I’m Upside-Down on My Home. Should I Rent It Out? Or Sell It?

A reader wants to rent out his current home he's upside-down on until the market recovers enough that he can sell it. But is this a good idea?

Should I Rent Out This House?An Afford Anything reader recently emailed me about this dilemma:

He’s upside-down on his home. He owes more than the house is worth.

But he wants to take advantage of today’s low housing prices, which will let him move his daughter into the best school district in town. He can put 10 percent down on a new house in a fantastic school district.

He’d lose money if he sold his current home. There are only two ways he can sell it: either bring cash to the closing table (i.e. pay extra to get rid of it!) or process an excruciating short sale, which would destroy his credit.

Both of those choices are off the table. He wants to rent out his current home until the market recovers enough that he can sell it. But is this a good idea?

Check out the details:

MONTHLY INCOME
Rent:
$1,600

MONTHLY EXPENSES
Mortgage + Association Payment:
$1,200
Vacancy: $100 *
Repairs, Maintenance: $50 – $100 **
Property Manager: $100

Total Expenses: $1,450

This leaves him with $100 – $150 per month in cash flow.

Hold On, Where Did You Get Those Vacancy / Maintenance Numbers?

If the house is vacant one month per year, we can average that out to a monthly vacancy cost of $100. Of course, if it sits vacant for 3-5 months, he’ll be sweating.

The “rule of thumb” is that maintenance will cost 1 percent of the purchase price of the house. Of course, that’s a long-term annualized average. It includes rare, expensive repairs like replacing the roof every 20-25 years and re-painting the siding every 5 years.

Since he has an association payment, I assume his homeowner’s association takes care of all exterior maintenance. That brings his maintenance costs down. (Well, really, it just lumps his maintenance costs into a different category).

Assuming his house is in good condition, his big maintenance costs will rare but costly events like replacing the water heater, buying a new refrigerator, etc. He won’t literally pay $100 every month. Like his vacancy costs, this maintenance cost is a long-term average over the span of many years.

He reported a property management fee of $100 per month in the email that he sent me. That seems rather cheap (it’s only 6 percent of the rent), but some property managers will charge a cheaper fee in a neighborhood with higher tenant quality, so I’ll accept that premise at face value. (Some property managers charge one month’s rent as a “placement fee” for finding a tenant, which is NOT included here.)

So What Do You Recommend?

Here’s my advice:

#1: Use your $100 – $150 monthly cash flow to build some cash reserves. Use this to cover the mortgage payments when your house sits vacant. Vacancy is your single biggest risk, because you’ll have to cough up the cash for two mortgages (your rental house and the home you live in). Strong cash reserves are the single biggest weapon you have against this risk.

#2: Add even more money to those cash reserves so that you can quickly write checks for repairs and maintenance. What if the house sits vacant for 4 months, a tenant moves in, and a week later you need to call a plumber? Cash reserves will help you sleep better at night.

#3: Don’t even think about making “extra” mortgage payments before you have huge cash reserves built.

I’d recommend a minimum cash reserve of 6 months of mortgage payments, and an optimal cash reserve of 8 to 10 months. That way, if you deal with an extended vacancy, you’ll be able to cover the mortgage.

Many landlords “shoot themselves in the foot” by panicking about a vacancy and renting out their home to the first willing tenant that comes along — even if their gut instinct says it might not be a good tenant. That always leads to disaster.

If you have cash reserves to deal with a vacancy, you can take your time and wait for the right tenant — a good tenant — instead of accepting the first person who’s willing to move in.

One of my houses has been vacant for almost three months. (It’s the $21,000 foreclosure, which is in a part of town that doesn’t always attract — um — the most qualified candidates). I’m guessing that the house might sit vacant for four or five months before I get someone in there.

But here’s the thing: Several people said they’re interested in moving in. But none of them have met my tenant criteria. It’s nice to be able to hold out and wait, so that you’ll eventually get the right tenant, not the first one.




How One House Throws $5,000 a Year at Me

Want to know how we generate $5,000 per month in passive income from a rental property? This post is all about rental House #3.

Remember when we bought House #3? It’s now rented! Let’s see if this deal is hot or not.

Excuse Me, Did You Say House #3?

