An essential aspect of maximizing your returns in real estate investing is knowing when it’s best to hold on to your property and when it’s better to sell it and move on. None of us has a crystal ball, so how can we know when it’s right to hold or sell?
The question always makes me think of that Clash song, “Should I stay or should I go?” I hope the following will be a bit more useful than what the British rock band came up with.
Long Term Value
Most of our parents told us that property is a safe investment. While others might challenge that, there’s no doubt that in the very long term, real estate tends to go up in value. That makes it a great place to store wealth. It always has been and probably always will be.
So, if you’re not desperate for liquidity, long-term property investments should grow in value over time.
It may be possible for you to refinance investment properties every 5 to 10 years, which lets you extract some of the growing value of the property.
Cash-out refinances like this can be great, as you get money without incurring income taxes. After all, it is a loan so the transaction isn’t treated as income. Sure, those loans ultimately need to be paid back, but if you’re smart with how you use your money, you can win by using this strategy.
I should emphasize the importance of refinancing responsibly so that you don’t over-leverage yourself. I talk more about this in Keystone Concept 18 in my book, Backstage Guide to Real Estate.
If you keep this strategy in mind, you could do multiple refinances over decades to extract the maximum value from the property while holding on to it rather than just selling and moving on.
Transaction Costs
Holding on to your investment property means you can put off the headache of significant transaction costs, such as:
- broker commissions
- title policy
- legal fees
- other closing costs
Expect to pay anywhere between 2% of the sales price for a large multifamily property, up to 10% if it’s a single-family home.
Holding the property means avoiding these transaction costs.
Tax Consequences
On top of your transaction costs, selling means paying taxes on gains. If you’ve held the property for less than a year, the profit will be taxed just like your ordinary income. If you’ve owned it for a year or more, you’ll need to pay Capital Gains Tax and you’ll also need to recapture depreciation.
OK, you could do a 1031 exchange or utilize bonus depreciation to offset your taxable gains. But this doesn’t eliminate those taxes – it just defers the tax. Ultimately, you’ll still need to pay.
Holding the property means you won’t need to worry about the taxes. And if you die (sorry for that morbid thought) your heirs will get a step up in basis, eliminating taxes on the previous gains.
Reinvestment Challenges
Even if you can tolerate the costs and taxes associated with selling, you’ll be left with a return from your sale that you’ll need to do something with. Keeping it in cash isn’t going to help you (especially considering inflation), so you need to find a smart way to redeploy that money so it grows for you. Is there really another good investment opportunity out there right now?
Unless you have a pressing need for liquidity or you can see a path to using the money in an even better investment, holding on to your property might be your best move.
Reasons To Sell
There’s definite long-term value in holding on to property but that doesn’t make it right in every case. This reminds me of when I was getting ready to do my first syndication, so allow me a quick digression (but this is relevant).
A friend of mine had invested in a strip mall. It paid out 6% cash-on-cash per year via quarterly distributions, and my friend got his distributions like clockwork. As a newbie to investing, I assumed he’d be happy with this — but he wasn’t.
He confided in me that he had invested $200,000 into this deal. Only after he made the investment did he realize that at 6% per year, it will take him over 16 years to get his initial investment back!
The majority owner of the property had purchased it through a 1031 exchange to defer his taxes. This owner was probably never going to sell this property so he could continue to avoid paying the taxes on his previous gain.
Yes, my friend was getting the distributions he’d been promised, but he ultimately wasn’t happy given how much of his capital was locked in the property. Instead of having that money remain tied up for ages, my friend would rather have the property sold as this would be better for his particular situation.
The business plan for my own first syndication was set for 5 years. When I told the same friend about this opportunity, he immediately jumped in on the investment as soon as he knew he would be able to exit the deal in approximately 5 years. He knew when he would be getting his initial investment (plus any profits) returned back to him.
The exit plan is important and selling can often be the right move.
Free Up Your Cash
The anecdote above shows that having too much cash locked into a property indefinitely can be problematic. Instead, you might prefer to commit to shorter deals where everyone knows the likely time horizon for exiting. This is often around 5 to 7 years for most of the deals I’m involved in, though the exit can be sooner than that if the conditions are right.
Take multifamily value-add syndications, for example. I might get into a deal for a class B property built in the 1990s, and we’ll do renovations to elevate the property — fixing up the parking lot, the pool and furniture, painting and renovating interiors, and generally making it a nicer place to live.
While our business plan is usually to hold the property for 5 to 7 years, the renovation period might take only between 2 and 4 years. Once we have completed the renovation cycle and our business plan, there has been a significant increase in the value of the property. If we sell the property and free up our cash, we can redeploy that capital into another opportunity that has greater upside potential.
Avoid Endless Renovation Cycles
If you hold a property for the longer term, say 10 years or more, the first round of renovations that added value is going to start to look dated.
If you sell after the first 5 years, everything still looks good and appliances and furniture still have plenty of life left in them. But making subsequent rounds of renovations in future years (new countertops, appliances, pool furniture, whatever) changes the equation, and you have to go through the cost and hassle of doing it all again and again.
We see a significant lift in value in the first couple of years when renovating, because we can raise rents as we take properties from the bottom of the market, up to the middle of the market. Holding the asset for a longer period of time can produce greater returns overall (we can do gradual increases in rent, for example) but not at the same rate as in the first couple of years. You can lose the velocity of your return, resulting in a lower IRR.
Perhaps we could hit a 70% return in the first couple of years. If we could achieve anything like that, maybe we would sell well before 5 years are up and move on to the next opportunity. This is just a theoretical example and is of course all dependent on the state of the market — I don’t want you thinking that a 70% return in 2 years is to be expected.
If your project is performing well and there’s a chance to get out early that can be the wiser move — and then we can find another property to invest in and renovate, making further profits.
In other words, we don’t need to be locked in for 5 years if it suits us to exit early. And when that’s the case, selling makes perfect sense.
Find New Investment Opportunities
If you can take your returns out of your investments and put them into more investments that produce the same or better returns, then you’re really winning.
Finding those deals isn’t easy, but that’s what I specialize in, bringing great opportunities to those interested in making passive real estate investments.
Don’t Rely On Refinancing
Holding for the long term can work but that will often rely on the assumption that you can refinance to keep extracting value from your properties.
Who knows where interest rates will be in the future? There are many factors that influence if refinancing deals will be possible when you need to make them. And even if everything does align, you could put yourself in the difficult situation of being over-leveraged if you don’t refinance responsibly. To avoid that risk, selling can often be the smarter strategy so long as the returns on the deal justify it.
There are definitely pros and cons for both sides of the decision and ultimately you will need to decide what is right for your specific goals.