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Why I am Selling My South Bay Residential Income Property (Part Two)

I recently received a lot of feedback on last week’s blog post titled “Why I am Selling My South Bay Residential Income Property.” There was some good feedback and a lot of great comments.

Below are a few examples of questions and comments I received:

  1. “If you own at such a low basis, your returns are much higher…so why the heck would you sell?”
  2. “I only want to invest in real estate and have been sitting in cash for two years. Thanks for the post and I will continue to wait.”
  3. “What are you going to buy with the proceeds that justify taking such a big tax hit?”

All of these comments and questions are excellent and it makes me proud to have such a thoughtful reader base.

I try to write blogs that apply to everyone, but these comments show that real estate is not a one-size-fits-all business. Sometimes an individual scenario will dictate different actions on a piece of property. While I might be a seller, others may be buyers or continue to hold.

I cannot stress enough how important it is to analyze your specific real estate goals. The comments above actually suggest to me that some people should sell (like me) and others should buy now…and everything in between.

Before I get into further reasons as to why I am selling, I want to address some of the comments and questions above.

  1. “If you own at such a low basis, your returns are much higher…so why the heck would you sell?”
    1. Answer: You need to make an ROE (Return on Equity) calculation once you have a lot of equity in a property. If you can reallocate the equity that computes into a higher ROI (Return on Investment) and you feel that another asset has a better growth story, then it is time to sell and move the money.
  2. “I only want to invest in real estate and have been sitting in cash for two years. Thanks for the post and I will continue to wait.”
    1. Answer: This is a situation where if you do not like other assets and only want to invest in real estate, then it may be okay to buy. If you plan to hold long-term and buy multiple properties over that long-term period, then timing does not matter nearly as much. Real estate will likely beat cash over the long-term, so why try to time the market?
  3. “What are you going to buy with the proceeds that justify taking such a big tax hit?”
    1. Answer: As my CPA says, “Never let the tax tail wag the profit making dog.” If you are paying a big tax bill, then you made an even bigger profit. If you can reallocate the money into a higher yielding asset with a similar risk profile, then ring the register. On the other side, if you are ONLY a real estate investor long-term, then it probably behooves you to reallocate by utilizing a 1031 exchange to defer taxes to a later date.

Enough of my “answers.”

Let me get into more detail as to why I am selling beyond the fact that I think my Hawthorne triplex appreciation and rent growth has run its course.

Everyone has personal motivations that dictate their motives for buying, selling, or waiting. So, I am going to share my personal analysis so you can see how an investor thinks.

These are the three top reasons in addition to last week’s blog that is compelling my sale:

  1. A poor ROE that I want to reallocate.
  2. I can make a better, “guaranteed” return elsewhere.
  3. For someone my age (34), I believe covered land plays will drive more wealth creation.

Reallocating a Poor ROE

I purchased my Hawthorne triplex for $525,000 at an online auction on Christmas Eve of 2014 and closed in the new year of 2015.

The property was purchased with some creative financing and was then refinanced into traditional debt. To keep things simple, I am going to break down an example if this was acquired by standard means, which is a 25% down payment and financing the remaining balance.

That 25% down payment would have been $131,250 and a mortgage amount of $393,750.

If I were to achieve a full asking price for my Hawthorne triplex at $1.1 million, net of selling costs, my net revenue would be $1.034 million.

Then, subtracting out my $393,750 existing loan will give the equity position in the property.

That equity number is just about $640,000.

The current NOI (Net Operating Income) is $52,884 a year. I have a property manager that manages my Hawthorne triplex so my true NOI is $49,164 a year.

My $393,750 loan at a 4.5% P&I 30-year fixed is equal to debt service of about $24,000 a year.

So the net cash flow is about $25,000 a year.

Now, let’s run the ROE.

  • $25,000 cash flow / $640,000 equity position = 3.9% ROE

A 3.9% yield is a poor return in my opinion.

I believe that I can do better reallocating that money elsewhere with the same or even better growth potential in another real estate market or asset class.

A “Guaranteed” Return Elsewhere

Please keep in mind that my ROI (my original investment) is CRUSHING it.

  • $25,000 cash flow / $131,250 down payment = 19% ROI

That is a great return…if the value of my property was still $525,000. If it was, then I would continue to stick with this income property investment.

