There are two reasons why I’ve been thinking about selling my main rental property. Real estate is on fire here in San Francisco and it’s always better to sell higher than sell lower. We’ve clearly passed through the worst of the property market and sales prices are up anywhere from 15-25% in the last 12 months alone. Meanwhile, the median asking rent is commensurately up 21% YoY to $3,398. Spending $41,000 a year after tax on rent seems hard to sustain, even if you are making over $150,000 gross a year and working for Google.
The second reason for wanting to sell has to do with hassle. The older I get, the less I want to deal with conflict. I’m currently writing this post during a moment of frustration so my thoughts may be biased. However, it is my hope by writing things out we can come to a rational decision for those who are also thinking about selling their rentals.
At about 2pm the other day I get a blast e-mail from our HOA management company saying,
“I have seen a number of complaints regarding tenant occupied units which needs to be addressed by the Unit Owners. In particular are the following issues:
1. Parking without authorization in someone else’s parking stall.
2. Parking beyond the confines of the parking stall’s floor marking.
3. Not breaking down and bundling their cardboard boxes in the garbage area.
The lack of compliance by tenants places the Unit Owner in serious jeopardy as the Board will be meeting next month to discuss in conjunction with other business matters, solutions and punitive assessments. You are required to have your tenants sign off acknowledging receipt of these documents.”
I’m accustomed to receiving such e-mails because it’s always the same three issues over and over again when a new tenant moves into the complex. No matter how much the landlord stresses these three issues to our tenants, an owner will inevitably complain to the HOA or the property management company about new tenants. The older the owner, the more they will complain, especially if the tenant is younger.
Owners feel they own more of the place than their condo dictates. The longer the inhabitant, the more rights they think they have. Furthermore, there is a bias against younger people because they are viewed as more inconsiderate, entitled, rude, and lazy. The funny thing is an older generation’s bias against a younger generation has held true even during the times of Socrates.
“The children now love luxury; they have bad manners, contempt for authority; they show disrespect for elders and love chatter in place of exercise. Children are now tyrants, not the servants of their households. They no longer rise when elders enter the room. They contradict their parents, chatter before company, gobble up dainties at the table, cross their legs, and tyrannize their teachers.” – Socrates, 470 BCE.
A PHONE CALL SOME TIME PAST MIDNIGHT
The next morning I woke up to a voice mail complaint from my tenant’s downstairs neighbor saying that my tenants were still letting people into the complex at 11:49pm. Because the neighbor lives near the entrance of the complex’s main door, she can hear the buzzing and slamming sounds every time someone enters and leaves. The building rules states there is a quiet period after 10pm, which is loosely defined as being respectful to your neighbors and not throwing large parties with music. Entering and exiting the building after 10pm is fine. This isn’t jail.
The unexpected voice mail I received rudely stated that tenants are not welcome and neither are landlords. It almost sounded like a hate crime insult. She plans to complain to the HOA board and try to institute fines against me. I’m a pretty calm fella who hates getting disturbed at night as well so I sent her a cordial e-mail saying,
“Hi Jane (neighbor) – I apologize for the disturbance and will be having a word with my tenants today and get back to you. I also understand that b/c your unit is next to the main entryway that the buzz and door closing sound can be a problem. Regards, Sam”
I then proceeded to send an e-mail to my tenants to hear their side of the story and get as much info as possible to defend myself from allegations,
Hi Shirley and Stephanie (tenants),
I received a pretty nasty voice mail around midnight from Jane complaining about the noise from your apartment last night. She’s basically going to complain during our next HOA meeting and try to institute fines against me.
I’ve got to now defend myself so I need to know the details of what was going on the evening of October XX, 2016. I’ve noticed their complaints always make things seem bigger than they are, so I hope you can provide some details as to:
* The number of people at the party
* When were the people coming in
* How long did the party last
* Did Jane call/visit you guys to ask to turn it down
* How loud do you think you guys were e.g. blaring music, jumping around, etc.
* Did you violate the house rules?
Because Jane lives right next to the main entryway, she can hear the buzz and doors slam shut the most. I can understand that if she was trying to sleep at midnight how this would be very inconvenient for her. Please let me know your side of the story. And if the party was out of hand I encourage you to visit her and apologize.
MANAGING RELATIONSHIPS IS DIFFICULT
“Can’t everybody just get along?” said Rodney King. This current scenario brings me back to the time of managerial duties at work where egos needed to be massaged and expectations needed to be managed. Sometimes you get lucky and hire the superstar employee who is humble, collaborative, and hardworking. Then there are other times when you make a mistake and hire a prima dona who believes he deserves to make at least $125,000 his first full year out of college like one of my old subordinates. It’s the same thing with finding a great tenant.
To keep the peace I was apologetic to my tenant’s downstairs neighbor even if my tenants didn’t throw a rager. Whatever the true story is, my tenants disturbed the neighbor and that is the bottom line. I have to deal with the neighbor for as long as I own my place while my tenants can simply leave once their lease is done. Maybe I’ll even buy the neighbor a bottle of wine.
