Real estate prices are booming right now. Supply is tight and competition for investment properties tend to also overlap with first time home buyers. To me, the math doesn’t add up as much as it used to, even with low rates to finance the properties.
The funny thing about super low interest rates is at a certain point, you start to not discriminate between a low rate and a no rate. I know it sounds crazy, but for example, a treasury bond with a 0.5% yield starts to be pretty close to just a zero coupon bond.
It’s happened to me psychologically – I can tell.
I’ve looked at some rental properties recently, I have a long time horizon, and so I think “well, as long as the income covers my mortgage at the minimum, that’s all I need – I’ll generate a levered return to real estate prices.”
This is dangerous because unexpected capital expenditures, occupancies, etc. can knock off your cash flow assumptions.
I own several rental properties today. While I can sell them and generate profits, I’ll either be taxed (and greatly reduce those profits) or I’ll 1031 like-kind exchange into rental properties that are also expensive. Not really a “win.” It’s one expensive home for another expensive home.
So back to low rate vs. no rate: if I’m comparing rental property where competition is very high due to tight supply… I started to think to myself:
Why not just buy land where I think housing developments are moving?
“Skate to where the puck is going.”
Can you 1031 rental property for land?
Actually the rules are pretty broad. You can exchange commercial for residential. Single-family residential for apartments. Farmland for other real estate. What matters is each is real estate used for investment purposes on either side.
How does is work?
I decided to walk through a hypothetical situation where you bought $650k of rental properties 10 years ago, which are now worth $1.06MM. As shown below, if you sell you’ll either take $387k after taxes or $580k that you can reinvest in real estate.
Is a 1031 Worth It?
Clearly, it seems like if you can sensibly reinvest in real estate, it might be worth it to avoid the taxes and continue to compound capital. Alternatively, if you’re comfortable with your cash flow covering your debt, you could do a cash out refi which I previously discussed. Or, you just keep the property.
But I’m exploring hypotheticals here.
Look at the tables again and you can see one labeled “acres purchased.” I did a quick check for land for sale on outskirts of areas I currently invest in, but places where I am reasonably confident growth is moving and the land would be reasonable to develop.
You may know of cheaper land and I definitely saw some expensive land and as of right now, that was a reasonable median. So I could buy nearly 80 acres for around $12,500 an acre and use all that cash.
A note on these assumptions: I’m not being scientific. I think some of this hypothetical lot could trade for 25k an acre in 10 years, or double the price. That’s mainly because (i) some of the lots that are currently butting up against the “next” housing area are selling for that, so in 10 years if you picked the right spot, I’m OK with that assumption (ii) home price appreciation will make it easier for a developer to capture that price, and (iii) we have a shortage right now. I think it will take a reasonable amount of time to rectify that shortage (although affordability may hit demand as well).
Mortgage Boot Kills the Fun
In a 1031 like-kind exchange, there’s the concept of “mortgage boot” which basically means you need to reinvest the cash flow from the gain + take an equal sized mortgage. Or cough up more equity of equal size to the mortgage. You may have noticed in the table I included a mortgage. Ideally, you could just take the gain with no mortgage for the next property and no additional cash, but that’s not the way it works.
The IRRs without mortgage boot are shown below. Not too bad – all you owe are the taxes along the way!
IRR with mortgage boot shows the drag on cash flow may be too much for people. This also doesn’t include the principal payment on the mortgage (I assumed a 10-year mortgage, which would be $52.5k in total payments – not fun).
I like my cash flows to go the other way…
There is one other upside, and I’ve heard a few stories of this, is you buy the land and are able to sell the timber immediately which basically covers your cost. This is treated like a farmland, so there are some specific taxes you have to work through, but that would be an ideal scenario.
Then you own the land and have most of your basis out. Unfortunately right now, with lumber prices through the roof, you probably won’t recognize that value or the person selling the land would have already cleared it for themselves.
Bottom Line: I don’t think switching from a low-cash flow property to negative cash flow property makes much sense.