The following guest post was submitted by Dr. Altelisha Taylor, a resident physician in Atlanta, GA who writes on personal finance and real estate on her blog Career Money Moves. We have no financial relationship.]
Contrary to popular belief, not all homes make good investments. An ideal real estate property will provide you with extra cash in your pocket each month or allow you to increase your net worth in a tax-efficient manner. Some homes have both of these benefits, but many homes have neither. You can evaluate where your starter home falls on this spectrum by asking yourself these 6 questions:
6 Questions for Evaluating Your Home as a Rental Property
1. Do the numbers make sense?
Cash on Cash Return
Before you list your home as a rental property you must “run the numbers.” The first calculation you should make is the “cash-on-cash return.” The cash-on-cash return helps you determine how much money you’ll make on the investment based on how much money you spent to buy the investment. In other words, it will help you see whether investing money into this starter-home-turned-investment-property is more lucrative or less lucrative than putting your money into something else like index mutual funds.
Monthly Cash Flow
The second thing you need to calculate is your monthly cash flow. Computing the monthly cash flow will help you see how much money this rental property will put in your pocket each month after you pay the mortgage and account for repairs and other taxes and fees. Some properties have a high cash-on-cash return and positive cash flow. Others do not. Run the numbers for yourself to see if your home provides an ideal cash on cash return (at least 10%) or enough monthly cash flow to make it worth your while.
2. Are you planning to make expensive aesthetic changes or upgrades?
Altelisha Taylor, MD, MPH
If you purchase a home and pay the mortgage each month, you will build “equity” or value in that home. However, the more money you spend on upgrades and costly aesthetics, the less equity you may keep. Don’t get me wrong, there are certain upgrades that may add value to a house, but oftentimes when we purchase things that are more aesthetically appealing, we do so for our own self-gratification.
As a result, many of the upgrades people make to their homes (modern cabinets, renovations to a basement, the addition of a pool, etc.) cost more money than they add in value to the home. Increasing expenses (through costly upgrades) without an identical increase in home value, decreases the overall profit you could gain from using the home as an investment property.
3. What is the housing market like in your area?
Before you purchase a starter home with the intention of using it as an investment property, look at local housing market trends. Have houses been going up in value or down in value?
Is it a sellers’ market, in which houses are being sold for more than they are worth? Or, is it a buyers’ market in which the supply of homes exceeds demand, so houses are being sold for less than they are worth?
Purchasing a home in a sellers’ market makes the home more likely to be a cash-flow negative investment property. Purchasing a home in a buyers’ market makes the home more likely to be a cash-flow positive investment property.
4.Will you be able to secure (and afford) two mortgages?
In an ideal world, you’d rent out your starter home to a reliable tenant and use that rent money to pay down the mortgage. You may even ask the bank for a second mortgage to purchase a larger home for yourself in the meantime.
Unfortunately, life doesn’t always go as planned. Asking the bank to loan you money for a second home when you haven’t paid off the first home and may also have a significant amount of student loan debt may be more challenging than you realize.
Plus, it may take a few months to find a reliable tenant and there’s a good chance this starter home will have an occasional vacancy between renters. Do you have enough money to cover costs during these transition periods? Can you afford to pay the mortgage on the starter home while you find a tenant AND pay the mortgage on the other home you live in? If the answer is no, then planning to maintain two houses may not be financially feasible.
5. Can you or someone you trust effectively manage the property?
Managing a rental property as someone’s landlord is no small feat. You have to be diligent about collecting the full rent on the due date. You also have to be available to receive and coordinate maintenance requests at inopportune times. Do you think you have the time, experience, or energy to do this yourself? If not, you may want to consider hiring a company to do it for you. Keep in mind that paying for a management company may significantly decrease your monthly cash flow.
6. Have you already maxed out less-cumbersome investments?
If you’ve never owned a rental property, let me be the first to let you know, it’s a lot of work. Securing responsible tenants who will make on-time payments requires more background work than you may realize. Spending hours negotiating the buying price and loan terms with real estate agents and loan officers can last a lot longer than you may have anticipated. Unless your return from this investment is significantly better than what you could get elsewhere, it may make more sense to max out other investments (like your employer retirement accounts and Roth accounts) first.
The decision to turn your starter home into a rental property should not be taken lightly. For some people, renting out their home may be a lucrative investment strategy. For other people, renting out their home may require more time and money than they can provide. Thoroughly evaluate whether turning your starter home into an investment property is the right decision for you.
What do you think? Did you turn the first home you owned into a rental? What did you learn? What advice do you have for doctors considering to do it? Comment below!
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We turned our starter home into a rental property. Out is a condo and I am responsible for HOA fees while the tenant pays the rent and everything else. Initially I was foolish and didn’t have a property manager but 20 days into this I found the need to have one and it was the best decision I made! I also plan to rent exclusively to incoming medical residents, preferably with family who can keep this home a home.
We did it for 16 years on our $102,500 starter home from 2003 to 2019. It rented for $1050 or $1100 a month. It sat fallow a few months (about one month for each tenant turnover). The debt service, non-homestead property tax, and insurance was about $900 a month. It later went up to $1000 a month after it was switched to a 15 year at 3.75%. Repairs and maintenance made it a ~ $1000 loser per year.
We showed no income for years and accumulated “passive activity losses” of $15,000. We managed it ourselves after the refinance as the 8% off the top was too much for the debt service.
At the worst of it (2009), it dropped in value to about $70,000 as property values tanked 40%. We could not get rid of it for a decade. Finally, after values came back up, and we paid $4000 for cleaning and damages, 6 months unpaid water bills, and we dumped it for $108,000 and cleared $24,000 after these expenses and closing costs.
