2016 was supposed to be the year where I’d finally achieve my passive income goal of $200,000. The goal was first established in 2012 when my passive income machine was generating about $80,000. I figured, if I could find a way to generate $200,000 a year by 2015, life would be good and I’d never have to work in the salt mines again. In 2015, I came up $25,000 short. Now it looks like I’m going in reverse! What the hell is going on?!
As fate would have it, just a couple weeks before my business trip to Europe, my tenants gave me their 30-day notice on a rental that is generating $4,000/month. After all expenses, the property nets around $3,000/month or $36,000 a year. This rental has been a champ with not a single month of vacancy since its 2005 deployment.
Now I’m faced with a decision. Do I try and find new tenants or sell the property in what appears to be a weakening real estate market. Maybe you will face this dilemma one day. Let’s discuss some considerations to make the best decision possible!
Rent Or Sell?
The older I get, the more I want to simplify my life. When I was working full-time, I used to love real estate. During my darkest corporate hours, real estate was the main HOPE that would allow me to one day break free. I didn’t care about doing house calls when things broke. I didn’t mind going to the yearly HOA meetings. Hosting open houses was fun because I could meet all sorts of people who shared fascinating details about their lives. I knew that every action brought me closer to financial freedom.
Since escaping my employer with a severance, however, I have slowly become less interested in landlording. Every text message from a tenant with a problem or every flaker at a open house bums me out. Due to my severance that is still paying out today, the plan to live off my passive income did not materialize. In fact, since I left work pretty much all my passive income has either been saved or reinvested.
Then starting in 2014, I rented out my old house because I downsized to a fixer in a quieter neighborhood. With two rental properties to manage plus a vacation property, I became even less satisfied with landlording. Although I have a lot of free time, landlording started feeling like a job, which is completely opposite of why I wanted to retire early! And what bums me out most is tenants agreeing to lease terms and then breaking the lease terms. Why can’t everybody just do what they promise?
The final thing that’s really made me consider selling is the unexpected growth of my online business. I’m having so much fun being an entrepreneur, that I’m finding I don’t really want to bother with real estate anymore. I’ve always preferred having fun and making money on the side rather than making money and eking out some fun.
My layoff strategy guide alone makes around the same amount as my rental property. Further, the book requires no maintenance or ongoing tax on its value. It’s about as passive an income stream there is. I’ve got a pretty fun post in the pipeline which compares real estate and an internet business you won’t want to miss.
Do The Math
Now that I’ve shared my subjective feelings, I’d like to focus on objective numbers. At the end of the day, an asset’s value is based on the cash flow it can provide.
Not continuing to rent out the property means roughly $36,000 in lost income. Due to depreciation, the taxable income is actually much less. Not all is lost, however, because selling the property would yield proceeds that can be reinvested.
Nobody knows exactly what they will get for their property until they finally get some offers. But you can make educated guesses about a price range you will likely receive by comparing the comps that recently sold based on price/sqft and using cap rates.
Analyze The Comps
My property is 1,000 square feet. Recent comps have sold for $980 – $1,500/sqft in the Pacific Heights neighborhood. Therefore, the range is $980,000 – $1,500,000. Anything above $1,300/sqft is a prime property that has been remodeled. The only thing that has been remodeled in my condo is a bathroom. Everything else is original since 1980. But, I’ve got an amazing dead on view of the park. Therefore, my educated guess is somewhere around $1,100 – $1,200 / sqft, or $1.1M – $1.2M.
Please don’t get hung up about the price of property here in San Francisco. It’s expensive here. Focus on the methodology.
Use A Realistic Cap Rate
Now turn into an investor and use a capitalization rate (cap rate) to value your property. Take your annual Net Operating Income (gross rents minus property taxes, maintenance, HOAs, etc) and divide it by a cap rate in your region. Think about a cap rate as the required rate of annual return on the property or the rate of return buyers in your area are willing to accept.
For example, if you accept a low cap rate of 2%, you believe the property is in a rock solid area and has a strong chance of appreciating. Therefore, income is a secondary consideration to appreciation. If you accept a high cap rate of 10%, it means there’s probably little chance of strong capital appreciation, so you want higher income now.
In San Francisco, the cap rate is currently around 3.8%. That’s 2% higher than the 10-year bond yield, also known as the risk free rate of return. If I want to drill down even further, I need to calculate the cap rates in Pacific Heights. If SF’s cap rate is 3.8%, then Pacific Heights’ cap rate must be between 3% – 3.7% in my opinion.
