How to evaluate options for selling a rental property

Question

I own inherited rental property in the San Francisco Bay Area, and have been thinking about doing a 1031 exchange into Chicago, where I now live, for a few main reasons. One, I inherited the property with a family member and would like to be in business for myself. Two, the CAP rate on the property in CA is low because valuations are so ridiculous, and I would be able to have higher cash flow with the same equity in Chicago. And lastly, I like the idea of having the property be physically close to me.

I have been watching local properties that are worth about the same amount as my equity in the CA property (roughly $3.5M), and, because of rising interest rates, there has not been a lot of inventory over the past few month on the MLS that fit my criteria, geographical and otherwise. In the past few weeks, however, there have begun to appear more and more properties, presumably because rates are plateauing; I assume that inventory will be even better if there is a fed rate cut at the end of this year.

However, I went to a conference for realtors and brokers this past week and a realtor told me that it was a terrible time to buy property, that I should absolutely not sell the property in CA, and that I should buy out my partner family member with a mortgage, and then use additional equity to get something small in Chicago to start.

As a reasonably data-driven person, how do I begin to evaluate what's best to do here? I assume that buying out the family member would put a real crimp on cash flow. On the other hand, I'm not sure how to best evaluate when a sale / 1031 makes the most sense except that options seem better when rates are low.

What is the best way to make this decision, using data as much as possible?

Answer 1

You're asking for an investment advice, and that's generally off-topic here.

Several factual pointers about California real estate, especially SF Bay, that may help you though:

• People don't sell property in the Bay area unless they have to. There's no good reason to sell unless you absolutely need the money, cashing out on inheritance with no taxes due, or you co-own it with someone and cannot buy them out. Properties going on the market are usually due to the three D's: deaths, divorces and debts. That in turn leads to chronically low inventory, leading to chronically high prices.

• The Bay Area generally is geographically restricted. There's no new undeveloped tracts, there's nowhere to expand. So the inventory is restricted, due to the geographical limitations. Again, leading to chronically high prices.

• People want to live in the Bay Area. Be it the gold rush, the tech boom, the bio-med boom, or just the weather and the proximity to major transportation hubs at SFO and SJC and three major urban centers (SF, SJ and Oakland), major educational centers (several UC and Cal State campuses, private universities like Stanford and Santa Clara, etc), excellent school districts, all combined with the close proximity to a lot of attractions and recreation for any age - all this makes the area highly desirable in any economy. Prices in the Bay area don't go down by a lot, and bounce back up quickly.

• 1031 exchange out of CA is troublesome. CA will not let you leave with the money without paying the taxes. You'll continue filing CA tax paperwork until the deferred tax is due and paid.

One thing to remember though:

• There are a lot of renters in the Bay Area, which leads to a significant pressure on the politicians to try and regulate rental prices through rent-control, making evictions harder, etc. Depending on your local laws (especially cities like SF, SJ, Oakland, Mountain View, etc) you can have really bad policies geared at harming landlords and essentially taking over their properties in favor of the "protected" renters. The end result is that the rental market in these locations is very skewed: the properties coming on the market are priced very high, but once you rent it out you may end up being stuck with your tenant forever with little ability to raise prices and little recourse if they end up not paying. In such locations market is a bit different and you'd probably want to cash out and leave and not be a long-term landlord.

Find a really experienced local realtor to help you evaluate more pros and cons specific to your property.

Answer 2

What about the other person?:

One, I inherited the property with a family member and would like to be in business for myself.

Are they wanting to sell their half? If they don't want to sell, they will have to be bought out, or they buy you out. Or will that other person still want to be your business partner with the new properties.

You mention the equity:

"I have been watching local properties that are worth about the same amount as my equity in the CA property (roughly $3.5M), "

But you don't mention the amount of the taxable gain. You received the property at a stepped up value, and you have been renting it. First calculate how much the taxes will be if you sell this year. If the number is small enough it might be worth it to sell the California home, pay the tax and then decide what to do with the money. Also don't forget state taxes.

While you did mention the equity, you didn't mention a mortgage. The new properties will also have to have a mortgage if the California one has a mortgage. So the 1031 exchange won't make the mortgage go away.

What is the best way to make this decision, using data as much as possible?

Do the calculations under every scenario. Get your tax person involved. Get a California real estate person to give you an estimate. Talk to your family member. When you have all the numbers make a decision.