As long-time Afford Anything readers know, Will and I bought our third rental property in May. It’s a 3-bed, 1.5-bath single-family home in a good school district in Atlanta. The asking price was $125,000, and we snagged it for $94,000.

This needed the fewest repairs of any of our houses. Here are the “before” pictures. As you can see, the scope of work was small. Knock out a wall or two; bust up some concrete steps; install a skylight. Voila – instant awesome!

Check out the “after” photos, below.

Rental Property - Nice Living Room

We’ve painted the walls, refinished the floors, and spruced up the entryway.

 

Rental Property - Kitchen Photo

The former owners remodeled the kitchen, so these new cabinets and countertop were included. Score!

 

Rental House - kitchen skylight

Remember that skylight we were installing in the kitchen? Here it is!

 

Rental Property - Kitchen

Here’s the dining area. It’s a little narrow, but it works.

 

Rental house - new paint and refinished floors

You’d be amazed at how a few plants can help with staging.

The total cost of the renovations came to $6,000, which means our “total purchase price” (purchase plus upfront repairs) was a solid $100,000.

It now rents for $1,295 per month. Passive cash, baby! Right away, we see that this passes the One Percent Rule with flying colors.

(The One Percent Rule states that the monthly rent should be at least one percent of the purchase price. Move the decimal point two spaces left. If the monthly rent isn’t at least that high, buy a different rental.)

But let’s dig down deeper. How do those numbers check out?

What’s the Cap Rate?

First, let’s find the “capitalization rate,” or cap rate. This measures the net return that the house provides, excluding your financing arrangement.

Why examine this? Because it shows you the strength/weakness of the deal itself, in a vacuum. Remember, ANYTHING can be cash-flow positive if you buy it with cash. That doesn’t mean it’s a good deal.

The “cap rate” helps you examine the quality of the underlying deal. Once you decide whether or not the investment is worth pursuing, you can calculate how different cash/financing scenarios will affect your passive income.

How do you find the cap rate? It’s easy: Just divide the house’s price by its net income.

Gross Income: $15,540 per year

Expenses:
Management – 10 percent of rent – $1,554/year
Taxes – $1,100/year (includes trash service)
General Repair/Maintenance Fund – 1 percent of purchase price – $940/year
Utilities – The tenant pays everything! That’s one huge benefit of renting out a single-family home, as opposed to a multi-unit building. (In contrast, we pay $300+ per month to cover the tenants’ water bills in our three-unit building.)
Yard Work – The tenant handles it!

Total Expenses: $3,594 per year

NET Income (Income after Expenses): $11,946 per year. Yeah baby!

Right off the bat, I can see that this is a sweet deal. I’m netting almost $12,000 a year for a $100,000 house. That’s roughly 12 percent.

Crunch the numbers, and the cap rate is $11,946/$100,000 = 0.1194, or 11.94 percent.

I don’t know about you, but I think a near-12 percent return is pretty stellar. It’s not as sweet as the 17.8 percent return I’m getting on House #2, but hey, you can’t strike gold every time. ☺

So How Much Cash Goes In Your Pocket Each Month?

Okay, now we know the cap rate. How much passive income are we collecting?

We have a private loan in which we’re making interest-only payments at 7 percent. (Hold your horses! I know this might create chaos in the comments section. I’ll explain why we choose this below.)

Let’s look again at the numbers.

Net Income: $11,946 per year
Financing Payments: $7,000 per year
CASH FLOW after debt service: $4,946 per year! Wahoo!!

We’re getting $5,000 in passive income each year from this house! That’s one huge step closer to financial freedom.

Why did we get the financing that we did? Look again at the numbers. Look carefully. How much money did we pay out-of-pocket for this investment?

Zero. Zip. Zilch. Nada.

Without spending a dime of our own money, we set up a deal in which we receive about $5,000 in passive income per year. That’s AFTER paying a property manager to do the actual work, plus setting aside a “rainy day” fund for long-term maintenance and repairs.

In other words, we borrowed at 7 percent and used the money to snag an investment that pays 12 percent. This practice is called “arbitrage,” which might be my favorite word in the English language. ☺

“Why get interest-only financing?”
It gives us the most flexibility. We’re earning $5,000 a year in passive income, with no money down.

