To illustrate this, I have a case study of a client who came to me for advice on what she should do with her house that is entirely paid off.  Using my Return on Equity (RoE) spreadsheet, I was able to walk her through all of her options and help her make the best decision for her.  

You can find the podcast for this blog post within the episode #292: Seeking Input for ADU Course, Simple Investment Metrics, and a Deep Dive into Paid Off Properties. Tune in Wednesdays at noon MT to join me live for the next Drinks and Deep Dives show.

My client has a single family rental in Longmont, CO that she bought about 20 years ago for $79K.  The conservative value of this home today is $450K, though some comps could push it closer to $650K.  She paid off the home and is getting an annual rent of $1925 a month.  Using the standard operating assumptions and the conservative home value, I ran her information through the RoE spreadsheet.  

Return on Equity Spreadsheet Inputs and Options

Using this information, I was able to run through the scenarios of what would happen if she kept the property, refinanced it, or sold it and used the proceeds to buy another property.  Using these options, we can see what would happen if she were to reposition the equity on this property, how it affects both short term and long term cash flow, and how the wealth building mechanics of real estate (appreciation, depreciation, and debt pay down) are affected.  The cash out refinance is not a strong choice here, so we focused on keeping it or selling it and buying a new property.  

Option #1: Keep the Rental Property

With the Keep It option, we are looking at three main things: rent minus all expenses, which leaves her with $15K a year; the 6.4% return on equity, which is about $29K total; and the cap rate of 3.3%.  

Depending on the phase of life of the investor, these numbers could mean different things.  For me, I’m in the phase of life that I’m accumulating properties, so these numbers don’t excite me because I’m looking for a greater return.  At these rates, I could make more money in the stock market with fewer headaches and liabilities.  However, if I fast forward a couple decades, these are the types of numbers I am going to want as my investments go from riskier to more conservative.  The 6.4% return necessarily isn’t good or bad, it’s just a number that needs to be put in the context of my goals. 

Option #2: Sell the Rental Property

If she were to sell this property, my client would walk away with about $420K in cash.  Because it’s a rental property, she needs to be aware of the tax implications of selling it.  This is why taking advantage of the 1031 exchange is important, since it allows people to buy and sell while deferring capital gains taxes.  

Comparing Returns

For our purposes, we will assume that she would put down 25% on the new property and it would have a 4.7% cap rate.  

We can see that the highest cash flow comes from keeping the property.  This makes sense because the biggest expense is almost always the mortgage, so without that, the rental income is going straight to the investor.  Buying a newer, more expensive property means there will be financing, so the cash flow will drop from $15K a year to $9K.  Does that mean that she shouldn’t sell the property because of this?  Not necessarily.  

Comparing Net Operating Income

To compare apples to apples, we can look at the Net Operating Income (NOI) of both properties.  The NOI is the income from rent minus operating expenses but before the mortgage expenses.  For the existing property, the NOI is $15K a year since there are no mortgage expenses.  The NOI of the new property is $80K, which means that once the mortgage is paid off, she would get $80K a year vs the $15K she’s currently getting.  

This is why clients’ goals and timelines are so important when making a decision.  If my client wants cash flow today, then buying a new property and cash flowing $500 less a month may not be worth it to her.  However, if she is at the point that paying off the property years down the road matches up when she’ll want to cash flow, then selling and doing a 1031 exchange is the better option.  Clients get the greatest return by leveraging up and matching up their acquisitions to their timelines so they’ll get the greatest cash flow at the time that cash flow is most important for them.  

Is now a good time to do a 1031 exchange?

I often get asked about 1031 exchanges, especially now that there are proposed changes to the tax code.  These changes would limit capital gains from an investment property to $500K for a single person or $1M for married couples.  If you’re a mom and pop landlord, these numbers are probably not going to affect you.  However, this would greatly affect an institutional investor, and is worth paying attention to for them.  If these changes would impact you or you’re losing sleep thinking about it, then doing a 1031 right now makes sense.  

On a more general level, doing a 1031 exchange right now is a smart move from a market standpoint, too.  In the current market, you can sell a property and get top dollar for it, so it’s a good time to take advantage of equity and buy another property.  While this would then put you in a competitive buyer pool, you’re also using leverage to lock in a long term low interest rate.  This is a great time to take advantage of the market to buy a better performing property, as well as getting cheap, long term debt.  

Whether or not you want to do a regular or reverse 1031 exchange will depend on your circumstances.  A regular 1031 exchange requires you to sell your first property and then identity the replacement within 45 days of closing.  This is a tight deadline, especially in a competitive market, so many people are looking into a reverse 1031.  In the reverse 1031, you can buy the replacement property first and then sell the preexisting property within six months.  However, this comes with a higher fee of about $5K vs $1K, and you have to have the means to buy a property without first selling one.  Some people have the capital to do it, while others are meeting with lenders to find creative ways to finance the purchase.  There’s always a risk with the reverse 1031 that the market could go off a cliff, leaving you on the hook for two properties, though that isn’t likely.  

Most of our clients are doing regular 1031 exchanges, and while the turnaround time is short, we have a 100% success rate.  The main reason for our success is that we do a lot of prep work ahead of time.  We identify the replacement property prior to closing and try to get our clients under contract before their closing date on the first property.  If you are considering doing a 1031 exchange, reach out to us and we can make sure you fit the requirements and answer any questions.  

Conclusion

While these are complex topics, the most important aspect is creating goals.  At Envision Advisors, we focus on long term wealth creation, not short term wealth.  We can help you create a plan for your goals, review your portfolio to ensure you’re on track, and put all of it into context.  Reach out to us with any questions and we are happy to help you.

If you would like more information on how to use the Return on Equity spreadsheet and analyze investment properties, check out our free online Investment Property Analysis Course. Module 3 of the course focuses specifically on the RoE spreadsheet.

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Seeking Input for ADU Course, Simple Investment Metrics, and a Deep Dive into Paid Off Properties