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How to Decide Whether to Sell Investment Real Estate

I received an inquiry about selling investment real estate that leads me to think that the discussion in my previous post on the decision to sell investment real estate may have been confusing to some readers. In this post I will expand further on my discussion to the approach I use in deciding whether to sell investment real estate.

There are many reasons why someone might want to sell their investment real estate:

• A job change could require a re-location to another part of the country,
• A divorce could require the splitting of marital assets,
• The investment may have been purchased to cover a specific future liability such as a child’s college tuition and the child is finally ready for college requiring the liquidation of the asset.

These unique situations aside, unless you plan to keep your investment real estate forever, you should have a process to help you decide if the time is right to sell your investment real estate. In the 2005 to 2007 time frame it was obvious that home prices had become over-valued making the sell decision very easy. But, in most markets, extreme market valuations do not exist. Every year I make an assessment whether it makes sense to keep my real estate investments or invest the real estate equity in the financial markets. I use a 3-step process to make this assessment on each property.

To illustrate the 3-step analysis, I will use the mythical $300,000 property from recent posts as an example. We will assume that 10 years have passed since purchasing the $300,000 investment property and you are now considering selling the investment.

Let’s assume the original $300,000 investment property now has the following financial data after 10 years:

• The original $300,000 property has increased 2.25% per year to $375,000,
• The original $1,800 gross monthly rental income has increased 3% per year to $2,430,
• The original $250 monthly real estate taxes and insurance has increased 3% per year to $338,
• The original $150 monthly property maintenance has increased 3% per year to $203,
• Original $240,000 30-year loan at 5%, with a monthly payment of $1,288, after 10 years,  has been paid down to $195,500,
• Net annual rental income = $7,212 ($2,430 – ($1,288 + $338 + $203)) = $601 x 12 months
• In year 11 the property loan will be reduced by $5,833,
• Annual tax depreciation benefit = $2,400 ($220,000 building value divided by 27.5 years Straight-line depreciation = $8,000 x 30% assumed tax bracket = $2,400 per year).

Step 1: Calculate the current equity position and the annual gain of the property investment

To do this I need to know the current capital I have in the investment property and then calculate the current annual gain the property provides.

To determine the current capital, I calculate my net property equity:

Current market price – 6% selling costs – remaining loan balance = Net equity.

In this case net equity = $375,000 – $22,500 – $195,500 = $157,000.

To determine the annual property gain, I add two profit areas together:

Net annual rental income + Loan reduction in year 11 = Annual gain.

In this case current annual property gain = $7,212 + $5833 = $13,045.

This indicates a Return-On-Investment (ROI) of about 8.3% ($13,045/$157,000). In today’s low return environment an 8.3% annual return without considering any capital appreciation is nothing to complain about.

I should note that, in calculating the annual property gain for the purpose of comparing the investment to other financial investments, I do not include any future property appreciation as this is not guaranteed. I also do not include the annual property depreciation benefit ($2,400 in this case) as I view this benefit as compensation for the fact that real estate investments require more time to monitor than financial investments. Additionally, the total property tax depreciation benefit must be re-paid on sale of the property (explained below).

Step 2: Calculate the income that could be withdrawn from financial assets if the net property equity were invested in financial assets (i.e., stocks, bonds, cash)

The net property equity calculated in step 1 is $157,000. However, when the property is actually sold, this figure will not be available to re-invest as it must be reduced by the taxes owed. There are two taxes owed when selling invest real estate; capital gains and depreciation re-capture.

Let’s assume the following tax rates:

• The federal capital gains rate is 15% and the state rate is 5% for a total capital gains tax rate of 20%.
• The federal depreciation re-capture rate is 25% and the state rate is assumed to be 5% for a total depreciation re-capture rate of 30%.

The property taxes owed are calculated as follows:

• The property capital gain is: $52,500 ($375,000 – $22,500 selling costs – $300,000 purchase price); $52,500 x 20% tax rate = $10,500 capital gain taxes.
• The depreciation re-capture taxable amount is $80,000 ($8,000 per year x 10 years); $80,000 x 30% = $24,000.
• Total taxes owed are: $10,500 + $24,000 = $34,500.

The net property equity available, after taxes, for re-investment in the financial markets is $122,500 ($122,500 = $157,000 – $34,500).

I will not get into how the $122,500 net equity should be invested in the financial markets. I have written many previous posts on this subject. Additionally, I do not even care what the current interest rate or stock dividend rates are. Since I view the assets as retirement assets, the only calculation I do in this comparison is I apply the 4% rule I wrote about in an earlier post. This rule says you can only withdraw 4% of your liquid retirement assets per year regardless of what income they produce.

Step 3: Compare the Income from the Two investment Types

The last step is to compare the annual gain from keeping the investment property to using the net property equity to invest in the financial markets.

From step 2 applying 4% to $122,500 produces $4,900 of spending income per year (increased by inflation every year thereafter). Keeping the property investment produces an annual gain of about $13,045 as calculated in step 1. Obviously, $13,045 is higher than $4,900 so this would indicate that keeping the property investment would be more advantageous. But if you are retiring, you may care more about the income you can spend today. In this case the property produces about $7,200 net spendable income per year versus $4,900 if the property were liquidated. The $7,200 is still almost 50% higher and would indicate that keeping the property is still better.

Of course, there are other always other considerations. For example, if the income difference is as large as this example indicates, and you have enough other liquid assets, I would opt for keeping the property investment. On the other hand, if the annual property spendable income is only about 10% to 15% higher, and I did not have a lot of other liquid assets to rely on in retirement, I would probably consider selling the property.

Another consideration is that property values can drop as we have seen in the last few years. No one can predict the future, but when deciding whether to sell an investment property, an assessment should be made about whether the property could decrease in value in the next few years.

That is all there is to the 3-step process to determine if it makes sense to sell an investment property. If there are not any other non-economic issues involved, this is the process I use to determine if it is time to sell a real estate investment.

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