We can choose – CHOOSE – to use that $5,000 to pay down the principal on the house. (There is no pre-payment penalty). We can use the money to buy another house. Heck, we can blow it on champagne and strippers, if we wanted. It’s our choice.

“What are you doing with that money?
First we’ll buy a few more rental units. Then we’ll start paying down the loans. In other words, we’re reinvesting the profits back into the business.

“Are you disciplined enough to re-invest that money?”
DUH!! If you’re not, get out of the game!

“Why not just borrow from a bank?”
I’d love to. But banks are sick of us.

“Are you worried that you’re over-leveraged?”
Nope. We use cash frequently, and we have kick-ass equity. We bought House #2 in cash. We paid for repairs on House #1, Unit B with cash. Relative to many real estate investors, we’re quite conservative.

“You allot $1,554 for paying a property manager. Why not manage it yourself?”
I do.

“Then why do you include a ‘management’ line-item?”
Because I pay myself for my time.

The management fee is active income I pay myself for the time I spend managing the property. It’s a radically different beast than the passive income I earn from the investment.

Rookie real estate investors conflate ‘paying themselves’ with ‘profit.’ You can’t pay yourself $0, pay someone else a a fair wage, and make an apples-to-apples comparison.

Every investment must allow me to make a profit after paying myself. That way, I can remove myself from the equation and the numbers will stay the same. Remember, the goal is financial freedom, not a lifetime job.

“Are you talking to yourself, in the form of italicized questions?”
Uh, yeah.

“In public? On a blog?”
Uh, yeah.

“You’re a dork.”
That’s not a question.

“You just proved my point.”
Whatever.




House #2 is Rented! How Good of a Deal Was It?

cap rateHouse #2 is officially rented! Last week I showed the house to a man who liked it so much, he grabbed his checkbook and handed me a deposit on the spot. I ran the necessary screening – credit check, criminal background – and he looks great.

He drives a brand-new Mercedes Benz, which costs twice as much as the house. :-)

So how good of a deal was this?

The total cost – purchase plus repairs – came to $30,000, and the monthly rent is $895 per month. The One Percent Rule says that a rental is a good deal if the gross monthly rent is 1 percent or more of the purchase price. In this case, the gross rent is 2.98 percent of the purchase price. Score!!

But Does It Cash Flow?

Most new investors – myself included – start with the question, “Does this house have a positive cash flow?”

The problem with that question is that if you buy a house in cash, ANYTHING will have a positive cash flow. You can’t decipher whether or not a house is a good investment based on that.

The better question is “What’s the house’s return on investment?” The common way to measure this is through a metric called the cap rate.

The cap rate shows you how long it will take you to recoup your costs. You figure this out by dividing the house’s price by the net cash flow.

In this case:

The Price: $30,000
Annual Gross Income = $10,740 ($895/mo * 12 months)

A quick glance at those numbers tells you that the gross income will pay off the cost of the house in less than 3 years. In other words, I’m getting a 35 percent gross return. That’s a good sign!

But I don’t care about “gross” return. I’m concerned about “net” income, which means income after expenses. So let’s look at the costs.

Yearly Costs:

Advertising = $150 per year (or per lease term)
Trash = $396 per year ($33/mo)
Insurance = $1,100 per year, approximate
Property Tax = $1,200/year, approximate
Management = $1,074 per year ($89.50/month, or 10 percent of gross rent).

Repairs and Maintenance = There are two competing rules of thumb here. One rule of thumb says that 50 percent of your rental income goes to maintenance/repairs/management.

I don’t think that rule applies here, for two reasons. One, rent and maintenance are “independent variables” – one can move without impacting the other. Secondly, I’ve heard from many investors that the50 Percent Rule tends to apply to apartment buildings, not single-family homes. (Apartment buildings have higher operating expenses, as they need to maintain common areas like the lobby, hallways, parking lot, facilities, etc.)

A different rule of thumb says that 1 percent of your purchase price will be the home’s annual maintenance cost. I’m suspicious of this rule, as well, because the purchase price and the maintenance costs are also “independent variables.” The purchase price fluctuates based on the economy, the neighborhood and the school district performance. The maintenance costs are based on how long your roof will last. These two are unrelated.

rental house cap rateBut I’m willing to play ball. During the peak of the housing bubble, this house sold for $98,000. Let’s take 1 percent of that, and assume the maintenance will cost $980 per year.

