This is a question I was recently asked by one of our multifamily investors. Most of our projects are projected on a 5-year hold. She was wanting to know why. That is a great question. As I was thinking about this question, it occurred to me that this question should be applied to any piece of real estate. How long should you hold that rental house you bought a few years back? How about that piece of land?
My answer to this question is simple. Ideally, you hold it forever. Ideally, when we buy commercial assets, we'd like to hold them as long as we can. If they're great assets, then they should continue to produce value over the long haul. We buy multifamily, storage and mobile home parks. I think we all agree that these assets are going to be worth a lot more in 20 years than they are today. When you hold a property over the long term, i.e. as long as you can, you get the full benefit of price appreciation, maximum principal pay down on the debt, no capital gains taxes, and the ability to refinance the property to acquire more assets. In short, the longer we hold the property, the more value we can extract from it with little or no transaction costs or taxes.
So the natural question is, why sell? Why do we sell a multifamily asset every five years? And why are you considering when to sell your small multifamily property or rental house?
On commercial properties, the reasons are many. But here are a few. Loan structure on commercial real estate dictates the exit strategy in most cases. If the loan terminates in 5 years, or 7 years, then we'd rather sell than face the high costs of refinancing the asset. At the same time, most of the value delta in the project has been captured by that point so it's often best to harvest our capital and profit, and pay back investors, We then will look for another project that provides another similar profit delta. In commercial value add investing, we grow our capital fastest by rolling equity from one value investment to another.
Most investors want to see their money returned to them in a relatively short period of time, so that psychology also plays a role here. Having said all this, there are projects out there with longer hold periods of 10 years where investors can stay in the deal and continue to reap the cash flow and tax benefits.
What about the rental house? I sold a triplex recently that had very strong cash flow relative to its price. The reason I sold it primarily had to do with its location and the challenge in managing the property and tenants. When a property begins to drag down your business, you put it on the chopping block and look for better assets that will grow faster and are easier to manage. I have smaller residential properties that are doing very well in Central Texas and there is really, at present, no reason to sell them. As my equity increases over time my return on equity (ROE) will decrease; Equity/Cash Flow = ROE. This is a problem because I want to have a high ROE on my capital. Over time ROE sags as equity increases relative to cash flow.
In order to remedy this sagging ROE on a property I want to keep, I simply do a cash-out refinance (provided the cash out is enough to purchase another asset or invest in one of our syndications) and reinvest the capital elsewhere. This reduces my equity in the asset relative to cash flow and will increase my capital efficiency.
It's a great thing when your portfolio equity can actually grow your portfolio over time. Great assets should be held as long as possible. So long as they're easy to manage and the location continues to improve there should be no reason to sell. The long term buy/hold investor understand this well, but sometimes it's a hard decision. Life circumstances also play a role, but as always, real estate investing is very personal and so the strategy you choose should factor in your family planning and goals as well.
More Articles on Real Estate from Mike Krieg
The Seven Reasons I Prefer Multifamily Apartments
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