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TRADING UP PROPERTY
TO INCREASE INCOME IMMEDIATELY
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As mentioned in the yield article Real Estate investments return a better yield as the property increases in units as shown in the chart below. However, that article simply looked at purchasing property outright and did not fully explore the situation where someone owns a single family rental and wants a better investment. Here we compare this exact situation.
YIELD FOR DIFFERENT TYPES OF PROPERTY |
Property Type |
Purchase Price |
Prorated Property Taxes |
Other Monthly Expenses |
Total Monthly Expenses |
Monthly Rent |
Monthly Cash flow |
Yield/Cap Rate |
| Condo |
$500,000 |
$458 |
$390 |
$848 |
$1,600 |
$752 |
1.8% |
| SF* Home |
$800,000 |
$733 |
$450 |
$1,183 |
$2,500 |
$1,317 |
2.0% |
| Duplex |
$900,000 |
$825 |
$500 |
$1,325 |
$3,000 |
$1,675 |
2.2% |
Fourplex |
$1,200,000 |
$1,100 |
$900 |
$2,000 |
$5,200 |
$3,200 |
3.2% |
| 12-Unit Apartment |
$1,950,000 |
$1,788 |
$2,000 |
$4,188 |
$13,200 |
$9,013 |
5.5% |
| SF= Single Family Home |
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The problem with trading up from a single family home to an apartment building in the Bay Area is that it can mean taking on a substantial loan, higher property taxes and additional expenses. The irony is that the return on investment for apartment buildings is similar around most areas in the United States (5%). The variable is the cost of the property, future appreciation, maintenance costs and interest rates.
What I often run into are people that have owned a single family home which they have rented out for many years. They know its worth a great deal of money, but the rent they receive from it appears to pale in contrast to the home's value. The owners would like to trade up, but don't want to be cash flow negative. These owners typically have one of two goals in mind:
- Maximize monthly Cash Flow immediately - typically the older retired group.
- Break even for now, with an investment that can produce greater cash flow in the future without additional investment.
Both these goals are attainable and in my opinion almost financially irresponsible not to research if they are right for you. Below is an example of a real world investment that I'm in the middle of assisting someone complete which falls into the first category mentioned above.
REAL WORLD EXAMPLE - IMMEDIATE INCOME INCREASE
A retired couple has owned a second single family home for 30 years and it's been rented out for the last 25 years. The retired owners don't intend to ever live in it again, but depend on the $2,500 per month gross rent it generates. The net rent is about $1,930 per month; the expenses are low because the home is completely paid for and the property taxes are relatively small. The house is worth around $850,000.
This couple wishes they could get more income from this asset, but buying a multi-unit property in the Bay Area does not make financial sense for them because of the meager income it would produce. The chart below compares different income scenarios.
- The first scenario (Home) looks at simply keeping the home.
- The other scenarios assume the home is sold and clears about $780,000. Then this money is used to purchase another property. A loan with an APR of 7% will be taken out to finance the remaining amount of the purchase.
STUDY OF SELLING A SINGLE FAMILY HOME & BUYING OTHER PROPERTY
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Property Type |
Purchase Price |
Prorated Property Taxes |
Other Monthly Expenses |
Total Monthly Expenses |
Monthly Rent |
Monthly Cash flow |
Yield/Cap Rate |
| Home |
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$120 |
$575 |
$570 |
$2,500 |
$1,930 |
2.7% |
Fourplex* |
$1,200,000 |
$1,100 |
$4,110 |
$4,794 |
$5,200 |
$406 |
0.6% |
12-Unit*
Apartment |
$1,950,000 |
$1,788 |
$10,244 |
$11,972 |
$13,200 |
$1,228 |
1.9% |
16-Unit **
Apartment |
$850,000 |
$900 |
$3,366 |
$4,266 |
$6,000 |
$3,734 |
5.7% |
| * Local Purchase (Redwood City, CA) |
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** Albuquerque, New Mexico
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The chart above demonstrates that buying a local fourplex is a complete disaster. The couple will end up owning the property and not receiving much income from it. Buying a 12-unit apartment in the area is also a big step backwards since it it reduces their monthly income by 36%.
However, if they take advantage of the better investment return an apartment building can offer vs. a single family home and they can purchase with only a tiny loan, then its a big win for them.
By going outside the state, they can buy a 16-unit building for virtually the same price as the home they sold. Even with paying property management fees, they doubled their rental income and now can also take advantage of depreciating the new property whereas their old home was already fully depreciated. So, this couple will more than doubled their income and have a larger tax-write. If they had decided to leverage their investment and off set receiving income, the dividends would be much larger years later.
The strategy of selling a single family home for an apartment can also work for seniors planning to downsize their primary residence. Why buy a smaller house? Why not rent and invest the proceeds from the sale of the home. There are of course tax strategies and other legal considerations to be explored before embarking on such an adventure, but it truly can be a good decision for many people. Consult your accountant and/or lawyer before proceeding.
Balancing the ratio between the purchase price of the new property vs. the equity in the property to be sold combined with interest rates and other factors, can provide investors with different degrees of maximizing immediate income vs. leveraging the asset for maximum appreciation and income at a later date. Set your investment goals, research carefully and buy accordingly.
The above scenario was put together in early 2007, we ended up not taking any action because we felt the market was too precarious at the time. Although we could have sold the single family home and bought a multi-unit building as the market was collapsing, the danger became rent depreciation. When economies are collapsing sometimes it's best to stick with the disaster you know you can weather rather then get into an unfamiliar situation. |
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