Yearly Costs = $4,900

Then add another 10 percent as a “safety margin” so that we have a conservative estimate.

Total Yearly Costs = $5,390

Now, subtract your Yearly Costs from your Gross Income, $10,740. This tells you the “net income,” which is your positive cash flow.

Cash Flow: $5,350 in passive income each year!! Wahoo!!

But wait! ANYTHING can have a positive cash flow if you buy it in cash. That doesn’t mean it’s a great investment.

So let’s take the final step and calculate the cap rate:

Cap Rate = Cash Flow / Price of House

Cap Rate = $5,350 / $30,000 = 0.178, which is a 17.8 percent return!!!!! Happy dance!!

A 17.8 percent return is absolutely solid. At this rate, it will take me 5.6 years (100 / 17.8) to recoup the initial investment.

FAQ’s

Let me answer a few questions that I imagine this post is going to pose:

Q #1: Ouch. This sounds like a lot of math.

A: Technically, that’s not a question. But I get what you mean. As I said recently, I’m terrible at math.

Fortunately, this is all middle-school math. It ain’t calculus. And while it looks daunting, a few minutes of number-crunching can save you from a terrible investing decision (or push you into a great one!!)

Q #2: Wait a sec, I thought you did your own property management. Why are you subtracting the property management costs?

A: Yep, I do. But I need to make a profit AFTER paying myself. I can’t value my own time at $0, value someone else’s time at more than $0, and make a fair comparison between the two.

I pay a property manager. In this case, I hired myself to do that job. That’s not part of my return-on-investment, that’s a second job that I took on. (In other words, $5,350 is passive income; the additional $1,074 in my pocket is active income).

Q #3: Aren’t you forgetting the cost of yard work? And water bills?

A: The renter is expected to mow his own lawn and pay his own water bill! Whew! That’s because this is a single-family home, not a multi-unit building.

Q #4: Are you rewarding yourself with a flight to Austin, Texas, now that you’ve found a renter? You said you would, when you put the house on the rental market.

A: Why, thanks for remembering! Yes, I am! I leave on Wednesday. :-)

Note from Paula: This post was updated on 10/18/2012 to reflect a less expensive property management fee. The original post (published 5/21/2012) reflected a property management rate of “one month’s rent per lease term, plus 10 percent ongoing. That’s $895 upfront plus $89.50 for the next 11 months, for a total of $1,879.50 per year.” However, after shopping around, I found reputable local property managers who will do the job for $1,074 per year (10 percent of gross rent). By lowering the overhead cost, I increased my return.



Our House Shot Up $100,000 in Value … And It Means Nothing

blog 133 copy

**Note from Paula: You’re probably going to wonder how this article’s introduction relates to the headline. Just stick with me for a minute.
is good news always good? maybe

An elderly farmer and his horse tilled the fields for many years. One day his old horse ran away.

The man’s neighbors came to offer sympathies. “How unfortunate,” they said. The man shrugged and replied, “Maybe.”

The next day, the old horse returned, bringing with him three strong wild stallions that could work the fields. Again, the neighbors came. “How lucky!” they cried. The man shrugged and replied, “Maybe.”

The following day, the man’s son was thrown off one of the stallions and shattered his leg. The neighbors came by. “How unfortunate,” they said. “Maybe,” the man replied.

One week later, the military instituted a draft. All young men had to fight on the front lines of a bloody war from which few returned home. But the son, whose leg was broken, was awarded a draft exemption. “How lucky!” the neighbors said. “Maybe,” the man replied.

***
The story above is a Taoist myth. Today I had an experience that reminded me of the tale.

We’ve been trying to borrow against our triplex to buy another rental property. About four months ago, our broker asked us to hire an appraiser. The appraiser’s job is to decide how much our property is worth.

We paid $400 to have an appraiser visit our home. He sent us a figure that was $25,000 more than we paid for the house one year ago. We celebrated. How fortunate … right?

Maybe.

