A Better Path to Home Ownership

If you own it, who says you have to live there?

This is going to sound wrong to many or even most of you when you first hear it, but what if I told you the best way to become a home owner is to buy it and rent it to someone else? Weird, right?

There are certainly some major caveats to this idea, which I’ll detail later, but it is possible today to buy a home, rent it to someone else and come out more financially independent than if you bought the same house to live in yourself.

How is that possible?

In my prior post I discussed how the house you live in is an expense and not a productive asset. Why? Because the house you live in costs you money to live in, just like when you rent, except it may be a higher or lower expense depending on the housing market in which you live.

When you buy a home as an investment property to rent to others, if you do your homework correctly - the caveats (see below) being the homework you MUST do - you are acquiring a productive asset. That is to say it ADDS to your income AND cashflow. Even if the house you buy to live in increases your cash flow through lower expenses, it doesn’t provide income in addition to your normal job(s).

When buying to rent to others you will still have to surrender some amount of cash in the down payment and closing costs, but with more money coming in each month, your ability to replace those depleted funds (not gone, but now imbedded in your equity in the property) will become easier.

Better yet, this becomes income not tied to your primary job! The more income you can generate for yourself not tied to your job, the faster you will achieve true financial independence.

So let’s find a real world example to explore. We need not limit ourselves to the immediate area you live in. As little as 20 years ago, this would have been a foolhardy idea. But with the internet and access to all the information you will need to buy and manage a property, you can look at properties anywhere in the country (and beyond).

To give you an idea of how real this possibility is, our first three rental properties were purchased in 2009 in cities a thousand miles or more from where we lived at the time. One of the properties was in a city I’d never even been to before. Each was a profitable venture, generating more revenue than expenses for the duration of the investments. One of our great advantages was living in an area where salaries were much higher than the place we were buying these properties.

In my current research of where to buy rentals for profit, Detroit, Michigan has been a standout. In Detroit, the median sold home price is around $75,000 (per Realtor.com) and the average rent is around $1,176 (per RentCafe.com). This works out to $1,881 of rental revenue per $10,000 dollars invested, much better than the minimum threshold I like to rely on of generating $1,000 in rents for every $10,000 invested, so let’s explore an opportunity in Detroit, Michigan.

A Buy to Rent Case Study: 15521 Auburn St, Detroit, MI 48223

On Sunday, September 11th, I found the above property listed for $89,000: Using Rentometer.com to estimate the potential rent for this property (a very reliable tool in my experience), we come up with an estimated rent of $1,150 per month. Since homes in Detroit have been selling for 90% off the list price lately, I can probably propose an offer of $80,000 for this home and see how it goes. What is interesting about the sales history of this property is that it sold for $67,000 earlier this year, so this is likely a flip where the seller has renovated it to some degree with an eye on reselling it at a profit. Looking at the pictures in this case, that may have been limited to paint and perhaps some other minor repairs.

Digging into the math of this opportunity at $80,000, I know I will need a $16,000 down payment for this property plus another 4% of the property sales price for closing costs. Using the rental rates on Realtor.com for this area on September 11th, the estimated 30-year mortgage rate is 5.671%, so I’d load that by an additional 0.50% to get a mortgage loan rate of 6.171% for a rental property. The table below shows how I would evaluate this property from a revenue and expense perspective:

Allow me to explain a few of the terms used in the table above:

Revenue - This is the total amount of money received in the rental of the property.

Vacancy - This refers to when the property is not occupied and not collecting rent.

Management Fees - This is the fee charged by a property manager to rent and care for the property on the owners behalf. It can range from 8% to 12% for long term rentals.

Maintenance - This includes the cost to keep the property in adequate condition to be a rental and can include lawn care, paint, repairs, etc.