I have no idea what happens to the passive activity losses. I assume that since it was depreciated that the government will want half of that money. The basis was about $125,000.
So, after nineteen years as a landlord, with only folks with crappy credit applying to rent it, it is finally just a bad memory and a conundrum for my accountant.
I’d like to go back in time and sell it for $125,000 in 2003, clear $5000 after closing costs and invest that $5000 in the stock market. Even with the stock debacle of 2009, I’d have made more money for doing nothing. Never again.
Heck, I make 9% a year for passive investing in REIT apps and own and maintain nothing.
Thanks for sharing your experience. This is precisely what has kept me away from owning a property. I am especially worried with the current buyer’s market that housing is overpriced and will adjust at some point.
Why did this property not work out? It seems like it met the common metric of renting at 1% of purchase price. I am foreign to real estate but am interested in the idea of owning a rental.
Sounds like the main reason is it never appreciated, which is a major source of return, especially on a leveraged property. All properties don’t appreciate.
What made you decide to keep the property as a rental in 2003?
If the house or condominium is worth significantly less when you bought it for, you will take a loss when you sell it that you cannot write off. As I understand it, if you converted to a rental property for two years and then sell it, that loss is now tax-deductible
That’s correct, although technically, you’re only supposed to take the loss that occurred while it was a rental property.
Purchase price: $102,500 in 1994. Basis after improvements across the decade we lived in it: $125,000
Rental from 2003-2019. Sold 2019. It was rented right up to the sale and still on higher non-homestead exempted taxes.
Sold $108,000. I paid several thousand of the buyers closing costs plus my own. Selling price $108,000.
After expenses and the $4000 cleanup, yard work, and unpaid water bills, I cleared about $24,000.
To me, we sold it for a loss: $125,000 – $108,000 is a $17,000 loss, but I think writing off depreciation for 16 years comes into play on the basis? Anyway, I’ll ask my accountant.
There are an additional $15,000 of passive activity carryover losses that we could never deduct because I make too much money. If your “modified adjusted gross income is $150,000 or more you usually can’t claim passive activity losses against other income.”
Nice review of how to think this through.
Too many are Pro-real estate or Anti-real estate. The truth requires some finesse and thought.
My wife and I never had a “starter house” or housing plan for that matter. When we moved in 2007 we were unable to get the price we wanted for our old house. We rented it out for a few years and then put it back on the market. The demand was better then and we were happy with our price. Since it had no mortgage, we were able to use all of those rent checks to help pay off the mortgage on our new house. In the end we had two houses and no mortgage. A tenant can help accelerate your wealth accumulation.
There are lot of of guys which are now leasing a property after proper evaluation and then renting it on AirBNB and such sites, and making good amount of money. What do you think about that?
I think the hotel business can be a really good one, but it’s a bit cyclical.
At any rate, there’s no doubt you can generate a lot more revenue from one property by AirBNBing it instead of monthly renting it, but there expenses are also higher, especially the time of the person doing the booking and the cleaning.
“The cash-on-cash return helps you determine how much money you’ll make on the investment based on how much money you spent to buy the investment.”
I’m not sure I agree with this statement for turning a starter-home into a rental. Shouldn’t the calculation for computing cash on cash return be based on the liquidated value of the asset (value – remaining mortgage – transaction costs) and not the initial procurement cost?
The initial procurement cost is probably irrelevant when choosing to rent or sell an already owned property. It’s the net proceeds of the (potential) sale which should be used for any analysis. Right?
I agree it can quickly become irrelevant, but that is how it is calculated.
When I was a fellow 8 years ago I mentioned to my attending I was considering renting out my condo in the city when we moved out the suburbs. My attending at the time responded, “That is the stupidest thing I have ever heard of. Everyone sells their condo and uses the funds to purchase their next home”. Well I started doing my research (around the time I started reading this site) and educated myself. Here where the numbers back in 2013 when we started looking for a home in the suburbs.
Condo original cost purchased in 2009 =$500,000 (built 2007, 2100sqft 3 bedroom, near medical facilities)
Down payment=$100,000
Remaining mortgage $375,000
Interest rate 3.875 30 year fixed
Monthly mortgage/interest $1900
Taxes $400 per month (would increase after loss of residency exemption.)
Condo expenses (water/insurance) $200 per month
Total minimum expenses $2500
I had realator give rental estimate 1 year prior to our planned time to purchase.
Estimated rent and they felt it would easily rent $2750 (2013)
Estimated sale price $640,000 (2013)
We also had funds for downpayment on our new home.
So I will leave this open for comments and questions and will let you know what happened. Without telling you the city I will say it is on the east coast.
What would you do? the stupidest thing ever?
Are you making a judgment of whether it was a good decision or not on the outcome? Because that’s probably not the best way to do it. The better way to do it is to consider ALL the possible outcomes and their likelihood and then make the decision.
At any rate, I would assume you made money given the real estate market the last 6 years.
Happy thanksgiving everyone. Post overnight shift, time to wake up and have some Turkey.
Nope, It was meant as more of an exercise for readers to run the numbers and decide what they would have done. I didn’t say if I kept the property or sold it.
I did run multiple scenarios and built spread sheets to assess all possible outcomes I could think of and your site helped me make an educated decision at the time.
Yes property values have increased but S&P 500 has gained over 10% per year over that time period. Since we lived in the unit for 5 years all the proceeds from the sale would have been tax free and directly available for investment.
Based on the numbers provided who would keep the property as a rental and who would sell and invest the capital?
I expect some will give an answer directly based on the numbers I provided and others would want more data.
I am just curious how people would approach the question with the data available at the time. What if those numbers were today’s? The eventual outcome is irrelevant it is really just the procees of how to actually approach and answer the question.
Should I have turned our starter home into a rental property?