So how passive is being a landlord with no property management company really? I include my rental income as a key part of my passive income portfolio. Property management is usually very quiet as my turnover average is once every 2.5 years. Meanwhile, I only get a work order request or complaint once every nine months on average so it doesn’t take much time at all. Most of the complaints are in the first six months and then there are no more complaints for the remaining two years because my tenants start “getting it.”
Thank goodness everything turned out OK in the end as my tenants did apologize in person the next day. My hope is that this is the last complaint about my tenants for a long while.
TIME TO SELL MY RENTAL AND SIMPLIFY LIFE?
When I was working, I’d get more stressed when dealing with my tenants. Now I can easily go visit during the day and help out where needed. I still love rental property despite the work it entails because it’s tangible with a income stream, but as I grow my online business, rental property is losing its favorite nation status. Let me highlight the pros and cons to help readers and myself come to a better decision.
PROS OF OWNING A RENTAL PROPERTY
* Relatively passive income stream. So long as a tenant doesn’t do much damage to the property, gets along with the neighbors, and pays on time, rental income is relatively passive.
* Someone pays your mortgage. A tenant is paying your mortgage and helping build equity in your property. This is usually a net positive over the long run.
* Rents increase over time. Thanks to inflation and general population growth, rents consistently increase over time. The most recent rental income increase for San Francisco is 21% year over year as previously stated.
* Mortgage rate is fixed over time. Not only is the mortgage rate fixed over time, the percent of payment going towards principal also increases over time. Meanwhile, you are paying down your mortgage with inflating dollars making the real cost of mortgage even cheaper.
* Tax shelter while you build equity. All expenses related to operating a rental can be deducted from the rental income stream. If you happen to be in a high income tax bracket, the expense deductions are even more valuable. I wanted to receive 0 net rental income while I was working because I was in the 36% (39.6% equivalent today) tax bracket. Now that I’m no longer working, I’m more inclined to pay down my mortgage and raise the rent because the income will now be taxed at 28% or less.
* A real asset to utilize. Unlike a stock or a bond, you can derive utility in your rental by moving in. My general rule of thumb is to always buy a rental that I’d be willing to live in for two years. I’ve always envisioned having a paid off pied de terre in San Francisco if and when I relocate to Honolulu. I so wish I bought a place in NYC back in 2000 when I had the chance. Even if I lose everything, I’ll at least have my rental to come home to.
* An asset I can pass down to my children. My grandparents left my parents property when they died and such property will likely continue to be passed down. If I have children, I hope to give them a head start by providing a subsidized or free place to stay when they first graduate. I’ve seen so many young adults really progress faster in their career if they don’t have to worry as much about housing costs. Moving to San Francisco or NYC are no brainers for college graduates who want to participate in robust economies. The Step-In Basis is a rule where your children inherit the property at the cost of the present market value, not when you purchase the property. This is a huge tax savings if my kids decide to turn around and sell the property.
* Wealth accumulation. Property appreciates with inflation over time. If you can hold long enough, even a 3% increase is a 15% cash on cash increase of your 20% downpayment. I put down $120,000 back in 2003 for my $580,000 condo. Zillow.com currently has it valued at $910,000. Let’s take a 10% discount to $910,000 and we get $819,000. If I sell for $819,000, I’ll receive gross proceeds of ~$485,000 after subtracting my mortgage and 6% selling fees. I’ll end up paying at most a 15% long-term capital gains tax on a profit of roughly $239,000, for net proceeds of roughly $450,000. Of course I could live in the place for two out of the next five years to avoid the $34,500 in taxes altogether, but let’s stay conservative. My $120,000 downpayment turned into $450,000 over 10 years (includes paying down mortgage, excludes depreciation recapture which I will write about in the future). That’s a 375% cash on cash return after all fees and taxes annualizing at around 18% a year. The return based on a $580,000 purchase price and $819,000 selling price is only 3.7% a year. But as my numbers just demonstrated, the real cash on cash return is much better.
CONS OF OWNING A RENTAL PROPERTY
* Stress. If you are a busy person who works a stressful job, the last thing you want is a scenario that I’ve provided in this post. Fixing a toilet is easy because the job is outsourced to a plumber and just costs money. Ditto goes for installing a new dish washer. Maintaining harmonious relationships is much harder when there is conflict. Conflict is what’s most stressful.
* Liability. Whenever people are involved there is liability. Liability is the main reason why I rejected two Google tenants because they both wanted to have their parents stay with them for six months to a year in my two bedroom. One could slip and fall or get in a fight with another owner. That’s not something I want to deal with hence the reason for my large landlord insurance policies. Make sure your tenants take out renter’s insurance as well.