But as an investor, you need to always analyze the equity position/growth in your property or asset. From there, you can consistently make ROE calculations that will dictate when it might be the right time to sell and reallocate to drive better long-term wealth creation.

In my case, I have invested in another income property in Los Angeles that I think has better appreciation prospects currently than my Hawthorne investment does.

I will explain the growth in the next section.

Over the last few years, I have constructed and built a daycare building that houses a local operator. During construction, I borrowed at 9% and have recently lowered those rates to 7%.

Since I am earning 3.9% on my equity, I have made the decision that it makes sense to reallocate that cash and earn a “guaranteed” rate of return of 7% by paying down the debt.

It is guaranteed because I am paying an interest of 7%. So by saving 7%, I am actually earning a 7% ROI.

If you take a tax rate of say 25% on my gains, then the true net of the equity is about $510,000 (I did not tax the original down payment). At 7% interest expense on $510,000, that is $35,700 in interest savings which beats my Hawthorne cash flow by over $10,000 annually (remember, $25,000 a year in cash flow with Hawthorne).

That is big money to save aka earn.

I lock in a profit of an amazing gain, net of big taxes, and I earn a better rate of return that I can absolutely guarantee will continue into perpetuity due to the savings.

Covered Land Plays for Appreciation on Steroids

My daycare property was a big risk because it did not cash flow before I constructed the new building. The debt was expensive at 9% and it is still expensive at 7%.

By paying off the debt, I trade cash flow of $25,000 with the Hawthorne triplex and now save $35,000 in debt service. An easy $10,000 boost to my income statement…guaranteed.

Why am I willing to sell my Hawthorne triplex and keep my Los Angeles daycare?

Well, one is at its “highest and best use” and another has a lot higher use.

My daycare property is zoned for at least 24 apartment units. I cannot afford to build the apartment complex, nor does it make sense today. But, it will pay off long-term.

Let me explain why and what is known as a covered land play…

A 25-unit apartment building on my lot would cost about $6 million to construct.

The new apartment building would be worth about $8.4 million at a 5% CAP rate which can be achieved in Los Angeles.

I could build the apartment building today and have equity, but the spread is just too thin and not worth the risk of fully financing with $6 million in capital that I do not have.

My current property and buildings are worth about $1.1 million as-is, just like my Hawthorne property.

So, here is the point.

If you assume 5% appreciation on all Los Angeles property over the long-term, what happens to the Hawthorne triplex owner and the Los Angeles daycare owner?

The $1.1 million Hawthorne triplex in 20 years is worth almost $3 million.

The Los Angeles daycare property does not appreciate at $1.1 million, instead, the property appreciates at its “highest and best use.”

So…

The $8.4 million 25-unit apartment complex in 20 years is worth almost $23 million.

Would you take $3 million or $23 million?

I have leverage (and not risky debt leverage) of the new building potential that will be attached to the property long-term. Does that make sense?

Now, for you nerds with calculators, sure, if I build the apartment building in 20 years it would cost more too. So if you factor 2.5% inflation to building materials over 20 years, it would cost about $10 million to build.

I will still take a $13 million gain over a $2 million gain.

And to improve returns, I could choose to build in 10 years and lock in those construction costs and then ride the apartment complex growth for another decade.

Not everyone is comfortable building an apartment complex, but the land value alone on the daycare property will surely get more than the $3 million triplex if the apartment building is worth $23 million and it only costs $10 million to construct.

This very small detail of two properties worth the same today but one being a covered land play and one not being one is a very very big deal long term…

…if it all works out.

Conclusion

My blog from last week still holds true on why I am selling.

I think this additional information is what makes me a hard seller, whereas others may choose to buy my triplex or hold it even longer.

The additional benefits I can achieve are:

  1. A better return on my equity than currently being earned today.
  2. That return is guaranteed.
  3. I believe the covered land play will give me crazy appreciation and wealth creation (paying down debt turns it cash flow positive post-construction so I can hold it over the long-term).

It is so important to underwrite every real estate move for the specific person and their goals.

I hope you learned how I make decisions for myself personally. More importantly, I hope you learned how this could be completely different for someone else.

Additionally, I really hope you took away the insane power of a covered land play. At my age, I will continue to look for more of those opportunities to create long-term wealth for my family.

Wishing you the best in your real estate and investing endeavors.

Cheers,

Richard

DRE: 01779425