Would My House Be A Good Investment After I Move Out?

10

Ever come up with the great idea that when you buy a new home, you’ll just turn your existing home into a rental property? Well, it’s not as easy as it sounds and there are definitely some things to consider.

This Today’s Classic post is republished from The White Coat Investor on this very subject. The original post can be found here. Enjoy!


Q. I want to buy a house in residency.  I know that in general you think most residents shouldn’t buy a house.  What if I keep it as an investment property after I move?

A. If you want to buy a house as an investment, you need to evaluate it as an investment BEFORE buying it.  There are two great reasons to keep a house you used to live in as an investment property.

First, you already own it.  That means you get to save on transaction costs.  I conservatively estimate transaction costs at about 5% of the value of the home to buy it and 10% to sell it.  If you don’t have to pay one (or both) of those, it automatically makes an investment a little better.

Second, you get a better interest rate (and often terms) on an owner-occupied property than you do on an investment property.  But no lender expects you to get a new loan just because you move out and convert your residence to an investment property.  The extra interest you don’t pay is now investment profit.

Would My Home Be a Good Investment Property?

Calculating A Cap Rate

A real estate investor should be familiar with a few basic terms, such as capitalization (cap) rate.  The cap rate is the amount of cash on cash return you would get from your property if you owned the whole thing free and clear.  It is the net operating income (NOI) of the property divided by the value of the property.  If a property gives you an income of $15K per year and is worth $200K it has a cap rate of 7.5%.  That’s pretty good.  So for every thousand dollars you invested in the property, you’re getting $75 a year in cash as your investment return.

This ignores other sources of real estate return, such as amortization of the loan, depreciation of the building (tax benefit), and appreciation (or in recent years, depreciation) of the property.  The 55% Rule The easiest way to calculate the cap rate is to use the 55% rule.  Several studies have shown that a good estimate of your net operating income is about 55% of the gross rents.  45% of the gross rents go to property taxes, insurance, maintenance, repairs, HOA fees, vacancies etc.  It is much easier to use the 55% rule than to try to estimate all the expenses every time you consider a property.  So if the gross rent on your $200K property is $20K per year, then your NOI is $11K, and your cap rate is 5.5%.

Levered Cash On Cash Return

Many professional investors prefer to use the levered cash on cash return to evaluate a property, rather than the cap rate.  This takes into account the size of your down payment as well as the rate and terms of the mortgage on the property.

For example, if you have a $200K property, you put 25% ($50K) down, your NOI is $11K, and you get a 3% 30-year mortgage with P&I payments of $10,204 per year, then you can calculate your levered cash on cash return.  You take your NOI and subtract the costs of the mortgage.  That means you’ll clear $796 per year.  On your $50K investment, that’s a levered cash on cash return of 1.6%.  Doesn’t sound so good does it?  Yes, part of that payment goes to principal ($4203 that first year), which would increase your total levered return to about 10% a year, and you get some of that rent tax free thanks to depreciation, and the property might even appreciate (which is awesome when you’re highly leveraged, but remember that leverage works in both directions), but your cash on cash return is still pretty pathetic.

You can compare your cash on cash return to similarly risky investments.  For example, if I expected 9% a year out of a risky, but completely unleveraged, stock mutual fund, then I would want something like 12-20% out of an investment property to compensate me for the risks of leverage, lack of diversification, illiquidity, and hassle factor.  (It only takes me 5 minutes on the computer to buy a mutual fund.)

I certainly wouldn’t be interested in an investment property with a levered cash on cash return of 1.6%.  I recently evaluated an investment opportunity with a levered cash on cash return of 6.6%.  (Cap rate was 5.9%.)  That’s better, but I certainly didn’t feel like I was missing out on a huge opportunity when I gave it a pass.

People Don’t Buy Homes As Investments

The problem is that people really don’t buy homes as investments.  Most buyers don’t even find out what a similar house in the neighborhood would rent for.  They buy homes as a luxury consumption item.  In order to have a place to call their own, they are willing to essentially overpay for a house.  That’s okay, you can’t take your money with you when you go, but a consumption buyer utilizes a different mindset than an investor when evaluating a property.

Typically when you buy a home, you take a look at what similar homes have sold for.  So does your appraiser and your realtor.  Nobody considers whether it would be a good deal as an investment property because it rarely is.

