Lon Welsh of Ironton Capital is back to explain why it’s not always advantageous to hold onto a rental property. While most investors’ knee jerk reaction is to hold onto their properties long-term, this could actually result in lower returns. Today, we’re looking at a case study of a 4 bedroom/3 bathroom Aurora single family home that Lon recently helped an investor analyze.
- Listen to the podcast “#419: Keep or Sell: Breaking Down the Options for Maximizing Returns” Denver Real Estate Investing Podcast
- Watch the YouTube video (at the bottom).
- Read the blog post. Note, the blog is an executive summary. Get the in-depth breakdown from the podcast or video.
What Are Your Real Estate Investing Goals?
Everyone has different goals for investing in real estate. Some people want to hit $XXX a year and live off of that income for retirement. To do this, they need to obtain a certain number of properties, generally 5-10, that they’ll pay off before retiring.
Most people run into difficulties acquiring that number of properties as it takes a significant amount of money to buy a home. This means they need to optimize their wealth creation so they can get on the right track.
How to Analyze Your Rental Property
Lon recently sat down with an investor who’s owned a single family home in Aurora for several years. He owns and lives in the identical house next door. His family needs a bigger home, so the investor’s plan was to sell his current primary residence and hold onto the rental property.
To calculate the numbers, Lon uses the Commercial Realtor Designation Certified Commercial Investment Manager (CCIM) spreadsheet. While this is a complicated tool, it’s his favorite way to break down the data. We have a simpler version on our website you can use for free.
In order to get the best rental data, put in the address, bedrooms, and bathrooms into a site like Rentometer. You’ll get a range of rents, which can be adjusted up or down based on the condition on your property. In this case, the median rent is $2950/month.
An important aspect that investors need to understand is that every time you renew your lease, you’re buying the property from yourself at the current market value. If the property value goes up and the rents only go up a little, your cap rate (return) is going down. Don’t evaluate the property based on the original purchase price because that is not relevant. This investor purchased the house for $300K 5 years ago, but now it’s worth $600K.
With today’s numbers, his Net Operating Income is $22,700, and his cap rate is 3.8%. Buying the property with these returns today wouldn’t be a great deal. He has $450K in equity that isn’t generating much in the way of returns. Having so much equity that just sits there will kill wealth creation over time. This is why it’s so important to understand how the property is performing today.
How to Make the Choice to Keep or Sell Your Rental Property
We assume the property will go up 4% annually in value over the next 5 years, based on expected trends. Using this data, we can calculate the Internal Rate of Return (IRR) to see the average profit year over year, which compounds over time.
With $450K in equity locked up, a 3.8% cap rate, and 4% appreciation, his annual returns are 8%. As we analyzed in a recent episode, 8% returns are significantly lower than what he could be making by investing that money elsewhere.
Looking at the returns, it’s clear that the investor is better off selling the house and paying capital gains taxes. When Lon showed this information to the investor, he was in disbelief. Because he’s getting $14K in cash flow every year, he assumed his returns would be higher.
Now, he plans on selling both houses, using some of the proceeds to buy the new home, and putting the rest in passive investments. He’s on track to generate a lot more wealth over time.
Analyze Your Own Rental Property
Always evaluate your property using the current numbers for everything: value, rent, interest rates, etc. Understand what options you have and what the returns will look like. When you see how they all play out, you might be surprised that it’s often advantageous to pay capital gains taxes to get better returns.
Before making any move, speak with your CPA or financial advisor.
To get help running scenarios with your own properties, reach out to Lon or me. We love to help investors understand what their portfolios really look like and help them figure out how to maximize their wealth creation.