Find Out Where The Two Values Intersect
Take your annual Net Operating Income and divide it by your area’s estimated cap rate. In my case, I would take $36,000 / 3% – 3.7% = $973,000 – $1,200,000. I can take the average and get $1,086,500. Now I compare the cap rate calculation value to the comps and focus on the overlap. The realistic selling price is therefore around $1.1M. Anything more than $1.1M should be considered a win. Anything less requires more deliberation.
Identify The Special Features
Every property has its intangibles that might sway people to bid much higher than the numbers dictate. I place a premium on properties with views. This property has fantastic park views. I would have happily paid at least $50,000 more for the property when I first stumbled across it for $580,000 back in 2003. But some people like to face other buildings and would never pay a premium for having their eyeballs massaged after work everyday. You just need to find that one buyer who places a premium on what your property offers to get top dollar.
It’s very easy to get biased about our own properties. Selling this condo is like selling my baby since it was the first property I bought as a 25 year old. Being delusional about your property’s shortfalls is hazardous when it’s finally time to negotiate a selling price. Remember to treat your assets as a means to an end. My end has always been happiness and freedom.
Future Income On Sale Proceeds
Let’s say this property sells for $1,120,000. After fees and taxes, I’m left with around $1,000,000 since there is no mortgage on the place. What can $1,000,000 generate based on what I want to invest in?
1) 5-year CD at 2.4%: $24,000 a year. Shortfall to existing income generation: $12,000.
2) California muni bonds at 2.5%: $25,000 a year tax free. Shortfall: $11,000. Don’t think California will default.
3) High Yield Dividend ETF (DVY): $36,000 a year in dividend income. No shortfall, but potentially lots of principal risk.
4) Venture Debt fund with target IRR of 16%: $120,000 a year for a total return of $840,000 over seven years if I assume a more modest 12% IRR. But there’s probably a 30% chance of losing $200,000 at the end of the fund.
5) Automatic investing with Betterment: I could choose a very conservative risk tolerance and have Betterment automatically invest a lump sum or new funds every month into a 50/50 equities and bond portfolio with a 2.5% yield to generate $25,000 a year in gross income.
These are only five examples of what I could theoretically do with the condo sale proceeds to make up for the shortfall. You’ve got to find what’s most suitable for you. There is one interesting investment alternative, which is investing in real estate through a crowdsourcing platform. I’ll do a write up soon as many people have asked.
The Final Question To Ask
I believe everybody should own property for as long as possible. The 5% commission rate and the taxes on profit are economic leaks. Given inflation is almost always up and to the right, your property should keep up over the long run. But if you just can’t take landlording anymore, don’t want to hire a property manager, and believe the timing is right, then selling is a good solution.
The final question you should ask yourself before selling is, “Will I be kicking myself 20 years from now for selling today?” If you’re over the age of 60 with a pension that provides for all your needs, who cares? Life expectancy is only about 84. You might gain a great deal by simplifying the remaining 24 years of your life.
If you’re still working towards your financial nut, don’t have any other income streams, don’t really like your job, and aren’t willing to start a side business, your property might be one of the few things keeping your hopes alive. It often takes several years of losses before finally breaking even. Be patient enough to let inflation make you whole.
Despite the reduced income, I will enjoy not having to manage this property more than the loss. It’s strange, because when you have total freedom, having to do things you don’t want to do feels EXTRA BAD. When you’re getting beat up by your micromanager every day, dealing with tenants and the HOA might feel like a nice reprieve!
If I can’t sell my property for top dollar, I’ll clench my teeth and try to raise the rent by $200 a month as a salve for being a landlord for at least one more year. Maybe there’s hope for achieving my passive income goal yet!
Explore real estate crowdsourcing opportunities: If you don’t have the downpayment to buy a property, don’t want to deal with the hassle of managing real estate, or don’t want to tie up your liquidity in physical real estate, take a look at Fundrise, one of the largest real estate crowdsourcing companies today.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible. For example, cap rates are around 3% in San Francisco and New York City, but over 10% in the Midwest if you’re looking for strictly investing income returns. Sign up and take a look at all the residential and commercial investment opportunities around the country Fundrise has to offer. It’s free to look.
Updated for 2020. I decided to keep my SF rental condo but sell my SF rental house for 30X annual gross rent ($2,740,000) and simplify life. I reinvested $550,000 of the proceeds in real estate crowdfunding and the rest in stocks and municipal bonds. It feels so much better to passively earn income.