The mortgage broker kept requesting “just one more document.” This stretched for weeks. Weeks turned into months. We diligently kept sending in “one last document” and watched as homes we wanted got snapped up in the meantime.

Two weeks ago our broker informed us that the never-ending string of “just-one-more-things” had lasted for so long that our appraisal is now more than 90 days old. This means it’s out-of-date. We’ll have to pay another $400 for a new appraisal.

Ugh. How irritating, right? …. Maybe.

The second appraiser came to our home last Sunday. We heard the results today: Our house is valued at $100,000 MORE than we paid for it one year ago — a 45 percent increase in value. WHAT????

How fortunate, right?

Maybe.

In the foreseeable future, this is good news. It means we have more access to capital to buy more rental houses. That’s good news, if everything goes according to plan (strong cash flow and good tenants!). Of course, this also exposes us to additional risk, so perhaps it’s bad news. Who knows?

Any “good news” or “bad news” may have far-away consequences we can’t predict. So I’m not celebrating my sudden $100,000 boost in home equity, which is an imaginary concept anyway. (Home value is theoretical except on the day you buy or sell.) And I won’t get too glum if the house later appraises for less than what we paid.

In theory, the house is worth whatever the appraiser says its worth.

In reality, the house is worth whatever the free market says its worth, and since I never plan on selling, that number will always remain a mystery.

In the meantime, all I can do is scratch my head, shrug my shoulders and say, “Let’s see.”

Thanks to Sylvester75117 for today’s photo.

A Tree Fell on Our House Last Night

The rain was picking up and the wind had kicked into a low, steady howl when my boyfriend came home with the bad news.

“Our homeowner’s insurance kicked us off their policy five days ago,” he said, “and didn’t even notify us.”

I looked up from the book I was reading and raised one eyebrow. At least, I tried to raise one eyebrow. I keep trying to imitate that incredulous, one-eyebrow-raised look, so perfectly done in movies. But both of my eyebrows shoot up, every time.

“They cancelled our coverage?” I asked. “How? Why?” Thunder boomed. It was louder than it had been a few minutes ago. The storm was coming closer.

“After covering our home for six months, they did a periodic review and decided we were a ‘commercial’ property rather than ‘residential’,” he said. “So they dropped us five days ago.”

We own a triplex — a three-unit building, filled with tenants. Perhaps that’s why they consider us ‘commercial.’

We plan on moving into the largest unit this fall, when the current tenant’s lease expires. Until then, we’re renting an apartment across the street.

“What’s annoying is that they didn’t notify me,” he continued. “If I hadn’t happened to call the insurance company today, I never would have known.”

“Why did you call?” I asked. Outside, the wind was howling louder. Rain, which minutes ago had been coming down as a normal spring shower, started pounding the pavement more fiercely.

“I wanted to ask about their auto insurance,” he said. “I wanted to see if I could get a cheaper plan through them. So I called my agent, and he had no idea our homeowner’s policy was cancelled, either. He pulled our file and then became really flustered. Said he’d have to talk to his supervisor and call me back.”

“When he called back,” my boyfriend continued, “he said they already cancelled our policy. Our agent seemed mad that they didn’t bother telling anyone — not even him, whose job is to know.”

“Hmmm.” I wasn’t too concerned. We’d just buy different coverage tomorrow. “Did we miss a payment?”

“No, we were on auto-pay. They withdrew money directly from our checking account every month. But here’s what’s interesting: they didn’t withdraw anything last month.”

“So they just — stopped taking our money? But they never notified us of the cancellation?”

“Yep.” Hail began pounding the siding. The cat scurried underneath the couch. Her pupils dilated as big as her eyes.

“Isn’t that like the movie Office Space — instead of quitting his job, the guy just stops coming to work? Isn’t that what the insurance company did to us — instead of notifying us that they cancelled our policy, they just stopped withdrawing from our account?”

“Yeah, it’s pretty lame,” my boyfriend agreed. The lights in the room flickered for a second. “I should file a complaint with the Georgia insurance commission.”

The lights flickered again, and he suddenly looked concerned.

“Paula? Unplug your computer,” he said quietly. The hail was pummeling the windows like kids throwing rocks.

