1. It Becomes a Seller’s Market
In 2021, home prices rose by a staggering 17.8%, which would explain why 6.9 million homes were sold during that period. Homeowners and investors saw an opportunity to cash in and, boy was it a great time to do so!
CoreLogic revealed that homeowners with mortgages have seen their equity increase by $3.6 trillion since Q2 2021. The average homeowner saw their equity increase by $60,000 over a 12-month period from Q2 2021 to Q2 2022.
It’s worth noting that homeowners in states like Hawaii ($129,800), California ($117,000), and Florida ($100,000) saw the largest equity gains, while Iowa ($17,600) and Washington DC ($16,900) saw the lowest gains.
Even though homeowners in some areas saw a meager increase in home equity, small gains are better than no gains.
2. Being a Landlord Becomes a Burden
You probably have a thorough understanding of the ongoing responsibilities that come with managing a rental property since you’re a landlord.
However, the unfortunate aspect of being a landlord is that you’re basically on call 24/7 if there’s an urgent repair that needs to be addressed.
If you’re going to hire a property management company to handle your rentals, then this isn’t going to be too much of a headache. The property management company will handle most of the calls from the tenants.
However, if you plan on going to manage the property yourself, that means that when the hot water heater blows and water is gushing in the basement at 3 AM, you’re going to have to leap into action and get a repairman out there ASAP. If your tenant is locked out, they’re going to call you for help.
Then that’s not even accounting if your tenants don’t pay rent, you have to try to collect rent, start the eviction process, and so much more.
When you pile all of that on top of your regular 9-to-5… That kind of stress can be a lot to deal with if you have multiple properties or if you already have a lot on your plate.
3. Negative Cash Flow
A common mistake new investors make is to overestimate their earning potential for the property. They assume that the rental will be occupied for the whole year, but that’s never a guarantee.
Even if you have great tenants that have lived in the unit for several years, life happens, as evident from the 2020 COVID pandemic.
If your rental property is experiencing a negative cash flow for a month or two, that doesn’t necessarily mean you should go ahead and put the property on the market.
If you’re able to get to the root cause, you may be able to ride it out and focus your energy on making the most out of your rentals (maybe use this time to make improvements so you can increase rent for the next tenant).
New Western’s General Manager, Timur Medaric, points out that some investors are willing to overlook a temporary bout of negative cash flow if the equity grab proves to be profitable. If they’re able to manage the debt until they need to sell the property, then appreciation could offset the negative cash flow.
On the other hand, if there’s a prolonged vacancy or a high tenant turnover and you’re in the red for longer than your cash reserves can handle, then that’s when you might want to reconsider selling the property.
4. New Investment Opportunities
Your rental property may be performing as expected and everything is fine. Why would you consider selling a rental property that’s meeting your expectations and all is well?
One reason An investor might sell their property is for the opportunity cost. Investors are constantly presented with choices on where to put their money in order to get the best (or safest) return. The cost of passing on an investment and choosing another is the investor’s opportunity cost. In other words, it’s a trade-off.
An example of opportunity cost in the world of real estate investing would be if you had to choose between Property A which needs minor repairs, but may not be in a desirable area, and a property that needs more work in a desirable area.
While you might be able to fix and flip Property A in a short amount of time, the location could prolong its time on the market. However, if Property B is located in a desirable area, it may sell within a few days once the repairs are made.
Although you might have to spend more money to fix up Property B, the quick turn-around time could be worth it – especially if you come across a deal you can’t pass up.
When you consider it in this manner, the opportunity cost formula is fairly simple:
Missed Returns / Earned Returns = Opportunity Cost
This simple formula can help an investor decide what to do in a number of different situations. However, it’s worth noting that you should consider a number of factors before choosing an investment and figuring out opportunity costs.
These involve your investment objectives, the risks involved with each alternative, and your potential for suffering potential losses (i.e., how much risk you’re willing to take).
For a better understanding of how to measure the opportunity cost of a real estate investment, look at the examples below.
Examples of Real Estate Opportunity Cost Examples
Scenario #1: Investing in Real Estate vs. Not Investing in Real Estate
There are various key aspects that should be considered when you’re beginning your journey into the world of real estate investing. There are so many opportunities out there, it’s incredibly easy to feel overwhelmed and just settle for whatever comes their way.
We all know how important timing can be when it comes to choosing an investment, so this might have devastating effects. Particularly in the world of real estate, it’s not hard to miss out on a great opportunity if you’re hesitant to bite the bullet and invest in it.
If you think about it, the opportunity cost of doing nothing is real. Consider a situation where you have $50,000 saved for investments but later decide to leave the cash in the bank.
In this scenario, you forgo the advantages of buying an investment property, on top of the money you could have made (the ROI), all because you were hesitant to put yourself through the “headaches” that go along with owning said rental property.
Scenario #2: Investing in One Area vs. Another
Let’s say you invested $50,000 in real estate. How would you determine the opportunity cost of making different choices? One of the most important considerations is when a rental property’s location has a significant impact on the earnings you can expect from it.
The various factors that play a role in determining which area to invest in include things like the demand for rentals, job growth, rate of appreciation, and rental rates. When taking these factors into mind, it’s no wonder that some areas are more appealing to real estate investors than others.