*Depreciation - This is often where some of the magic happens in real estate investing. The IRS assumes any property owned for investment purposes has a useful life of 27.5 years, and on that basis allows the owner to deduct 3.636% per year (being 100% divided by 27.5). In this case, because the income is limited (in our very conservative analysis) the contribution to cash flow in the first year would be limited to tax savings realized from deducting depreciation from the property’s net income. In the case above for a single California investor making $50,000 a year they would be in a 22% tax bracket for Federal and 8% tax bracket for CA, for a total tax savings of 30% of the $636 in property income, or an additional ($636 x .30) $190 per year of cash flow. Since the depreciation amount is greater than the income, the portion not used against the income in the current year is carried to the next year, so the available depreciation against the next year’s net property income would be $2,900 - $636 + $2,900 = $5,164. Any unused depreciation gets carried into the later years until it can be claimed.

The Findings of the Analysis

Now that I've clarified some of the above terms, consider what I’ve done here to analyze this opportunity. I’ve taken the expected rental revenues, deducted my anticipated expenses (which is based on my actual experience doing this sort of investment), factored in potential unexpected issues (vacancy, maintenance, dropping rents) and still come out cash flow positive before any tax advantages - that being primarilly depreciation - are considered. If I still have a positive number, and all the caveats have been satisfied, I would invest in this opportunity.

What was the initial investment? $16,000 plus closing costs of about $3,200, so a total of $19,200. To then receive in return $827 per year in additional cash flow from that investment yields about a 4% ($827/$19,200) first year cash on cash return, which is not great, but is based on heavy expense assumptions.

If rents don’t drop and the location is occupied for the full year (this was my experience for the three homes I did this with just after the financial crisis of 2008), this calculation improves quite a bit. Net income increases to $3,166 and since the full depreciation can now be claimed the net cash flow increases by $870 ($2,900 x .30) to $4,036. Subtract the 30% tax obligation on income not offset by depreciation, being $80 ($266 x .3) and the final net cash flow increase is $3,956. That racks up a more impressive cash on cash return of ~21% ($3,956/$19200)! As a point of historical fact, rents rarely go down - even in financial crises - ironically, due to government intervention.

The key to success here is being cash flow positive. You can’t know the future, but conservative assumptions can help improve your odds of being positive and, as demonstrated above, have massive upside potential.

If your annual salary is $50,000 and you do this deal, you just gave yourself somewhere between 1.6% to 8% raise in the first year and you now derive as much as 7.4% of your personal income from a source not tied to your primary job…think about what doing this five or six or ten times will do for you over the next decade, and the cumulative effect of this type of investment on your income.

Since this is a decision to buy to rent instead of buying to live in, you’re still a renter where you are, but now you own property just the same, putting a stake into the terra firma as a hedge against long term inflation, just like you would as a home owner, only your income has just grown by the amount of net cash flow derived from the property.

Being a Buyer to Own the Same Property

Okay, so let’s compare that to you buying that home instead.

Let’s make a couple of fair assumptions as well. If you are living in Phoenix, Arizona and making $50,000 a year, to live in this house you must move to Detroit. The cost of living in Detroit is 84.4% of that in Phoenix, so your salary in Detroit for the same work would likely be in the $42,300 range.

You make an offer at $80,000 and they accept. So far so good. Here’s what your expense load would look like after buying this home:

In this case, as you can see, there is a net expense because there is no revenue component to the property as the place you live. Since we know the rent for this house would be $1,150 per month, we can say you’ve reduced your annual expenses for shelter by $13,800 - $9,552 = $4,248. Buying here is a better deal than renting when looking at this from the standpoint of substitution. Just be sure to resist the urge to remodel or these savings and then some will be gone in a flash!

The Caveats

Okay, after getting you all excited about accelerating your path to financial independence, it’s time to throw some cold water on you (sorry). There are several important caveats to this type of investing:

• This won’t work in every marketplace. You can forget trying to do this for single family homes in large swaths of the Pacific Coast. Cities like Los Angeles, San Francisco, Portland and Seattle have rents that are much lower than the relative cost of the homes. This makes buy and hold cashflow opportunities poor. You need to be buying in a place where annual rents generate at least $1,000 for every $10,000 invested. For example, if you buy a $300,000 home, it will need to generate $30,0000 annual in rents to give you the margin to work this homeownership hack with a high probability of success.

• You should work with a trusted provider of turnkey homes, that being homes ready to be rented the day you close escrow, or be prepared to put in sweat equity and additional funds to turn a fixer upper into a rental - which can be more profitable, but also more difficult to accomplish. Beware of old homes that may need total a renovation if buying a fixer upper.

