Rebalancing Your Real Estate Portfolio

Feb09: Goldilocks

You want your portfolio to be just right.

“There’s a lot of — I don’t know what the term is in Austrian, wheeling and dealing.”
–Barack Obama

If you are a real estate investor and you come from the Warren Buffett school of investing, then you’re probably likely to want to buy a property and hold onto it forever.

That’s what I thought we would do when we started building out our portfolio. We wanted to buy properties at a discount, put in renters, and ideally, those renters would stay there forever.

It is part of our path to PIRE, as we plan on creating a real estate portfolio where 50% of the rental income of our rental properties cover more than 100% of our monthly expenses.

However, as we have accumulated properties, we’ve discovered that we bought some properties that are actually better properties for long-term owners to live in rather than renters.

What do I mean by that?

Let’s step back and look at how we purchase properties in the first place.

There are only a few rules that I look at when evaluating investment properties:

  1. Can we purchase the property at a significant discount to the retail value of the house? Invariably, these are situations where the seller is not in a strong negotiating position. It could be a foreclosure. It could be a pre-foreclosure. It could be a property that the kids inherited from the parents and don’t want. It could be a divorce. It could be an investor who needs to fire sale his properties. Who knows? How we arrive in a situation where the seller needs to get out fast does not matter. What does matter is that the property is a steal.
  2. It has to make financial sense. To quote Thomas Jefferson, “Never buy what you don’t want because it is cheap.” Just because a house is on sale does not mean that it is a house that would fit into our strategy. It still has to financially make sense – the rents that we can get must create a sufficient return on our investment in order to justify us making the purchase in the first place. I always look at real estate purchases as long-term income-generating investments. Appreciation is icing on the cake, because I treat real estate in the same way that I treat a dividend paying stock, except that I have much more control over the probability of dividends than I do with an individual dividend paying stock.
  3. Pay cash. Yes, we could get a better return if we borrowed money to purchase our investment real estate. However, if a property needs to sit vacant for a couple of months while we do repairs, renovations, or upgrades, so be it. We’re not going to be sweating whether or not we can swing a mortgage payment. While even paid for properties have ongoing expenses – insurance and property taxes never go away – we avoid the biggest potential land mine by not having a mortgage.

So, the anatomy of purchases is pretty simple. Buy cheap. Buy what makes sense. Purchase in cash because you have both negotiating leverage when you make the offer and you have lower stress long-term outcomes.

But, just like when you’re investing in your brokerage and retirement accounts, what you purchased, over time, may not look like what you have now. Some stocks go up. Some go down. In general, you’re better off over the long run having (110 – your age) in stocks and the remainder in fixed income. But, if you bought 80% stocks and 20% bonds but the bond market tanked and the stock market soared, at the end of the year, you may have 89% in stocks and 11% in bonds. So, you need to rebalance.

Just like in the stock market, you may find yourself in need of rebalancing your real estate portfolio.

Let’s look at a situation we recently faced where we decided to do a deal.

The Anatomy of a Real Estate Rebalance

The property that we have held the longest in our real estate portfolio, and the first one that we bought from our property manager, we bought sight unseen.

Do as I say, not as I do.

We were very fortunate that it turned out to be a pretty good deal. It was a divorce situation and the owner needed to move out very quickly. We already knew our property manager from our dealings, so we trusted that she knew a good deal when she saw one. We were right.

Our original all-in purchase price was a little under $59,500. We rented it out for over two years at $950 a month. However, because we were able to purchase it for such a low price and had a renter ready to move in, we didn’t do a lot of upgrades. Most of the upgrades were unnecessary for a renter but would be if we wanted to sell the property.

While we’d purchased the property on sale, the market also rose for the area where we owned the property. One day, I asked our property manager what she thought she could sell it for if we did a few upgrades, and she said that she thought that we could get about $99,000 for it. About $13k in upgrades later, we put it on the market and eventually put it under contract for just over $95,000.

