By Thomas O'Shaughnessy
Choosing an investment property isn’t really that difficult. Seasoned investors can eyeball a property and know right away if it’ll generate cash flow, but even novice investors can use guidelines like the 1% Rule to get a pretty solid idea of a property’s potential investment value.
Deciding when to sell, on the other hand, is more complicated. There are dozens of good reasons to sell, some of them related to big picture market conditions, while others are more personal.
Let’s go over some of the most common and urgent reasons to unload your investment property.
If Real Estate Is Too Much of Your Net Worth
Investment property, especially if it’s a rental property, can be a fantastic investment. It generates cash flow and increases in value over time. That being said, the market is volatile, and while home values always go up in the long term, the short term can have rough patches. If you get to the point where real estate is more than 50% of your net worth, you might want to consider diversifying a bit; ideally, experts suggest you hold investments in at least three or four different asset classes, with a roughly equal portion of your value in each class. Many of the Americans who went bankrupt after the Great Recession did so because most of their net worth was in their home.
If a Surplus Is Coming
Supply and demand is a universal economic law; scarcity creates value. The other side of that coin is that excess drives down value. If you own property in a city where a large amount of new housing is being built, you might want to consider selling well before all those new units hit the market. When they do, they’re sure to dilute the value of your property.
If Long Term Tenants Move Out
A stable, respectful long term tenant is every landlord’s dream. But having long term tenants can also prevent you from fully updating your property. If your tenants move on, and the market looks strong, you might want to consider exhaustively upgrading your property, so it can fetch a higher tier of rents, and putting it on the market.
If the Numbers No Longer Work
There’s a point where property value growth eclipses rental income; that’s the point where you should consider selling. For example, let’s say you invested in a single-family property that’s now worth $1 million and you’ve paid off the mortgage. If you’re renting it for $2,500 a month, that only comes to $30,000 a year. In this case, it probably makes more sense to sell, since you can cash out for a bigger and better property.
When Property Taxes Are Going Up
In booming cities, property taxes go up right alongside home values, sometimes even outpacing them. When property taxes increase, landlords have to pay them out of their rental income, so either their profits go down, or they’ll increase rents to make up the lost revenue. In either case, the situation can get complicated; higher rents means a smaller tenant pool to draw from, and smaller profits means, well, less money. Only a few successive property tax hikes can make an investment property financially unfeasible.
While you can fight property taxes in many cities (and often win), it’s a hassle you might not want to deal with. If your cash flow suffers from appreciating home values, it might be time to sell to eager buyers looking to get into a hot market.
You Need to Reset the Depreciation Clock
If you’re an advanced real estate investor, depreciation probably plays a big part in your financial strategy, especially come tax time. What is depreciation? Generally, it’s the cost of buying and improving your rental property, and the IRS lets you distribute those costs across a span of multiple years.
Since you can deduct depreciation from your taxes, properties that offer steady depreciation can be a vital part of an investment portfolio. The reverse of that is that when those properties no longer offer any potential depreciation (and the tax benefits that go along with it), it’s time to sell, and buy newer properties, thus resetting the depreciation clock. Turnover can be necessary as often as every five years, depending on how you’re calculating that depreciation.
If the Market Is Hot
This one depends on your investment timeline. If you’re in it for the long run, you probably don’t pay much attention to market fluctuations. But if you’re trying to cash out in the next decade, or sooner, that means you probably aren’t interested in sitting out another full market cycle.
If that’s the case, simply wait until the market seems very strong, and then list your property. Once you decide to sell, move fast, because you never know when the downturn is coming. Though a rushed sale is less than ideal, one way to maximize your profits is by using a full-service discount broker, to save big on commission.
How do you know when the peak is here? You won’t know; like everyone else, you’ll be guessing. It’s highly unlikely you’ll be lucky enough to get out at the absolute peak, but anyone who held onto their condo through 2007 and 2008, waiting for the perfect moment to maximize their profits, will tell you: it’s better to get out a year early than a day too late.
A Bigger, Better Opportunity Presents Itself
Ambitious investors are always looking to level up their investments, and when an opportunity presents itself, you shouldn’t hesitate. If you’re looking to turn your present investment into a larger one, a 1031 exchange is a valuable tool. The 1031 essentially lets you trade one property for another, a more valuable one, while temporarily deferring capital gains taxes.
The best part? It can be used repeatedly. An investor can exchange a small duplex for a larger six-unit property, using a 1031 exchange, and then flip that six-unit property for a full apartment building with another 1031 exchange, and defer capital gains from all the transactions. Since capital gains taxes can take a huge bite out of your profits when you sell, being able to delay this tax bill, potentially indefinitely, is incredibly valuable.