An Example

There’s a home in my city that is listed for rent for $2100 per month.  Zillow estimates it is worth $391K.  Applying the 55% rule, the NOI is $13860 and the cap rate is 3.5%.  Investors typically consider a cap rate of 6-8% to be adequate compensation for their investment, and a double-digit cap rate to be a real score.  3.5% does not impress them I assure you.  Even if you put down 20% and scored great financing at 3.5% for 30 years, your levered cash on cash return is actually negative (NOI = $13,860, mortgage cost=$17,007, downpayment = $78,200, so levered cash on cash return is a NEGATIVE 4%.)

The problem is exacerbated for a typical resident.  Most residents don’t put 20-25% down, acquiring a “doctor loan” instead that only requires 5% down.  Imagine the house above that costs $391K and has a NOI of $13,860.  If you only put 5% ($19,550) down (and are thus paying 4% instead of 3.5%), then your annual mortgage costs are now are $21,481.  Your cash flow is now a negative $7629.  Considering you only put $19,550 down, that’s a levered cash on cash return of NEGATIVE 39%.  Even if you don’t mind the negative cash flow situation (feeding this beast $636 per month, of which $552 goes toward principal) you’re still banking on uncertain appreciation to get any kind of significant return on this investment.

My Home as an Example

If I calculated out the cap rate for the home I live in, it would be about 5.0%.  I have a very low-interest rate (2.75%) but also a 15-year mortgage, so despite having a relatively favorable loan to value ratio, I would be cash flow negative (and thus have a negative levered cash on cash return) if I turned my house into a rental tomorrow.

This is, unfortunately, the most likely case for most of us, especially a resident who only put 5% down on a property and then lived in it for 3 years.   That’s okay, I bought the house as a consumption/luxury item, and I’m not trying to fool myself that it would be a great investment if I moved out.  If you, however, have decided that you’re buying an investment and not a consumption item, then I suggest you run the numbers beforehand to determine if it is a wise investment.  You should also have a plan to deal with the almost inevitable negative cash flow situation.

What do you think? Have you ever turned a home you lived in into a rental property? Was it a successful investment? Why or why not? Comment below!

10 COMMENTS

  1. Love it. Most descriptions of cap rate are confusing for some reason. This is clear.
    BTW I bought another rental house yesterday. Cost: 150k. Expected rent: 1,400. Cap rate: 6.2%. Not stellar, but okay for my area. We’ll see how it goes.

  2. If you are really going to buy the place, calculate the real cap rate, don’t use an average number and make a guess just because it’s easier. That’s a habit that is destined to cost you a fortune.

    Dr. Cory S. Fawcett
    Prescription for Financial Success

    • Yes, I agree Cory.
      I was demonstrating this as a useful “screening tool.” The actual is close to the ballpark.
      I had several professionals run my actual numbers: At a price of $150,000 and rent of $1400 the Yield is 5.76% and monthly cash flow is $933

        • I have been buying in the Midwest: IL, IN, OH but I see similar or better deals in TX, FL, GA and other states. Have you heard of the “1% rule?” This property didn’t quite make that cut due to the lower cap rate. That rule would have me looking for a rent of $1500 for a 150K house. That level or higher is best to shoot for.

          • Does the 1% rule mean you should expect to get at least 1% of the purchase price for rent?

            I was thinking of Dallas, TX since so many company appear to be heading over there. We are in Southern California and it is nearly impossible to find a rental property that can command 1% of purchase price. So I am considering to invest long distance but that seem to have challenges of its own, such as maintenance and finding a good property manager. If you can share any insights on how you are finding these long distance deal that would be great. Thanks!

  3. We had an accidental rental property. Cost $600,000, 100% financing, 3% interest. Charged $3,000 a month plus utilities.
    I didn’t use what you described but was in the middle of learning about these terms when we finally sold it after 4 years. I knew in my gut it was not a good investment but never calculated the cap rate or NOI.

  4. Mr MFC
    Check this out: https://passiveincomemd.com/how-i-bought-an-out-of-state-investment-property-from-my-call-room/

    Here is a quote from PIMD: “1% or 2% Rule for Buying Rental Property
    This rule states that your investment property should rent for 1% of the purchase price.

    For example, if you purchase a 5-unit apartment building for $800,000, it should bring in $8,000 a month in rent ($8,000 is 1% of $800,000). This will likely help to ensure that you are in a cash flow positive or at least cash flow neutral situation. Some people use 2% as the rule, but unfortunately that isn’t a mathematical possibility in most parts of the country. Again this depends on location and risk tolerance.”

LEAVE A REPLY

This site uses Akismet to reduce spam. Learn how your comment data is processed.