Take out the Realtor commission, closing costs, and long-term capital gains taxes, and we had about $85k in cash remaining – about a 14% profit over a couple of years, not including the net rental income, which takes it to about a 34% profit.

At the same time, we found a property that had been foreclosed on. It had some cosmetic damage and needed new floors – about $15k worth of repair costs. It was for sale for $65k. Add in $1k of closing costs, and we would be in it for $81k. It will rent for $1,150 a month.

So, we will net $4,000 to add back to the property purchasing war chest while increasing our rents by $200 a month.

The basis for making this determination was one simple question:

If I sell a property, can I buy more cash flow with the same money or buy the same cash flow with less money?

If you can, then it’s time to rebalance your real estate portfolio.

The Update

Since I originally wrote this article in 2015, we’ve done this rebalancing act several times: 13 to be exact, with one property under contract and (knocking on wood), due to be closing in under two weeks.

We use Zillow to help manage our property investments, and use the nifty spreadsheet that I discussed how to build in the linked article to tell our property manager/Realtor exactly what to sell at any given time. She opens the spreadsheet. One property is highlighted. She sells it. I update the spreadsheet with whatever we buy. A new one gets highlighted. Magic.

With the amount of buying and selling that we do in properties, we have to be quite aware of the tax implications of selling a rental property.

If you’re going to invest in rental properties, then, not only should you be aware of and setting money aside for the tax on house rent that you’ll have to pay, but you should be pretty adept at determining the taxes on the sale and profit of your rental properties.

I’ve created a pretty simple spreadsheet that tracks my properties so I know when I sell one roughly how much tax I’m going to have to pay on it.

There are some people who like to optimize taxes to the penny and not send Uncle Sam a dime more than they’re going to owe. I’m not one of those people. I pay taxes on rental income quarterly and I pay taxes on the sales of properties as soon as the wire hits the bank account because I view that process as a forced savings program. If the money isn’t in the bank, then I won’t spend it. When I get a refund check, then I’ll invest it. Otherwise, I’ll see that great deal on Scott’s Cheap Flights, and blow that money I saved.

My process isn’t an exact science, since I’m not doing things like accounting for other passive income, deductions, etc. I just want to make sure that when I do my taxes, I don’t get a nasty surprise with a tax bill. So, we overpay each year and get our refunds, and then we squirrel those refunds away.

What’s the process?

That spreadsheet is simple.

For each property, I have a column. That column has the following information:

  • Our basis in the property
  • When we bought the property
  • The basis in the building (we take this from the tax appraisal’s building value versus total value and apply that rate to the building)
  • How much we’d sell the property for
  • Estimated closing costs (we find that ours generally runs in the 10.5%-11% range)

When we actually sell a property, I go back and fill in the specific details about how much we’re selling the property for, the closing costs, and the actual date of sale.

With those items, I can then calculate the two different taxes I’m going to have to pay:

  • Depreciation recapture. It’s 28% of the depreciation that we’ve taken since we’ve owned the property. The calculation is simple. It’s number of years we owned the property — (date of sale – date of purchase)/365 — divided by 27.5, which is the IRS defined amount of years to depreciate a building, multiplied by the basis in the building.
  • Capital gains. This one is easier. It’s (sale price – closing costs – total basis in property) * 20%. I assume a 20% capital gains tax rate for simplicity’s sake. If we manage our taxes well and wind up lower, then that’s great. More refund for us!

I add depreciation recapture and capital gains taxes together and file an estimated payment with the IRS. Easy peasy.

With that, we’ve minimized the amount of work that we have to do to rebalance our real estate portfolio. Our property manager/Realtor works like a sweaty elf, but, on our end, we’ve reduced the amount of decision-making and work that needs to be done in both determining what to sell and what to do afterwards.

About Jason Hull, CFP®

Jason Hull, CFP®, is the Managing Member of Broadtree Partners, a firm that acquires $1-5MM EBITDA companies.