Today’s question comes from John, and he’s asking a question about when should he sell his rental property and buy somewhere else? And he writes and says, Marco, I’ve been listening to your podcast the last several months, you do a great job in explaining the different topics that you bring to the table.
Well, thank you.
I have a few rentals that I own, and I am wondering if I should sell them as a 1031 exchange and buy somewhere else where my return on cash is better and will appreciate better. How do I determine if you should sell and move on to another area or state? And I am sure you’ve gone over this before, but can you explain it again or send me the podcast so I can better understand. Thank you, John.
[spp-player]
Well, John, I appreciate the question. I believe I have talked about this here and there. I don’t think I did a dedicated episode to the subject, although that’s not a bad idea. And I think ultimately that’s what this is going to become. So you may have actually answered your own question as to the why, and that is the only reason you would sell your rental in one market and then buy somewhere else. Whether it’s an area in the same state or outside the state and elsewhere is for either A better cash returns or B better appreciation, potential, or C a combination of both. And often it’s because of both. But here is my answer to your question as to when you should sell. First of all, I’m going to just say that generally speaking, you’re not going to be selling your properties and not very often, you’re not in the game of trading like a stock trader where you’re in and out of transactions and you might be in a market and in a property one year and then two years down the road, which in the stock world sounds like an eternity, but in the real estate world is not very long.
You’re not going to be buying one year and selling next year or the year after unless there are some incredible circumstances that have happened and it is pushing you in that direction. But again, generally speaking, you are not flipping properties. You’re not selling your portfolio very often. You’re going to build and buy and hold, build your portfolio buy and hold. But there are some times where it makes sense to sell part of your portfolio. That could be one property. It could be a couple of properties, or it could be all of your properties in a particular market and that you move that equity and build up in another market. So for me, there are three situations where it makes sense to sell off part of portfolio and move elsewhere.
So the first for me is when there are strong or major market shifts in a particular market. Now, often this has to do with two main things, which are the things I talk about most often. Number one is, are the jobs moving to other markets, meaning that you are losing jobs in a particular market. And that is a trend that has been going on for a while, particularly a number of years. And the writing on the wall is basically telling you that that is not going to change kind of a crazy example, maybe. But if you look at Detroit from years ago, when jobs were being offshored to other countries, and those jobs were disappearing from the Detroit Metro area, that was clearly a sign though, that dragged on for many, many, many years. And it is still to this day, a bit of a problem because of the, uh, support industries around the automotive industry. Now some of it has come back, but when you see jobs being moved from one state to another, IE California to places like let’s say Texas, or from cities like Detroit to other markets, such as whether it be Germany, China, wherever, then you have a problem because when the jobs go away, people tend to move to other places where the jobs are located.
And that’s also the flip side of the equation as to what markets should you be investing in? Well, obviously it’s the one that has strong, ongoing and sustainable persistent job growth. So when there’s a strong market shift in terms of jobs, that is a time to take a serious look at what that trend is and how long it’s been going on for and how long you anticipate it to continue. So if there are not things that are happening within that market economically and politically to turn the tide, then maybe you should start to move out. But if things are in play to bring jobs back, and there are a lot of policy changes and drivers and large employers coming in like the Amazon’s of the world or auto companies or whatever it may be, then yes, stay or maybe move to that market. So jobs is number one, number two, again, under that same bullet point of strong market shifts would be related to the jobs, but population growth.
So positive net migration or negative net migration. So if you have a growing population, that is a good thing because it creates the demand that you need for that market to have growth in rental properties, household formation, et cetera. But if you have negative net migration, then that’s a problem because if that’s consistent and persistent, it’s going to mean that you’re going to have lower demand for homes and rental properties in that market. And you really need to take a close look at this stuff. When you do your research, of course, you know, search engines like Google can be your friend, because you can put in search phrases and terms to pull up information and articles related to population growth, job growth, et cetera. So look at the market shifts in a market. Now the nice thing about real estate as markets move rather slowly, they don’t change overnight and they’re not erratic and volatile like the stock market. So you can see these trends coming. You can see them form, you can see them change month over month, year after year. So you have lots of time to observe and take the necessary action. That’s the great thing about real estate. So those are the market shifts.
The number two thing I look at is what is my rent to price or value ratio. Now it’s price when you first buy the property, but as the years go by the value of that property changes, and more often than not, it goes up. So your rents will typically go up with it. But often you will find that your monthly rent doesn’t grow or increase at the same pace as the property value. So what that means is that I like to use the hundred thousand dollar properties and example, you might buy a hundred thousand dollar property today with a thousand dollars per month rent. So you have a rent to value or rent to price ratio of 1%, but let’s just say 10 years down the road, that property has appreciated to say $150,000. Your rent may not have kept pace with the price appreciation of that property. So it may not be 1500 a month on that $150,000 property. Therefore you need to look at your numbers and just see if you are underperforming. So if you have $150,000 property with a $1,400 per month rent and that’s market rent, that’s fine. You know, that’s in the ballpark, it’s in line. But if your rent is still at, let’s say 1100 a month, because that’s all you can get for it. That’s what market rents are. But that property has appreciated rapidly and has gone up to 1500 a month. This doesn’t happen all the time, but it can happen where you see that.
