A popular topic at this year’s Global Property Summit in June was “When should I sell a rental property?”
For most people, the answer depends on the situation…
Of course, if you need the capital from the property for something like a medical emergency, the answer is easy.
But if you’re looking to reinvest the capital, there’s more to consider.
Taking the pure investment approach and ignoring diversification considerations, you start with the math. You need to compare the yield you’re getting on the current property to the yield you expect on the property to be purchased… except it’s not that simple.
Let’s say you’re getting a 6% net yield on your current property and the property you’re looking at is offering a 7% yield. Based on those numbers, you should sell and buy the new property. Chasing yields, though, is a dangerous investment strategy. You need to look at more numbers.
Start with how much cash your current property is making—not the yield on your original investment or the current value. You’re getting annual cash flow from the current property that you need to at least replace with the new investment… hopefully, you increase cash flow with the change.
Let’s go with US$10,000 for the annual net cash flow before taxes from your current property that has a value of US$200,000. That’s a 5% net yield.
Next, determine how much you’ll net from the sale of the property. You already realize you won’t get 100% of the sales price into your pocket, but do a full analysis of what you expect to net after all the friction costs—agent fees, attorney fees, escrow fees, inspection fees, and the dreaded capital gains taxes (assuming you’re not doing a 1031 like-kind exchange). That’s how much you have to invest in the next property.
If you sell for full asking price of US$200,000 for a property you paid US$100,000 for, let’s use these expenses for simplicity…
- 5% for the real estate agent—US$10,000
- 1% for the attorney—US$2,000
- 20% capital gains tax—US$20,000
That leaves you with US$168,000.
With US$168,000 to buy your next property, you need a 6% net yield just to match the US$10,000 you were earning with the property you just sold… except that you will have friction costs going into the next property… at least if you’re buying overseas.
Most countries have transfer taxes, also known as stamp duty in commonwealth countries. These taxes are typically paid by the buyer and range from 1% to as high as 10%. You may have sales tax, as well, if you’re buying a new property.
Attorney’s fees on the buying side also need to be considered.
Assuming a transfer tax of 5% and 1% again for attorney’s fees, you can buy a property for US$158,500. You need a 6.3% net yield on that property to achieve the US$10,000 a year net rental income you were getting with the US$200,000 property you’re looking to sell.
In other words, you need a 26% higher yield (6.3 divided by 5) on your net proceeds from the sale than you were getting on the original property.
Generally speaking, most properties in the same market get similar yields… or should. You may find an undervalued property in the same market to switch to… or maybe you can find a buyer willing to pay a premium for your property. Otherwise, you’re likely looking to a new market for higher yields.
Yield is only one part of the profit equation.
The second part of your analysis is less scientific and more market condition based… although the math on the property you’re selling could tell you a lot. This is where you take into account potential appreciation on both your current property and the new property.
If your current property has appreciated significantly faster than rental income, your net yield calculation based on the current value will show it. When that 8% yield you were getting when you bought the property drops to 3% simply because property values have gone up and rents haven’t, it’s definitely time to consider selling to buy another property.
Starting with your current yield figures gets you to the amount you need to make the same cash flow, but if the new market’s net yield is giving you just enough to make the same cash flow, you want it to have potential for appreciation as well. That’s not necessarily easy to predict… and we can leave predicting appreciation in a market for another time.
Much of the time, the sell decision should be easy… as long as you have alternatives for placing the proceeds from the sale. One investor at GPS told me about low-cost houses he bought in 2009 after the real estate crash in the United States. The gross yield when he bought was 21% (we didn’t dig into the conversation enough to get to net yields). Today, the gross yield is still a respectable 7.2%, but definitely time to sell a few of these properties and diversify the portfolio.
Another reader who wasn’t happy with the 2.5% net yields on a property she bought in Colombia sold it after two-and-a-half years for a 50% capital gain. The gain made up for the low yields for two years and she was able to easily replace the cash flow. The sell decision was easy in this case, and the options for replacing the cash flow abundant.
One other factor to consider when analyzing whether or not to sell one property to invest in another is the actual cash on both transactions. Selling the US$200,000 property to net US$168,000, and then find a new property for exactly the US$158,500 used in the example isn’t likely.
Don’t fixate on finding a new property that matches your cash from the sale. Look for a property that’s a good investment. Maybe that means investing less of your proceeds… or maybe it means putting up some additional cash.
Have a new property or market in mind before the property sells. Otherwise, you might feel like the proceeds are burning a hole in your pocket and you end up investing in whatever comes along rather than something that makes sense for your goals and portfolio.
Lief Simon
