How to Start Your Rental Property Empire for Under $5,000
What Not to Do...
Let’s take it back to 2010...the housing market had just collapsed, Justin Bieber and Selena Gomez’s relationship was in full bloom and I bought my first home! What a time to be alive.
Prices had dropped significantly in the area and the first time buyer tax credit gave me 7500 reasons to purchase instead of rent. The market was certainly not in a recovery but my 22-year-old mind told me that things just had to turn around quickly! I was wrong.
Prices continued to fall in the area and when my wife and I decided to move four short years later, we realized we would be writing a check at the closing table to get out of our home. Since we did not want to pay more to get out of our home, we decided to rent it out at a break-even rent.
We still own that home today, still break even and would still need to bring our checkbooks to the closing table if we decided to sell. The problem with renting a single family home is that the profit margins are usually tighter than you’ll find on multi-family properties. Unless you purchased at a huge discount, you will probably be making a very minimal profit at best.
Gross, right? Not exactly the American dream of making it big in real estate.
The worst part is, I wasn’t too far off. If only I had known about the power of combining the FHA loan with a multifamily property, I’d almost certainly find myself looking back more fondly at that first home purchase.
House Hacking 101
I am a total investment concept dork. The way some people’s eyes light up hearing about a meticulously crafted whiskey or a finely brewed IPA is the way I look when chatting about modern portfolio theory or dollar cost averaging...although I do enjoy a good whiskey as well.
I first came across house hacking in The Book on Rental Property Investing by Brandon Turner. I immediately saw how powerful it could be and the best part of all is how accessible and simple it is to pull off. In the Cleveland market, for $5,000 or less out of pocket, a homeowner could use house hacking to cover their housing expenses and earn a solid income all from just making a good decision on their purchase. Sound too good to be true?
To start, let’s chat a little bit about the FHA down payment assistance program. I find the biggest hurdle for potential homeowners is often the cash required to get a mortgage. Many lenders require 20% down to fit into their conventional mortgage products and this is a huge hurdle for many first time buyers. To help these people get into a home, the Fair Housing Administration offers a down payment as low as 3.5% to get a loan. There are other caveats to these loans, which we will touch on in a future post, but the FHA loan can be a great option for many buyers.
Now that we have our option to get into a home for a low down payment, which homes should we be looking at? When most people envision owning their first home, they picture a single family home. While a single family property offers a lot in terms of privacy and inventory options, it is very limiting when it comes time to transition out of that home.
It’s always good to have options when you are not planning to be in a home long-term and it can be a risky proposition to put your hopes on home value appreciation. Wouldn’t it be nice to purchase a home knowing that if you move out, you will be cash flowing immediately? This puts you in the driver’s seat where option one is renting out the home and if values happen to increase between the time you purchase and the time you move out, you also have the option of selling. Multiple exit strategies is always a good thing on an investment and house hacking sets you up for success by making the rental option a much more profitable venture.
You may be saying, this sounds great but can’t I only purchase a single family home with the FHA loan? Actually, the nice folks at the fair housing administration allow for a property with up to four units to be purchased using their FHA loan program. With house hacking, the more units you purchase, generally the better returns you will see on your margins. In terms of cash flow: Duplexes are better than single families. Tri plexes are better than duplexes. Four unit properties are the grand daddy of them all! While a house hack works great with any of these property types, tri and quad plexes are the ones that really make the magic happen.
Real Life Example:
Let’s look at a real example that I came across on today’s MLS listings:
City: Cleveland Heights
List Price: $139,000
Property Type: Tri-plex
Rent #1: $900
Rent #2: $884
Rent #3: Unoccupied
This home has three floors, with the first two floors being rented for a total of $1784 per month and the third floor is currently vacant. This home would be a great example of how to maximize the potential of house hacking.
Let’s run through the numbers assuming you purchase this home, keep the first two floors rented and choose to live in the third-floor unit:
You put in an offer at $130,000 with the owner paying $4000 towards closing costs to really minimize that out of pocket cash necessary to close. The owner bounces back at full asking with the $4,000 being given to you for closing costs and you accept.
Assuming you go with the minimum down payment of 3.5% with the FHA program, a down payment of $4,865 will be required to close on this home. If the closing costs end up at or under $4,000, that would be the only cash necessary at closing.
The total mortgage amount will be $134,135. An online mortgage calculator estimates the mortgage amount on this property at a 4.0% APR to be $640/month. The $3,000 tax bill will add
$250/month and let’s assume insurance on an older tri-plex like this runs $100/month. The total monthly investment towards this property will be $990/month. With rents currently coming in at $1784, you could be living in this home for free and make a profit of $794/month!
Life After the House Hack
I’m sure some people reading this are saying, “So I finally buy a home and now I’m stuck with living in a third-floor apartment for the next decade? No thanks!”
The wonderful thing about house hacking is the FHA program only requires a buyer to live in the home for one year after purchase. You then have two options: 1) Take the cash that you’ve saved from profiting on your new rental property and put it towards your new purchase’s down payment, or 2) Refinance your tri-plex into a conventional mortgage and finance your next purchase with another FHA loan.
We can get more into option 2 in a future post; however, this strategy works best for properties that need some TLC and can have their value improved by repairs. Regardless, there are plenty of options for a house hacker to transition into a single family property or even rinse and repeat into another multi-family.
Don’t forget when you move out of your property you will now be able to collect another rent check from the unit you previously occupied. In the example above, since it is a third-floor apartment, let’s say the market rent would be around $400/month. You are now profiting nearly $1200/month to put towards your new mortgage!
Hopefully, this post helped you realize the potential power of house hacking. It’s definitely one of my favorite financial concepts due to the ease of access and huge potential for residual income.
If you’d like to look into house hacking options in your area, give me a call at 216.309.0567 or email me at firstname.lastname@example.org.