• If you buy a property not local to where you live and have a property manager handle the property, vet the manager thoroughly (ask for lots of references and read the management contract very carefully). Also know you are adding an 8-12% layer of additional expense in having a property manager on a long-term rental property.

• When working out the revenue and expenses for a rental property, ALWAYS work in factors for your financial safety. For example, I assume 1 of every 12 months will be vacant and no rent will be collected. I also assume 10% of the rent will be spent on maintenance costs, even for a newly renovated home. Finally, I assume rents can fall 10% from where they appear to be at the time of purchase. If I am still cash flow positive after these factors are worked into the math, I am ready to proceed with the transaction.

• Pay careful attention to any covenants, conditions and restrictions (CC&R’s) if the property is in a Homeowners Association (HOA) to ensure you can rent it out to others in the way you intend to in your financial model before you buy.

• When buying a property (for any purpose) always walk the property yourself and/or pay the few hundred dollars it costs for a reputable independent home inspection service (NOT to be selected by the seller or seller’s representative) to walk the property and issue a comprehensive formal report on its condition. Any defects or issues found become negotiation points on the sale price or can become mandatory items for repair before the purchase closes.

• Know your projected property tax and insurance costs before closing any deal to purchase a property and I highly recommend you buy title insurance (banks will require this, but when paying cash, it is optional).

• When buying a property to rent it to others, you generally need to put a higher down payment - 20% being fairly typical. It was 25% in the years immediately after the financial crisis of 2008. This compares to as little as 5% when buying a home to live in. You will also pay a higher rate for investment properties, between .50 to .75% higher than a loan for a residence you intend to live in.

Closing Reflections

So, let me recap this discussion: When buying this property to live in, 100% of your income continues to be derived from your (now lower paying) job and you live in Detroit instead of Phoenix (It’s up to you to decide if that change is a gain or a loss - to each his own).

However, here’s the crux of the matter in buying this property to rent to others: your income increases, and, more importantly, reduces the percent of your income derived from your primary work from 100% to 94%. Repeat this trick again and again and with each iteration you can draw closer to true financial independence.

Which scenario do you think will get you to financial independence sooner?

Note I made no mention of appreciation. The buy to rent scenario above assumes no increase in the property’s value, but your financial independence improves regardless. Since the renter is paying your mortgage (sweet!), your net worth is growing too. Add any appreciation to this equation and your net worth will grow even faster, in just the same way as if you’d bought the home to live in…see how that works? Win, win!

In print it may look like easy money, and when you’ve got a network in place to help you get these opportunities vetted, it can be, but that first time out will be daunting and it is critical that you not cut corners in the vetting process.

I won’t dive into it for this post, but there is an option for buying your first home that threads the needle between these two scenarios and may be an even better choice for a first-time home buyer: buying a duplex (or multiplex) where you live in one unit and rent out the rest. You can eliminate the property management fees this way. However, know you are taking on another part-time job by doing so (on a related note, contracting with a bad property manger can have the same effect.)

Other alternatives are to find a house with a rentable casita in the back, or to rent rooms in your house to roommates (definitely not a comfortable alternative for everyone). I’ll work these scenarios for you in a future post, but since it is similar to the analysis I’ve done here, I’ll move on to some other topics for the time being.

Until next time, may peace and prosperity be with you.

The Natural Economist

Next up: Why I promote Financial Independence and not the currently popular Financial Independence Retire Early (FIRE) ideal. Hint: It’s a soul thing.

Disclaimer: I am not a licensed financial professional. What I write on this blog is my opinion and should not be taken as gospel for your investing decision making. I receive no compensation from any links in my posts unless disclosed in the post. Photo credit goes to Ross Joyner, posted at Unsplash.com

Note about the To Buy or Rent post: If you read a version of this post from your e-mail in-box, pease consider reviewing the online version. I rushed that one out and discovered to my dismay after the fact that there was a math error in the analysis, The online version has been corrected. I’ll be sure to review my posts more carefully going forward to avoid such errors.