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.
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%.
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.
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!