Relocating Equity To Improve Rental Real Estate Profits

Many factors affect the value and net income of rental property.  Design and condition of the structure usually get the most attention, but savvy investors know that location has the most significant impact on profitability.  When acquiring rental property, we look for neighborhoods where tenants desire to live and will pay the most rent.  But we also know that, over time, some locations lose value for any number of reasons.  When this happens, we might consider relocating equity to improve rental real estate profits.

In the 1979 film “Being There” Peter Sellers plays Chance, a simple-minded young man who grows to middle-age without ever venturing out beyond the walls of an up-scale Washington, DC home.  An old television is his only link to the outside world.  When the home’s owner dies and he is forced to leave, Chance discovers that over the years a once fine neighborhood has fallen on hard times.  It is now littered with abandoned homes blanketed with graffiti and empty lots strewn with trash.  The same can potentially happen to neighborhoods where we have rentals, no matter how well we maintain them or how much we work with adjacent owners to preserve the value of the neighborhood.

We can determine if a neighborhood is or is not contributing to the profitability of our rental by performing a market rent analysis, ordering an appraisal, and obtaining local economic data.  If these studies indicate that the neighborhood is in decline, we’ll see evidence of the following:

• Reduction in the property’s appraised value since a previous appraisal
• Local economic indicators trending in the wrong direction
• Decrease in employment opportunities and/or increase in reported crime
• Reduction in availability of local services and amenities (e.g. reduced Walk Score)
• Reduction in local market rents
• Increase in operating costs, taxes, insurance and vacancy rate

If we determine that our rental’s neighborhood no longer meets our investment criteria, we have options.  We could sell the property and get out of the rental business, which could generate a substantial capital gains tax liability, or we could sell the property and relocate that equity to another neighborhood that supports our investment goals.  The most common and cost-effective method for doing this is through a 1031 Exchange.  A “1031” lets us sell the poorly-performing property and defer taxes on the capital gain as long as we re-invest that gain in another rental property in accordance with Internal Revenue Service (IRS) requirements.  Like any strategy, moving equity out of a losing property and into a winner has its ups and downs.  Assuming that market conditions are strong enough to put cash in our pocket when the rental is sold, here are a few things to consider when relocating equity to improve rental real estate profits:

Pro:

• Moving equity turns slow or negative cash flow into profits
• Buying a newer property provides an asset with a longer economic life
• Buying a property in an improving market increases both rental margins and asset value

Con:

• Exchanging properties requires careful analysis and incurs selling and buying costs
• Rent can be lost during the period between selling the old rental and buying a replacement property
• Rules for conducting a 1031 Exchange must be followed precisely (primarily timing and exchanging the right type of property) or the capital gains tax may not be deferred

Rental real estate should provide a measurable return on equity.  Just as with any other type of investment, if that return does not meet your requirements it’s prudent to consider putting our equity into something that can.  If you like rental real estate and want to stay in the business, relocating equity to improve rental real estate profits might be the right investment strategy.