I moved from the couch, walked to my room and unplugged my computer at precisely the moment the lights in my room blew out. A blinding flash of lighting next to the window illuminated the room.

My phone beeped with a text-message from my roommate: “Pulled over on the shoulder of 10th St. All traffic lights out.”

I wondered about our triplex across the street. It’s a 101-year-old Victorian home in the heart of downtown Atlanta, surrounded by century-old trees in a tight cluster of super-urban density. Springtime Georgia storms are always wrecking havoc in this neighborhood. Just a few weeks ago, a tree fell on a power line one block away, triggering a small fire and causing a 12-hour power outage. A week before that, a neighbor’s parked car was crushed by a falling tree.

My eyes had adjusted to the electricity being down. One small red emergency light kept our hallway illuminated. I could see the outdoors by the glow of the early-evening haze. I stood in my room, with all the lights down, watching the rain pound the parking lot behind my apartment.

Then Everything went Dark.

Suddenly everything went dark. Even darker than when the power failed, minutes ago.

“What’s going on?” I thought, and then I realized — a tree had just fallen onto our next-door neighbor’s house. The foliage from the branches pressed thick against my window.

“Honey?” I called out. “A tree just fell onto the neighbor’s house!”

“I see that,” he said. He was standing in the living room, staring out the window, which wasn’t obstructed by leaves. “It’s really messed up their roof. See that? Hope it’s not raining inside their house right now.”

We waited out the storm another half an hour until the rain finally started to subside and the flashes of lighting grew dim. I heaved a sigh of relief. No frantic calls from the tenants at our triplex across the street. We had made it. We were in the clear.

“Let’s go to dinner,” I said to my boyfriend.

It was at dinner that we got the text message:

“Kinda big tree fell in backyard. Didnt break anything but its blocking the apt. stairs and walkway.”

And a few minutes later, my phone buzzed again:

“Someone may have mentioned it already, but a large limb came down in the backyard during the storm … blocking the exit to my apt. Who removes those?”

Oh sh*t. As the French say, “merde.”

I looked at my boyfriend. He didn’t know what was happening, but he guessed it was bad from the look on my face. His face mirrored back a panic-stricken expression.

“Um, babe? We gotta go to our house. Now.”

The tree had crashed just inches from the outdoor stairwell …

The small branches and leaves were blocking access to the stairwell, barricading one of our tenants inside. But the heavy limb — the part of the tree that could actually split the stairwell in half — had missed the stairwell by inches. The heft had fallen onto the driveway.

Another tenant’s motorcycle was parked at the opposite end of the driveway. The heavy limb had missed it by inches.

Miraculously, there was no damage. The house was fine. The roof was fine. The stairwell was fine. It was as if God Himself had said, “How can I make this tree limb fall at exactly the perfect angle such that nothing gets hurt?”

And then God added, “Just for fun — or maybe to teach them a lesson about the importance of homeowner’s insurance — I’m going to make it happen just hours — HOURS!! — after they discover they don’t have coverage. But don’t worry, kids — I’ll spare your house from damage.”

Whew! What. A. Close. Call.

We spent the rest of the night chopping off branches with a sawzall, clearing the stairwell so our tenant could go to work in the morning. Today I’m heading to Home Depot to buy a chainsaw (yep, little 5’1″ South Asian girl wielding a chainsaw), while my boyfriend is going to sign up with whatever company will give him homeowner’s insurance — NOW.

“I’m getting insured with whoever will do it the fastest,” he told me. “Price be damned.”

And just to make sure we’re notified the next time our coverage is dropped, he’s mailing a $3,000 check to pay upfront for the next 12 months.

“If they drop us, they have to refund the unused portion,” he reasons, “and then we’ll actually KNOW that they’ve dropped us.”

Meanwhile, as I write this, a crew of about five guys are outside my apartment window, chopping down the tree that crashed into our neighbor’s house. I can hear them arguing about the best way to cut down the tree without further damaging the home or the fence by the limbs hitting the ground. We’re going to have that same argument later tonight, when my boyfriend gets off work and it’s our turn to chop down the heavy tree limb across the street.

The cat hasn’t left her hiding spot under the couch. Between last night’s hailstorm and today’s chainsaws, she thinks she’s in Armageddon.