3/14/2048 | Casey Fleming |Is it time to sell your rental property?  The odds are good that if the answer isn’t “yes,” it will be soon.  Let’s examine why:

Diminishing return on assets

We tend to evaluate income-producing property using a cap rate; the net income on the property is x% of its value.  But that’s not the whole story, because the math assumes that you own 100% of the property.

That’s rarely true, because you probably have a mortgage.  Your return on investment is MUCH higher than the cap rate because of the principle of leverage.  If you have a mortgage, you are not only earning x% on your investment, but the bank’s investment as well.  The higher your mortgage (as a ratio of loan-to-value) the greater your leverage is and the higher your return on investment.

Now replace “investment” with “assets.”  Because your rental property has increased in value so much, your ownership in it (your equity-to-value ratio) has increased dramatically, and your leverage has decreased.  Because of this, your return on assets has declined even though your rental property still seems to be performing fine.

Well, you can always reassure yourself that at least it’s appreciating and will continue to do so, right?  Maybe not.

Are we nearing peak value?

No one can say for sure when the top of the market will be, but there are signs in the rental property market that point to that day coming sooner rather than later.

Values have risen very quickly

First, in Silicon Valley real estate values have risen by about 200% since the bottom of the market.  That foreclosure you bought for $250,000 could easily be worth $750,000 today.  Can it go higher?  Of course it can, but will it?

Unless you’ve pulled cash out of the property with a refinance, you have far more equity than mortgage today.

Financing might be harder to get

Second, the ceiling on the high-balance conforming loan limit is $679,650 in 2018.  This represented a much larger increase from 2017 than what was expected.  The current administration and Congress are determined to reduce the risk to taxpayers of another collapse in the real estate market, so they are reluctant to raise the high-balance conforming loan limit at all next year.  In fact, the high-balance loan limit was always supposed to be a temporary fix.  The nationwide conforming loan limit this year is $453,100; they could, if they wanted, revert to that.

In addition they are trying to figure out how to privatize Fannie Mae and Freddie Mac.  Without the guarantees the loan limits might become moot anyway.

Why is all this important?  Because if someone buying your rental property can’t finance it with a low-interest-rate conforming loan, they will have to get non-conforming, or “jumbo” financing, which requires substantially higher down payments and carries higher interest rates.  If buyers can’t finance their purchase, how will that affect values?

Financing is bound to get more expensive, too

Interest rates are always up and down, but no one doubts today that the long-term trend for interest rates is up.  This is bound to limit, and maybe reduce, the amount entry-level buyers can pay for your property.

Get your rental property investment working hard again

You may be able to exchange your equity into a new property and defer your taxes.  (See your tax advisor for your own personal situation.)   So what would you exchange into?

Another single family would at least get your return on assets back up again.  (And if you act now, interest rates are almost certainly lower than they will be next year.)

Alternatively, exchanging into a condominium (or multiple) would lessen your management burden.

Finally, moving your equity into multi-family units would give you much better return on asset cash flow, reduce your management burden, and put you in line to benefit from an area where growth is projected to be very high over the next ten years.

Calculating return on assets on rental property

If you don’t know, this is a simple calculation.  Simply take your net after-tax income for the last year and add back in depreciation (since it was a non-cash expense) and then subtract the principal you paid down over the last year (because it was a non-deductible cash outlay.)

This is your net, after-tax cash flow.

Then calculate your equity in the property by subtracting your mortgage balance from the current value.

Divide the net after-tax cash flow by the current value to get your annual return on investment.  Given today’s market, it’s probably not a bad return at all.

But then do the same calculation assuming that your equity is only 20% of the rental property’s value.  The return on assets should jump up dramatically.

This isn’t a perfect illustration of your situation because it ignores some less significant factors, but it’s pretty close.  You can usually double or triple your return on your rental property investment by moving up at the right time.  (But be sure to use a 1031 exchange if you can, to defer capital gains taxes.)

Long-term rental property strategy

Long-time rental property investors know that to maximize their total equity by the time they want to retire they need to constantly cycle up to the next investment, until they are ready to retire.  If your return on assets has declined, give this some serious thought.

Casey Fleming