Peter Lohmann, RL Property Management, 2019.
Something rarely discussed are the long-term advantages of holding rental property. Many “helpers” (realtors, lawyers, bankers, etc) in the real estate industry make money every time you transact property, so they have little incentive to share the below information with you. Here, we lay out six excellent reasons you should consider NOT selling your investment property.
1.Origination Costs. Most rental owners use a mortgage to fund the purchase of rental property. These mortgages are commonly 30 years long, and cost several thousand dollars to obtain. They are typically amortized (spread) over the life of the loan, which means they are even more expensive once you account for interest. The longer you own the property, the more years this cost is spread over, which increases your return (profit).
2.Mortgage Principal Paydown.. The amount of your mortgage payment that goes towards principal starts VERY SMALL and increases each year you pay down a mortgage. The later years of a mortgage are when principal repayment and the subsequent return on investment really start to kick in.
3. Capital Gain and Depreciation Recapture “1250” Tax. Remember all those lovely tax benefits you enjoyed while depreciating your property each year? Guess what – at sale, it’s time to pay the piper.
Example of Unrecaptured Section 1250 Gains (source: investopedia.com)If a property was initially purchased for $150,000, and the owner claims depreciation of $30,000, the adjusted cost basis for the property is considered to be $120,000. If the property is subsequently sold for $185,000, the owner has recognized an overall gain of $65,000 over the adjusted cost basis. Since the property has sold for more than the basis that had been adjusted for depreciation, the unrecaptured section 1250 gains are based on the difference between the adjusted cost basis and the original purchase price.This makes the first $30,000 of the profit subject to the unrecaptured section 1250 gain, while the remaining $35,000 is taxed at the regular long-term capital gains. With that result, $30,000 would be subject to the higher capital gains tax rate of up to 25%. The remaining $35,000 would be taxed at the long-term capital gains rate of 15%.
While you can avoid paying both of these taxes upon sale using a properly executed IRS 1031 exchange, it is simply easier to keep your existing unit and existing gain. If you really need the cash available due to appreciation, we would recommend completing a refinance.
4. Known Issues. This is the “devil you know vs. the devil you don’t” situation. You know your property well. You have either fixed all its issues or you know fairly well what it needs. Exchanging your known property for one that you don’t know brings with it the risk of facing unknown/undiscovered issues with the new property.
5. Appreciation. Because real estate is tied so closely to the skilled trades and materials inflation rate, the long term appreciation potential in the right cities cannot be beat. Growing your net worth via appreciation of a leveraged asset such as a rental property is as simple as doing nothing. But many people have trouble with this!
6. Property Management. Hiring the right property manager will literally allow you to forget you even own the property. See bonus content.
7. Selling Costs. 6% to the agents, 2% to the title company, many thousands in carrying costs, and many many more thousands in pre-sale repairs. Before you know it, you are giving up 15-20% of your sales price to these things. Why not keep the property, refinance, and buy another unit?
8. Final Thoughts.
- Real estate transactional costs are large
- Our tax system is set up to reward long-term ownership
- Generational wealth is created by owning income-producing assets for long periods of time. Not by attempting to play the market.
Bonus: Excerpt from Warren Buffett’s Annual Letter to Shareholders, 2013
Some Thoughts About Investing
“In 1986, I purchased a 400-acre farm, located 50 miles north of Omaha, from the FDIC. It cost me $280,000, considerably less than what a failed bank had lent against the farm a few years earlier. I knew nothing about operating a farm. But I have a son who loves farming and I learned from him both how many bushels of corn and soybeans the farm would produce and what the operating expenses would be. From these estimates, I calculated the normalized return from the farm to then be about 10%. I also thought it was likely that productivity would improve over time and that crop prices would move higher as well. Both expectations proved out. I needed no unusual knowledge or intelligence to conclude that the investment had no downside and potentially had substantial upside. There would, of course, be the occasional bad crop and prices would sometimes disappoint. But so what? There would be some unusually good years as well, and I would never be under any pressure to sell the property. Now, 28 years later, the farm has tripled its earnings and is worth five times or more what I paid.I still know nothing about farming and recently made just my second visit to the farm.
In 1993, I made another small investment. Larry Silverstein, Salomon’s landlord when I was the company’s CEO, told me about a New York retail property adjacent to NYU that the Resolution Trust Corp. was selling. Again, a bubble had popped – this one involving commercial real estate – and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly.
Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanned by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant – who occupied around 20% of the< project’s space – was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere.
I joined a small group, including Larry and my friend Fred Rose, that purchased the parcel. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our original equity investment. Moreover, our original mortgage was refinanced in 1996 and again in 1999, moves that allowed several special distributions totaling more than 150% of what we had invested. I’ve yet to view the property.
Income from both the farm and the NYU real estate will probably increase in the decades to come. Though the gains won’t be dramatic, the two investments will be solid and satisfactory holdings for my lifetime and, subsequently, for my children and grandchildren.”
If you are looking for a property management team that has several decades of experience dealing with nothing but property management including the issues described above, do not hesitate to reach out to RL Property Management Group. Contact Us Here.
RL Property Management Group, the only property management company in Columbus started and run by engineers. Our clients enjoy a premium property management experience without paying a premium price. RL Property Management is designed to provide our clients reliability and performance.