Consider a situation where you reside in Orlando, Florida, and want to buy an investment property. While Orlando is one of the best places to invest, there are other great markets in the state worth considering.
For example, properties in Lakeland, Florida, have an appreciation rate of 5.94%. Although the median household income in the area is $40,000, the rental demand is quite strong since most cannot afford to buy.
Another example is Tampa, Florida. Mosaic, Bloomin’ Brands, Masonite International, Primo Water Corporation, and Sykes Enterprises all have their headquarters in Tampa, which is good news for people who want to find better jobs.
Also, investors can buy properties at lower rates now due to affordable real estate prices and rent them at a higher price to new residents who have migrated to the city.
Scenario #3: Choosing to Invest in One Property vs. Another Property
The opportunity cost would be the return you would have received if you had chosen to invest in a different kind of property instead of the type you ultimately choose.
Let’s say you’re on the fence and don’t know which you should buy; a single-family property or a condominium. If you go with the condo, you could generate $1,000 in profit. But, you have to deal with HOA and you’d rather manage your property yourself. So, you choose to go with the single-family home, but it’ll only generate $700 in profits.
You can determine the opportunity cost by using the formula above: $700/$1,000 equals $1.4 in lost opportunity. What this means is that if you invest in the single-family home, you’re losing $1.40 on every dollar you could have gained from the condo.
Scenario #4: Investing in a Long-term Rental vs. a Short-Term Rental
The opportunity cost equation is another tool used by savvy real estate investors to assess which type of rental method is favorable: a traditional long-term rental or a short-term rental like Airbnb.
Suppose you already own a rental property and you discover that it can bring in $1,700 per month if it’s a traditional long-term rental, but if turned into a short-term Airbnb rental, it has the potential to bring in $2,000 per month.
You could choose to stick with the traditional rental method because it’s a safer investment and you’re not keen on the higher risks that are associated with a short-term rental. What is this real estate investment’s potential cost?
Divide the total returns you’re giving up ($2,000) by the profits your chosen investment will bring in ($1,700). The less profitable investment has an opportunity cost of $1.17.
Again, this implies that you might have been earning $1.17 from the short-term rental for every dollar you would have made from it as a long-term rental.
Another reason why an investor might want to sell is if they were presented with a better investment opportunity and want to “trade up,” or get a better asset through a 1031 exchange.
What Kind of Property Qualifies for a 1031 Exchange?
For a property to qualify for a 1031 exchange, as detailed by the IRS, it must:
“Both properties must be similar enough to qualify as “like-kind.” Like-kind property is property of the same nature, character or class. Quality or grade does not matter. Most real estate will be like-kind to other real estate. For example, real property that is improved with a residential rental house is like kind to vacant land. One exception for real estate is that property within the United States is not like-kind to property outside of the United States. Also, improvements that are conveyed without land are not of like kind to land.”
In other words, if you’re investing in a single-family rental property, the 1031 exchange allows you to buy and sell assets without being taxed on every sale.
You can defer related federal income tax liability and capital gains tax when you exchange one property for another.
You can read more about the 1031 exchange here.
5. Circumstances In Your Personal Life Change
Life likes to throw us a curve ball every so often and we have to adapt as best as we can. Life events like losing your job (or getting a new job!), expecting a new member of the family, health concerns, or just needing a sabbatical are examples of reasons why an investor may want to sell their rental properties.
Major life events can make it difficult to focus on managing your investment properties.
You could hire a property management company to manage your properties, but that would be an additional expense that may not fit into your budget or investing plan.
6. Costs too Much to Upgrade or Maintain
The costs associated with owning, managing, and maintaining an investment property aren’t cheap — not by a long shot. On top of paying the mortgage, property taxes, and utilities (granted, the tenant’s rent is usually covering this), you have to stay on top of regular maintenance tasks.
While you can do some of the repairs on your own (or with the help of an affordable handyman), larger repairs can drain your bank account pretty quickly — especially if the home was built before the 2000s, which makes up 61% of homes purchased in 2021.
To get an idea of how quickly the costs can add up, here’s a look at some common repairs in older homes.
Source: International Association of Certified Home Inspectors
One investment strategy Mr. Medaric is fond of is cycling your properties. As he explains, an investor will “sell off the underperforming ones or even sell off the ones that are about to come due on another expensive round of upkeep and maintenance.”
If one of the major systems in the home needs to be repaired, you might have to do it again sooner than you think. According to Mr. Medaric, it would make more sense if you sell the property before you have to make those repairs again so you don’t have to pay those additional costs.
Unfortunately, many things we use today aren’t intended to last for several decades – planned obsolescence.
Along with this, an investor may want to sell their property when it begins to lose value due to one of other three types of obsolescence:
- Functional Obsolescence: Functional obsolescence is the process by which a property loses value as a result of its architectural layout, construction style, size, outmoded facilities, surrounding economic circumstances, and evolving technology.
- Economic Obsolescence: Economic obsolescence is the loss of value of a property due to outside influences like modifications to the local traffic pattern or the installation of public nuisance-type buildings and facilities like correctional facilities and sewage treatment plants on neighboring property.
- Physical Obsolescence: Physical obsolescence is the loss of value of a property owing to egregious management errors and physical negligence, which results in neglected upkeep that is typically too expensive to fix.