Well, then you need to run your numbers, look at the property, and just see what you are getting in terms of your cap rate, your capitalization rate. Cause I I’ll bet anything that has dropped in tomorrow’s numbers. So when you’re actually doing the analysis, what may have been a 7% cap rate property, maybe today is like a 4% cap rate property. So it is not performing in terms of cash on cash return. It did do well in terms of appreciation, you did very well in terms of price growth, but now you’re not getting the rates of return that you could be in terms of cash on cash return. So look at the rent to value ratio, the rent to price ratio, the markets that have shown this type of price growth with lagging rent growth include for the most part a lot, if not all, a lot of the coastal markets in California, other markets would include Washington, DC, Denver, Colorado, parts of Phoenix, parts of Idaho, although not so much, but you get the point. And that is, is that prices have appreciated quickly, rapidly, and, uh, year after year after year and rents didn’t keep up. So that’s when you start to pencil the numbers and compare what you have gained and what you are currently gaining in terms of rents each month, each year, and compare that to similar opportunities in other markets that offer maybe better rates of return on your cap rate and your cash on cash return, but offer good appreciation potential, whether it be today or in the years to come.
So the third reason, and this is a big one for someone who really likes the passive income and likes to have a deduction to reduce or eliminate the tax impact of the cash flows from their properties. And that is depreciation. So after 27 and a half years, the depreciation on your property will essentially run out because the IRS allows you to depreciate the improvements, the property for 27 and a half years. So after 27 and a half years, you don’t have any more depreciation as a write-off. And so at that point, you have nothing to offset the taxes that you would need to pay on the rental income from that property. So that would be a point in time where it may make sense to sell the property and do a 1031 tax-deferred exchange, just simply call the 1031 and move that equity out of that property. And you can keep it in the same market. If the market still makes sense from an investment perspective, it just checks all the boxes. Or you may need to look at other markets where you have better upside potential and an improvement on your cashflow or an improvement on your property’s financial performance, such as the cap rate or your cash on cash return. After 27 and a half years, if you haven’t paid down your mortgage or accelerated your payments, you probably still have two and a half years worth of a 30 year fixed-rate mortgage, which means that you don’t have very much principal left.
And that would be very easy and quick to pay off. So for all intents and purposes, let’s just say, you don’t have a mortgage on that, but again, you don’t have the depreciation write off. So it may make sense to look elsewhere. You can’t just simply refinance it and reset the clock on the depreciation. You can certainly pull equity out, which is great, but you can do that by selling it under the 1031 exchange. So you can do a tax-free and reset the clock on your depreciation on a new property, as well as have the equity to go along with it. So you can invest in one or more properties and make a lateral move or step up and increase the size of your portfolio. Basically, go from that one property to two or three or more.
So those are the main reasons strong market shifts change in the financial metrics of that property. Like the rent to price ratio. If it’s not giving you what you should get out of that property, then look at other opportunities elsewhere. And thirdly is the depreciation clock. The 27 and a half years has simply run out. A fourth potential reason would be just simply a clear cut, better opportunity in another market where you are getting the same cash flows or better in another market on another property. And you have hopefully a stronger potential for price growth because of what is going on in that market. In terms of let’s say employment or big companies moving in consistently, not just one time, um, you gotta look at those dynamics. So if you have much better opportunities elsewhere, it might make sense to get out of a market that has been stagnant. If you will, for a period of time, even though it might do well for you financially, in terms of cash flows, et cetera, it’s all a matter of comparing what is going on today with your properties versus what you could be doing in other markets with the same equity and effort.
That is pretty much it. Keep in mind that whenever you do a transaction like this and you sell your properties in one market, or even if it’s just a single property and you’re selling from one market to another, keep in mind, you’ll have transaction costs. So you have to factor in the transaction costs in making that move. So in other words, do the math. And what that means is you have to look at the sales costs and the buying costs of getting out of one property and into the other. So you may not be paying taxes in moving and transitioning out of one market and into another, but you will have sales costs, whether it is a commission on the sale of your property, that could be 3%, 6%, or maybe nothing. If you’re selling it yourself, of course, there’s going to be some transaction fees related to the escrow process, transfer taxes, et cetera. And then of course there may be, or probably will be some costs when you purchase the other property, moving into the other market. So do the math on that and just factor that into the equation as to whether it makes sense now more often than not, that has a very minimal impact on the decision as to whether to move or not from one property to another one market to another. But again, it’s still a cost. So factor in the transaction costs in terms of selling, buying, and the escrow fees and whatnot.
Okay, John, well, I appreciate the question. It was a very good question. Of course. So I hope that was helpful for you and everyone else. That is it for today. If you have any questions about real estate investing or finance, please submit them to me. I’m going to have my team actually start looking at some of the questions that come in. So hopefully you guys don’t mind if I let my investment counselors reply to some of your questions. If I can’t get to them here on the show, if you haven’t subscribed to the show, remember to subscribe, we would love for you to be notified for each and every new episode that comes out helps share the show with other likeminded people. If you have friends that like real estate and investing, tell them about the show and that is it for today, thank you for listening. And I will see you on our next episode.
Are you having a hard time finding great investment properties? Unfortunately, the best deals are rarely found locally successful investing begins with the right properties in the right markets. Norada real estate provides everything you need to invest in the best deals across the US. Our simple proven system will help you create real wealth and passive monthly cash flow. Get your free copy of the ultimate guide to passive real estate investing at www.NoradaRealEstate.com/guide.