Every good investment needs an exit strategy.
Yes, even buy and hold investors like me should know what circumstances and market conditions would cause them to sell each individual property. Without this awareness, a great investment may become a mediocre one as opportunities are missed and obvious signs of trouble are ignored.
There are many macro indicators that can be used to track the local market, but that is a topic for another time. Even more important are the numbers surrounding your specific property, which incorporate not only the larger market but how your property is performing within that market.
There are three metrics that I calculate annually and use in tandem to assess whether to continue holding or to sell.
1. Cash flow
Cash flow is the crux of buy and hold investing. It sustains a long term investment and protects against financial ruin when the unexpected happens (as it inevitably will from time to time).
Cash flow is simply calculated by adding up all of a property's revenue throughout the year and subtracting all of its expenses. This number is the amount of money that you put in your pocket over those 12 months and was made available as income for other investments or expenses.
For a small-time investor with just one property, cash flow is very easy to track. No sophisticated accounting is needed.
Since your rental property is a business, you should already have a separate bank account for its activity. After you have made the initial cash contribution to this account to keep the business solvent, all you have to do is look at how much your account balance has grown from the beginning to the end of the year (as long as you have not taken any money for personal use during this time).
If you initially had $5000 in your business account on January 1st and on December 31st the balance is $7500, you have made $2500. This is your cash flow for the year.
2. ROI (Return on Investment)
There are several types of ROI.
Cash-on-cash ROI only looks at the cash flow relative to the amount of cash that you initially invested in the property. If you think of your investment like a stock, this is your dividend as a percentage of the price that you paid for the stock.
What I call "paper" ROI is the return on investment that you have achieved on paper, which includes the amount of principal that you have paid down on your mortgage debt and the amount of appreciation that the property has experienced. Paper ROI is not very useful to me since property values can change daily and your property is only worth what you actually sell it for, not what Zillow or some appraiser tells you.
The type of ROI that I use to determine when to sell is called Total ROI. Total ROI is similar to Paper ROI, but does not include capital appreciation. To calculate Total ROI, add up your revenues and subtract expenses to get cash flow. Then add to this the total principal that you have paid on your debt over the year. Divide this number by your initial cash investment to arrive at the Total ROI. ROI is expressed as a percentage after multiplying by 100.
For the remainder of this post, the term 'ROI' will refer to Total ROI.
3. Cap Rate
The capital appreciation rate – cap rate for short – is the metric that is used universally by real estate investors to compare properties for their investment potential.
The cap rate is unbiased by financing, which can vary greatly from one property and one investor to the next. Essentially, it is a measure of the cash flow you would receive if you owned the property free and clear (no debt).
To calculate the cap rate, add all revenues and subtract all expenses EXCEPT for debt servicing (principal and interest). Taxes and insurance are still included even though you may pay them through your mortgage. Divide this number by the value of the property (what you believe it would sell for today).
Be as realistic as possible with value. Zillow is a good start, but unless your property is a mass-produced condo or cookie-cutter home surrounded by dozens of identical properties with the same upgrades, you will have to make some assumptions and adjustments by looking at recent comparable sales. Your realtor is also a good source for present market value.
When calculating cap rate based on the past year, you should also be wary of irregular expenses that can skew the number. For instance, if you replaced the roof in that year you will not expect to replace it again for at least ten years.
However, you may be expecting to replace the air conditioning unit in the upcoming year or two. For the purpose of deciding on whether to hold or sell, you may want to smooth out these kinds of maintenance expenses to arrive at more of an "anticipated" cap rate for the next several years.
But if you are going to do this, it is best to err on the conservative side. In other words, expect some big expense to happen and see if you still want to keep the property instead of cashing out now.
Putting These Metrics Together
After you know the cash flow, ROI, and cap rate of a property, you can objectively determine if it is a good time to sell. This is much better than making an emotional decision based on fear or greed.
Your decision should be about opportunity cost. Is your money being put to its best use, or is there something better that can be done with it?
If you have a mortgage or other debt on the property, my rule of thumb is fairly simple. You should consider selling the property if the cap rate falls below your debt's interest rate.
If the cap rate is lower than the interest on your debt, you are paying more interest than you would receive in cash flow from the borrowed money if you bought the property today.
If the property has increased in value since you purchased it, this tells you that its value may be near a high point in the cycle and triggers you to sell before the price comes down. If the property has not gone up in value, this means you are simply losing money on the debt, and it might be time to cut your losses and find a better place for your money.
Of course, if you borrowed money on a credit card or some other vehicle with very high interest (which I would never recommend), having a cap rate below the interest rate may simply be a sign that you need to pay that debt off ASAP to maximize your gains. In this case, take a look at what your ROI would be if you knocked down the debt.
If paying off debt makes your ROI go up, then you need to pay it off to both increase ROI and be in a safer cash flow situation. If paying off the debt gives you high ROI (greater than 10% or so), then you may still want to keep the property.
If you happen to own the property free and clear, the cap rate equals the ROI that you would achieve if you purchased an identical property for cash today at market value. It is also the ROI you would need to achieve in order to make the same amount of cash flow through some other investment if you sold the property.
If you have positive cash flow and the value of your property has risen dramatically since it was purchased, the cap rate will be much lower than ROI. The lower the cap rate, the more enticing a sale will be; but only if you have a good use for the money when you sell (such as a 1031 exchange into a property with a higher cap rate).
For instance, if you bought a property for $100k in cash, your ROI was 10%, and the property had doubled in value to $200k, the cap rate would be just 5%.
If you sold this property you would have $200k (minus realtor fees and any taxes owed) and would only need to make about 5% on that money to break even on cash flow in a new investment.
In general, my threshold on ROI is about 7%. If I am making less than 7% ROI and have no reason to think that the numbers will improve the following year, then my money may be better used in the stock market or I may need to look for a better real estate deal.
If I also have significant debt on the property, my cash flow will be pretty weak in this situation. This looks like a time to sell. If I am making 10% or more, however, I may be happy making this cash flow for a long time.
What ROI do you look for in an investment property?
This article The 3 Metrics You Need When Looking to Sell Your Property originally published on The Bigger Pockets and is Copyright 2014 BiggerPockets, Inc.