* Crowding out. The crowding out effect in economics refers to when government initiatives crowds out more productive private sector initiatives, thereby stunting optimal growth. Having a rental property may take time away from you doing something more productive or fun. A rental property also ties up your money, preventing you from making potentially more lucrative investments. I’m pretty sure I could not match a 18% IRR for 10 years with the same amount of stress investing elsewhere. However, putting everything in Google stock would have done just as well.
* Property taxes. Property taxes is the #1 thing I hate about owning property, especially if you feel you are not even coming close to getting your money’s worth. Property taxes makes you realize how inefficient and greedy the government is. When the markets were imploding in 2008-2010, property taxes kept on going up for property owners not savvy enough to fight the tax assessors office. I fought every year for five years in a row and won my appeals. The government counts on its citizens to lay down and eat bitter pills. Stand up people. At least property taxes are deductible. Read: How To Lower Your Property Tax Bill.
* Lower cash flow. Real estate really starts to generate positive cash flow once a long enough period goes by thanks to inflation and a fixed mortgage cost. A $810,000 property in SF will generate approximately $45,000 a year gross revenue, or $33,000 a year after property tax and HOA, equivalent to a 5.6% gross and 4.0% net rental yield, respectively. The $450,000 proceeds from the sale will only generate approximately $13,500 a year if it’s dumped into a 3% dividend yielding portfolio.
To gain more cash flow, you can look into investing in REITs or real estate crowdfunded deals through a firm like Fundrise. Their platform allows you to invest in lower valuation, higher yielding properties in different parts of the country. They also allow you to invest in more expensive real estate deals (e.g. commercial real estate, large multi-family buildings) that once were unaccessible to the public for a potential 8% – 15% rate of return.
* Can’t get back in. There’s never been a point over the past 15 years where I thought real estate was cheap. There were certainly some good values here and there, but cheap never entered the lexicon unless I were to buy in the middle of nowhere. If you time your sale wrong in hopes of getting back in, the market may very well price you out. Ask any long term tenant under rent control whether they wished they bought the day they first signed the lease and they’d emphatically say yes. We’re seeing this happen in more expensive cities such as San Francisco, Manhattan, Singapore, Hong Kong, London, and Paris. Just when you thought prices couldn’t go any higher, they do. I remember when $1,000/sqft was unheard of in Manhattan. Now $1,000/sqft is the price of a nice apartment in Brooklyn!
EXPECTATIONS FOR THE FUTURE
From a financial standpoint we must make best guesses as to how much property prices and rental prices will appreciate. For example, San Francisco is estimated to show another ~4% increase in 2017. But the ramp since the 2012 low seems to be finally slowing down now. The only hope we have is AirBnB, Uber, DropBox and perhaps Pinterest going public to keep the bull market going.
We should also question how important rental property income is for our retirement. Currently I save 100% of my passive income and live off my active online income. However, my online income could one day disappear and my rental income makes up a good 35% of my passive income. Losing this income stream would crimp my style. The other big question is what to do with the proceeds after a sale.
By the summer of 2019 I’d like to have the full flexibility of relocating to Hawaii if I so choose. Having multiple properties in California is an impediment to freedom even if I do hire a property manager. I have no desire to pay California taxes. At the same time, owning real assets is a huge part of financial security. I’m leaning towards holding on to my main rental until my current tenant moves out (soonest would be June 2017) and selling after it is vacant. One or two more years of ownership should see at least a 2% per annum appreciation with tens of thousands more paid down in principal.
I’ll use the proceeds from my rental property to purchase another piece of property in Hawaii for myself or for my parents to live via a 1031 Exchange in order to not pay taxes. This way I’ll still maintain my real estate net worth allocation percentage. It’s my hope that by the time I move, online income will consistently surpass the minimum Hawaiian household income level of $67,000 a year. It’s not too expensive to live in paradise with no rent or mortgage!
Explore real estate crowdfunding: If you’re looking to buy property as an investment or reinvest your house sale proceeds, take a look at Fundrise, one of the largest real estate crowdfunding platforms today. They allow everyone to invest in mid-market commercial real estate deals across the country that were once only available to institutions or super high net worth individuals. They are the pioneers of eREIT funds and they are creating an Opportunity Fund to take advantage of tax-efficient Opportunity Zones. Thanks to technology, it’s now much easier to take advantage of lower valuation, higher net rental yield properties across America.
Shop around for a mortgage: Check the latest mortgage rates online through LendingTree. They’ve got one of the largest networks of lenders that compete for your business. Your goal should be to get as many written offers as possible and then use the offers as leverage to get the lowest interest rate possible. This is exactly what I did to lock in a 2.375% 5/1 ARM for my latest refinance. For those looking to purchase property, the same thing is in order. If you’ve found a good deal, can afford the payments, and plan to own the property for 10+ years, I’d get neutral inflation and take advantage of the low rates.
Update 2019: I sold my rental property for $2,740,000 and reinvested all of the money in 100% passive investments, including $550,000 in real estate crowdfunding. I’ve now got the cash and flexibility to move to Hawaii whenever I want!