The Facts About Owing Free and Clear Property in High Priced Regions

Posted @ 7:42 pm - Filed under 1031 Exchanges, Boise, Cash Flow, Depreciation, Financing, Palo Alto, Real Estate Markets, Retirement, San Diego Property Owners, Tax Shelter, Texas

You don’t hafta own debt free income property in San Diego, or Palo Alto, San Francisco, Orange County — heck, the west coast in general, to know how much of a value hit you’ve taken recently. For so many regular folks who’ve called me, the conversation often follows the same script. The good news (no always) is they own free and clear residential income units, usually 1-4 units per property. The bad news is they’ve dropped in value anywhere from 25-50% depending upon where they are and when they were acquired. Ouch and a half!

There are many areas like San Diego, where many of these calls originate. When duplexes are still selling for $300-450,000 with Net Operating Incomes (NOI) of $15,000 or less, the numbers simply don’t work for 90% of the investors out there. When it still requires 35% down just to break even every month, folks tend to look elsewhere — especially these days. There are several pockets around the country where a 20-25% down payment will yield positive cash flow from Day 1. Ironically, those alternative markets are more likely than not to offer better relative locations along with higher quality tenants to boot.

Two of those regions, broadly speaking, are Texas and Idaho. Had a conversation today with my Boise Team Captain, who gave a current example of what’s now available there. A 2 year old fourplex for $300,000 (maybe less) with annual gross scheduled income (GSI) of about $31,000. That would translate, give or take, to roughly $18-20,000 in NOI annually. How does that hit your bottom line?

At 20% down it barely cash flows, and with 25% down it cash flows $1-200 monthly. That would include vacancies, operating expenses (including professional local management) and debt service. Let’s compare that to someone in San Diego who owns a couple debt free duplexes. Their combined value is now around $900,000 — they’re well located and kept up nicely. Their combined NOI is now running around $37,500 — which is also their annual cash flow. It’s not sheltered any longer, as their depreciation ran out long ago — so that’s a pre-tax figure — not a good thing.

If they were to get rid of those in a 1031 exchange, the net equity generated would be approximately $800-825,000 — depending upon any required repair work, pest control, etc. Let’s use the smaller figure, alright?

Let’s say they stick to their guns, and don’t borrow any portion of the purchase prices on the properties to be newly acquired. Often that’s a mistake, but let’s talk about that some other time. They could easily afford a couple very well located Texas duplexes for under $500,000 total. They would then buy a Boise fourplex for $295,000. The Texas properties would be new, the Boise fourplex would be 1-5 years old. How would this shake out for the investor?

Their current cash flow is running at around $37,500 a year — again, pre-tax. The younger of those two duplexes was built in 1962. The operating expenses are gonna keep rising, so they better hope the income keeps up. Of course, that’s gonna be harder each year, as the units get older and older.

The two Texas duplexes will net them about $34,000 annually. The Boise fourplex will kick in another $18,000 or more. That’s a combined $52,000 a year in income compared to their present figure of $37,500 — an increase over $1,000 a month. Another way to look at it is as a percentage increase of over 35% in their annual income! For most folks this isn’t chicken feed — it’s a huge improvement in their potential day to day lifestyle.

As time marches on, if they remain in San Diego, or wherever their units are, the money required to make them viable will increase to the point of significantly diminishing returns. This isn’t news to them, cuz they’ve been putting that thought out of their minds for quite some time now. They know exactly what I’m talking about. This proposed move is a no-brainer not only from a cash flow standpoint, but from a future operating expense point of view.

Properties either new or nearly new, simply don’t cost as much to maintain. Think about it. 20 years from now the Texas/Boise properties STILL won’t be half as old as your current rentals are today. Does that stop ya cold, or what?

But, what if you borrow money to buy the new stuff? Glad you asked.

Being fairly conservative, what if you put about 1/3 down on 7 Texas duplexes and a couple Boise fourplexes? This would take less than your whole 800,000+ net equity. Your NOI on all that property would amount to about $155,000 annually. Your total debt service (at 6.25% interest) would amount to about $42,000 or so.

Here’s the really happy ending.

Your depreciation would go from a big fat ZERO to about $50-55,000 a year. Big deal you say? Here’s the big deal.

You would’ve gone from cash flowing $37,500/yr without a cent of tax shelter — to $42,000/yr TOTALLY tax sheltered. In California, the taxes, fed/state, would reduce the cash flow hugely — probably in the neighborhood of at least a combined 25% or so. That’s on top of your ever dwindling net operating income due to consistently increasing operating expenses, not to mention repairs and outright replacements.

Let’s now compare your after tax income, you know, the only income you can actually spend? Now it’s about $28,000/yr. Doing the exchange will increase that to $42,000/yr. This doesn’t take into account the decreasing cash flow from San Diego properties due to ever increasing operating costs as properties age mentioned above. Notice how I keep pickin’ that scab?

These are the cold hard facts. So, tell me — doesn’t it make sense to make a move? This decision falls into the category of no-brainer. Oh, by the way, the newly acquired annual tax shelter now allows your cash flow to grow by roughly 15-20% before you’d be paying taxes on even $1. In my office we call that the result of Purposeful Planning. These things don’t just happen — they’re made to happen through prudent Planning followed by experienced implementation.

If you own properties in relatively higher priced areas like San Diego, with little or no debt, and have already retired or are about to, this may be a fit for you. Look at the numbers, run them yourself, then ask the same question I have: Why wouldn’t you make this move?

Please, call me at 619 889-7100, as I’d love to talk with you about your situation. You can also choose to go through the Contact BawldGuy button up top. Have a good one.

This entry was posted on Monday, September 14th, 2009 at 7:42 pm and is filed under 1031 Exchanges, Boise, Cash Flow, Depreciation, Financing, Palo Alto, Real Estate Markets, Retirement, San Diego Property Owners, Tax Shelter, Texas. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.