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.
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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!
Great article. I wish that this information was more readily available to the mainstream readers. Thanks for the doing the legwork and making it easy for us!
I appreciate you taking the time to work out a CAP rate and Leveraged Cash on Cash Return, I think it is equally as important to talk about the savings/losses of owning the home during residency. If the area the resident is considering purchasing in has much higher rents than their mortgage would be, that certainly should be factored into the decision. Even if the property is a home that would have a meager CAP rate in 3-7 years, if the resident would save a couple hundred dollars a month owning versus renting, that should be taken into account as well. Finally, there is the time value of money – $100/month cash flow means a lot more to a resident than it will when there salary increases 300-1000%. These are all things to think about when deciding to rent or buy during residency – although I do submit that these things have little to do with the actual performance of the home as a rental property.
Many of my resident customers decide to keep their first home as an investment property. They often rent it out to new fellow students starting their residency at the same hospital. Looking at the CAP Rate is a great first step to calculating your return on the house. There are others that find it more advantageous to sell the property so they have a greater down payment on the next purchase.
The time where we see former residents keeping their residency home most often is when they are upside down on their mortgage. The hope is that the value of the home will come back up and in the meantime, they will minimize their carrying costs by charging rent.
There is a nice bi-product of this strategy that comes into play. Typically, any improvements made on the home and any losses resulting from the sale of a primary residence are not tax deductible. But the owner of a rental property can deduct the loss once the property is sold.
There are some critical rules to follow regarding timing to determine how much of your loss can be deducted but for any graduating/graduated resident facing a large loss on their home might do well to factor in the value of being able to realize a tax loss by converting the property to a rental. If the market improves, they’re better off, and if the market doesn’t they still might be better off by having a large tax loss.
Of course this isn’t a recommendation but something worth factoring into the big picture and relevant to the rental property discussion above.
That’s a great point. I expect a loss from my rental property if I sell it any time soon. I might get what I paid for it, or close to it, but not after commissions and not when I include the cost of improvements.
This thread is 2 years old so hopefully you see this. Would you ever recommend refinancing from a 15 yr to a 30 yr mortgage to make an real estate rental have a better cash flow? I have a home worth 200-210k, has about 150k left on the mortgage @ 3.375% (15-year mortgage with about 11 years to go). We will likely be in this home for another few years and may not need the equity in this home to put towards a new home, so am considering whether we should hold onto it as a rental. However the higher mortgage payment from the shorter term means I almost certainly would have a neg cash flow monthly as I could probably only get 1200-1300/month max for this property.
If your goal is more cash flow, that should work. You can also put down lots of money and refinance into a 15 year and achieve that goal. Or you can pay the whole thing off- that makes for particularly good cash flow.
In my experience, a home you bought to live in probably isn’t the world’s greatest investment, especially if you move out of town. Is there a reason you don’t want to sell it?