today and realize $225,000 (after depreciation recapture at 25% and payment of capital gains after passive carryover loss offset). If I dump this into index funds in a taxable account, at my desired AA, I might expect an average 6% annual nominal return. There will be minimal tax drag, so say 5% nominal return as a conservative estimate. That’s $11,250 this year and compounding going forward. Also free of landlord hastle.

B) If I hold the property (ignoring voluntary extra principal payments), I’ll net about $13,200, free of tax this year, increasing about $1000/yr with rent increases and slight decreasing mortgage interest. The property will also appreciate slightly on average each year, but the amount of total depreciation subject to recapture will also increase. If I wait to sell until a low income early retirement year, I likely can avoid any capital gains tax.

Which would you prefer?

Click to expand...

Historically stocks have returned 11% per year, not 6%. The tax drag is much less than 1% if you use a tax-efficient index fund; it is more like (0.23*2.5)= 0.6%.

And with B), you sacrifice both diversification and liquidity.

And in both cases, you can hold to a low income early retirement year and sell and avoid capital gains taxes.

It's not entirely clear to me that your argument is a winning one.

My rental is: $8000 net profit, over $110k in equity (if I sell, net of taxes, fees, recaptured depreciation). We also have seen rapidly rising rents and property values. To me, my rental is a toss up; I hold because of inertia, not much more. And I think my numbers are better than yours.

But I'm not an expert in real estates and don't pretend to be.

[TheGipper]

Yeah, I don't think 11% historical returns is a realistic expectation over the next 10 years, even if I invested 100% in equities, which I won't.

Since rental income (but not equity) is fairly guaranteed and low correlation to market returns, some might argue a better comparison would be bond or CD with marturity matching my planned holding period of the rental or a mixed stock/bond holding, not 100% stocks.

Your parsing hairs a bit about precise tax drag. You might be right it's only 0.6%, but for me was higher this year despite holding Vanguard Total US and Total international due mainly to the % non-qualified dividends with VTIAX.

[StarTrekDoc]

If one is talking about historical returns, real estate is 10%.

http://www.investopedia.com/ask/answers/052015/which-has-performed-better-historically-stock-market-or-real-estate.asp

If one purely leverage and forgetting cash flow/depreciation/recapture.

A $100,000 investment in equities nets $100,000 investments. 10 yr @ 10 on $100,000 compounded = $270,000 = $170k earnings

A $100,000 in RE with financing and flat cashflow conservatively nets you $400,000 investment.  10 years @ 10% on $400,000  compounded = $1,080,000 = $600k earnings on same.    even at 5% = 660,000 = 240k earnings beats out the market.

There's a lot of different ways to parse Real Estate -- it's not a 1:1 equation just as the same to say invest in stocks --  not so simple.

 

[NJDoc]

If it is a hassle - why not 1031 into a TIC ? Lots of companies out there willing to take a cut while doing the exchange.

The point is real estate can be a hassle, I dumped the single family home/condo thing years ago, and now am only in large real estate funds, and a couple of syndications with fellow Docs. Most of the funds are doing 7% or better COC, with estimated IRR's of 12-14%. Not only that but you reset the depreciation clock each time you roll into something else. Others will have different opinions on that, but it's my two cents.

 

 

 

[Cosmo]

StarTrekDoc wrote:

If one is talking about historical returns, real estate is 10%.

http://www.investopedia.com/ask/answers/052015/which-has-performed-better-historically-stock-market-or-real-estate.asp

If one purely leverage and forgetting cash flow/depreciation/recapture.

A $100,000 investment in equities nets $100,000 investments. 10 yr @ 10 on $100,000 compounded = $270,000 = $170k earnings

A $100,000 in RE with financing and flat cashflow conservatively nets you $400,000 investment.  10 years @ 10% on $400,000  compounded = $1,080,000 = $600k earnings on same.    even at 5% = 660,000 = 240k earnings beats out the market.

There’s a lot of different ways to parse Real Estate — it’s not a 1:1 equation just as the same to say invest in stocks —  not so simple.

 

Click to expand....  Cash flow is your ROI.

Forgetting cash flow?  That should be a primary consideration.

Where are you going to earn a $40,000 annual return on a $400,000 property? A 30 year $300k mortgage +insurance + taxes is going to run you at least $2,500 - $3,000 a month.  $40k/12 months = $3,333 a month profit??  I don't know of any $400k property that you're going to rent out for over $6,000 a month.  Maybe 10% on your $100k, maybe.

[StarTrekDoc]

Cosmo wrote:

StarTrekDoc wrote:

If one is talking about historical returns, real estate is 10%.

http://www.investopedia.com/ask/answers/052015/which-has-performed-better-historically-stock-market-or-real-estate.asp

If one purely leverage and forgetting cash flow/depreciation/recapture.

A $100,000 investment in equities nets $100,000 investments. 10 yr @ 10 on $100,000 compounded = $270,000 = $170k earnings

A $100,000 in RE with financing and flat cashflow conservatively nets you $400,000 investment.  10 years @ 10% on $400,000  compounded = $1,080,000 = $600k earnings on same.    even at 5% = 660,000 = 240k earnings beats out the market.

There’s a lot of different ways to parse Real Estate — it’s not a 1:1 equation just as the same to say invest in stocks —  not so simple.

 

Click to expand….  Cash flow is your ROI.

Forgetting cash flow?  That should be a primary consideration.

Where are you going to earn a $40,000 annual return on a $400,000 property? A 30 year $300k mortgage +insurance + taxes is going to run you at least $2,500 – $3,000 a month.  $40k/12 months = $3,333 a month profit??  I don’t know of any $400k property that you’re going to rent out for over $6,000 a month.  Maybe 10% on your $100k, maybe.

Click to expand...

Not sure what you're talking about on that.  the return is appreciation of property that I was referencing -- much like the 10% return on an equity on appreciation.   Cash flow on RE can be thought like a dividend producing stock.   So the complexity of a RE investment is oftentimes a mix of a stock that's both growth and dividend producing.

eg:  we have a $500,000 property in 2014 generating $2500 rent in a stable environment and is about $200 cash flow positive a month = $2400/year after all expenses .  If we fully leveraged this, the cost would $150,000.  So in stock speak the 'dividend' = 1.6% -- paltry in dividend terms.

But, this stable property with low turnover, has appreciated to $600,000 over the past two years and in high demand, HCOL, best school district and location that weathered even the 2008 downturn quite well and fully recovered by 2012.     Over two years, that's $100,000 paper earnings on $150,000.  or yearly ROI 33% yearly.

vs property #2 is in a lower SES area that is managed by a property company $200,000 and generating  cash flows of $600 monthly = $7200/year on $60,000 investment.  = 12% cash flow yearly.   The appreciation slower but we luckily bought on foreclosure and currently worth $300,000 after 7 yrs $100,000 on 60,000 / 7 = 24% annual yearly.