When I tell people what I did, the response is “WHAT? Why, you have a low interest rate!”

In short, it’s because I’ve made a huge amount of money on these properties and it’s time to transition my equity to higher performing investments

The return on equity (ROE) is 9.5%, which is about the same as historical stock market returns. If I’m dealing with the headaches and risks of rentals, I want a higher return than the stock market. My target ROE is 15%+.

Plus, the internal rate of return (IRR) is going down every year I hold onto it. IRR shows the annual returns over the investment’s holding period. ROE shows the estimated returns for the next year. 

The condos are in the same Aurora complex that I purchased for $195,000 and $207,000 in 2020 with a 25% down payment. Below is a graph that shows the IRR if I sold in that year. The IRR’s for both are very similar, so I took the average.

What do you notice about the IRR? It shot up in 2021 and 2022! Since the values peaked in 2022 and leveled-off, IRR will start decreasing every year. I wish I could say it was from the value that I added. It’s not. It was the gift of low interest rates that made the values dramatically increase. In markets, like Denver, most of the return has been through appreciation (equity gain), not from cash flow.  Since IRR takes into account the time value of money, it’s no surprise the IRR is highest in the first two years.

Note: This blog article is an excerpt from my Investing Goals Chapter in the 2024 Guide to Colorado Real Estate Investing book (where to link?)

Keep, Refinance or Sell Scenarios

Since the IRR has peaked and is declining, it was time to look at alternatives. My analysis was such a timely action item that BiggerPockets asked me to record a video for their audience. If you prefer video to blog posts, then watch it below.

Video Description: Even if you have low interest rates and plenty of cash flow from your rental properties, it might be time to sell. Giving up that low rate could unlock even better returns and more cash flow than you thought. But when should you sell a high-performing rental property? Chris Lopez is back with another “Keep, Refi, or Sell” episode as he shares why he’s strongly debating selling two of his highest-performing rentals to passively invest in an even better investment.

Chapter Timestamps:

• 00:00 Sell Your Low Rate Rentals?
• 01:57 This is CRUCIAL for Wealth
• 04:16 Sponsor: Property Llama!
• 5:05 Option 1. Keep the Properties
• 07:21 Option 2. Raise Rents and Refinance
• 08:15 Option 3. 1031 Exchange and Buy Rentals
• 11:42 Option 4. Sell and Re-invest
• 15:54 Which One to Choose

Scenario #1: Keep it and Raise Rents by $500+

Both units had the same tenants in there for the last three years. They are great tenants and I had no vacancy or turn costs by keeping them. However, my rents are below market by $250 per unit or about 8%.

Increasing the rents changes the ROE from 9.5% to 11.8%. A 2.3% bump is nice, but it’s still below my 15% ROE baseline target.

An interesting point is that a $500/mo increase in rents has a relatively low impact on IRR. Below is a graph showing the IRR results over the next five years if I held onto the properties and increased them to market rent. 

If I hold for 5 more years, the IRR still goes down! Since so much of the return was front-loaded in the first two years, IRR will not improve by holding onto the properties. 

The only way to tap into equity is to refinance or sell the property.

Scenario #2: Cash Out Refinance

I’ve run this scenario and know the results. Refinancing does not work when interest rates are high. The interest rate will be in the 7-8% range on a 5% cap rate property. It’ll end up being a negatively cash-flowing property. 

Scenario #3: Sell and 1031 Exchange into a Fourplex in Colorado Springs

Previously, I’ve had great success with selling a condo and then doing a 1031 exchange into a fourplex.  Let’s look at purchasing a turnkey fourplex in Colorado Springs for $750,000. It’s a 5.8% cap rate with property management. It needs a 33% down payment with a 7% rate.

Here’s a screenshot from a Property Llama scenario:

Analysis:

• Return on equity decreases by 0.4%, which indicates a lateral move for growth.
• Cash flow decreases from $11,800 to $3,000!
• The high interest rates make it tough for 1031 exchanges. Pass on this scenario.

Scenario #4: Sell and Lazy 1031 Exchange into Passive Deals

Another reason the fourplex trade-up doesn’t work is because prices haven’t dropped. They have dropped in commercial multi-family and other commercial assets. Since I’m seeing the best returns with passive investing and less hassle, I’m doing a “Lazy 1031 exchange”. This is a term I heard from Hall CPA. 

Here’s the process:

• Sell your property
• Don’t do a 1031 exchange
• Invest in a rental (when you find the right deal) or in a passive investment with depreciation. 
• The depreciation from the new investment will offset some of your capital gains and depreciation recapture.

Here are my estimated numbers:

If I did a traditional 1031 exchange, the $40,000 in taxes is deferred. With a Lazy 1031 exchange, I want to reduce my taxes and find a better investment. I’m making three investments with the proceeds:

1. $101,000 in a multi-family value add fund. The depreciation savings should offset my taxes by $10,000 to $15,000 for my lazy 1031 strategy.
2. $70,000 into a private credit fund that funds short term loans to real estate investors. I view debt funds as the new way to generate cash flow. Many are paying 8-12% per year.
3. $50,000 into a development investment for building single family homes in the Denver metro area. The houses are in a great location. The size and prices are also around the median price point, fulfilling a big need for more housing.

Why not invest all the proceeds into the multi-family value add fund for more depreciation? For diversification! Taxes are an important consideration but are not the only factor. Plus, these proceeds are invested with my overall portfolio in mind, which already has significant exposure to multi-family and more depreciation.

I’ll have about $220,000 to invest with the estimated multi-family tax savings. Here’s a table to illustrate my projected returns:

The timing of the return profile is very different than a typical rental. Hopefully, the above table clearly communicates the timing of the cash flows.

Comparison in Five Years

I’m choosing scenario #4 of selling my rentals to invest passively. Here is my projected comparison over the next five years:

Since I’m in growth mode, I’m more focused on equity growth, not cash flow. The passive portfolio is projected to generate more cash flow and more equity growth, while I have less hassle and liability.