Primary residence to investment property

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Primary residence to investment property

Postby mamarachel » Thu Jul 25, 2013 1:38 pm

Can you all help me evaluate the numbers on this property? Am I doing this right?

Purchase price net 143K (after seller assist). Bought with 5% down. Loan 139K, 4.25%, 30 years fixed. Risky but it was a builder foreclosure and about 15% below market value at time of purchase.

Expenses:

Loan (P&I): 687
Annual taxes: $2100, Insurance: $650
Total monthly PITI: $944

Market Rent: $1225

Monthly Operating Costs (we'd cover WSG):
Water: 15
Sewer: 35
Garbage: 20
HOA: $25 (includes all exterior landscaping and landscaping water - middle unit townhome)
Maintenance Fund (8% gross rent): $98
Updates Fund (8% gross rent): $98
Vacancy reserve: (8% gross rent): $98

Effective monthly cash flow: 1225-1333 = -$108

Monthly loan principal pay down at point of conversion $313.

Effective annual profit: 313+(-108)= 205*12 = $2,460

This is for year 1. Of course the spread gets better as the paydown proceeds and market rents inflate. It was new construction, but primarily builder's grade materials.

So while the effective cash flow is negative to our bank account after setting aside reserves initially, the net effect even in year one is positive profitability.

Annual income ~190K, 25% FIT (effective 30 after child credit phase out).


The alternative would be to sell this property and use proceeds to reduce mortgage on a new primary residence but even at a 5% fixed 30 year mortgage the increase in DP would only save us about $55 on our monthly PITI on the primary residence. We can definitely afford to float a negative cash flow (if any in "real" dollars) as our income to expense ratio is pretty high. We are maxing 401Ks. This would be for diversification purposes.

Any recommended reads if this is not enough information?
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Re: Primary residence to investment property

Postby SeattleCPA » Thu Jul 25, 2013 1:42 pm

mamarachel wrote:Can you all help me evaluate the numbers on this property? Am I doing this right?

Purchase price net 143K (after seller assist). Bought with 5% down. Loan 139K, 4.25%, 30 years fixed. Risky but it was a builder foreclosure and about 15% below market value at time of purchase.

Expenses:

Loan (P&I): 687
Annual taxes: $2100, Insurance: $650
Total monthly PITI: $944

Market Rent: $1225

Monthly Operating Costs (we'd cover WSG):
Water: 15
Sewer: 35
Garbage: 20
HOA: $25 (includes all exterior landscaping and landscaping water - middle unit townhome)
Maintenance Fund (8% gross rent): $98
Updates Fund (8% gross rent): $98
Vacancy reserve: (8% gross rent): $98

Effective monthly cash flow: 1225-1333 = -$108

Monthly loan principal pay down at point of conversion $313.

Effective annual profit: 313+(-108)= 205*12 = $2,460

This is for year 1. Of course the spread gets better as the paydown proceeds and market rents inflate. It was new construction, but primarily builder's grade materials.

So while the effective cash flow is negative to our bank account after setting aside reserves initially, the net effect even in year one is positive profitability.

Annual income ~190K, 25% FIT (effective 30 after child credit phase out).


The alternative would be to sell this property and use proceeds to reduce mortgage on a new primary residence but even at a 5% fixed 30 year mortgage the increase in DP would only save us about $55 on our monthly PITI on the primary residence. We can definitely afford to float a negative cash flow (if any in "real" dollars) as our income to expense ratio is pretty high. We are maxing 401Ks. This would be for diversification purposes.

Any recommended reads if this is not enough information?


You don't provide the value of the home, but if you could sell at a gain, you might want to make sure that you don't lose the opportunity to use the Sec. 121 exclusion.
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Re: Primary residence to investment property

Postby nimo956 » Thu Jul 25, 2013 1:48 pm

A lot of people on this site recommend looking at the cap rate for your property. This is the gross rents less non-financing expenses over the total purchase price (including closing costs).

Gross Rent = 1225 * 12 = 14,700
Non-financing Expenses = (389 * 12) + 2100 + 650 = 7,418
Purchase Price = 143,000

Cap Rate = (14700 - 7418) / 143000 = 5.1%

I'd say that's a fairly average/mediocre cap rate. I've seen people quote cap rates at 10%+, but those seem to be in more undesirable areas.
50% VTI / 50% VXUS
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Re: Primary residence to investment property

Postby mamarachel » Thu Jul 25, 2013 1:50 pm

SeattleCPA wrote:
You don't provide the value of the home, but if you could sell at a gain, you might want to make sure that you don't lose the opportunity to use the Sec. 121 exclusion.


We'd sell without renting it so there would be no need to consider the exclusion for residency. We live in it now. The only time to consider would be the future value of the property and the maximum I'd imagine this property would gain would be mid 5 figures. We could at that time consider a 1031. I'm not concerned about it today.
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Re: Primary residence to investment property

Postby mamarachel » Thu Jul 25, 2013 1:55 pm

nimo956 wrote:A lot of people on this site recommend looking at the cap rate for your property. This is the gross rents less non-financing expenses over the total purchase price (including closing costs).

Gross Rent = 1225 * 12 = 14,700
Non-financing Expenses = (389 * 12) + 2100 + 650 = 7,418
Purchase Price = 143,000

Cap Rate = (14700 - 7418) / 143000 = 5.1%

I'd say that's a fairly average/mediocre cap rate. I've seen people quote cap rates at 10%+, but those seem to be in more undesirable areas.


It's even lower than that isn't it because wouldn't T&I be considered a non-financing expense?
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Re: Primary residence to investment property

Postby SeattleCPA » Thu Jul 25, 2013 2:02 pm

mamarachel wrote:
SeattleCPA wrote:
You don't provide the value of the home, but if you could sell at a gain, you might want to make sure that you don't lose the opportunity to use the Sec. 121 exclusion.


We'd sell without renting it so there would be no need to consider the exclusion for residency. We live in it now. The only time to consider would be the future value of the property and the maximum I'd imagine this property would gain would be mid 5 figures. We could at that time consider a 1031. I'm not concerned about it today.


You may have missed my point. So let me elaborate. One of the biggest boo-boos new real estate investors make is turning a primary residence that they can sell at a tax-free profit (due to Sec. 121) into investment property where ultimately the sale may be taxed.

Sec. 121 if available is way better than Sec. 1031... and it's immediate.
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Re: Primary residence to investment property

Postby ResearchMed » Thu Jul 25, 2013 2:08 pm

You aren't including anything for repairs, and there's almost always something that needs fixing occasionally. And sometimes it can be costly.
It's less likely to be catastrophic (like a new roof) with relatively new construction, but there still *are* repairs needed sometimes.
Do you have reserve $$ set aside for this, or easily accessible?

Have you checked about insurance rates when it isn't your primary residence?

Are there any restrictions about rentals, in condo association or homeowners' association?

Also, it would be prudent to account for vacancies between rentals. In the best of circumstances, there would be time needed to clean and perhaps re-paint, etc.
In less good circumstances, it could take a while to find another renter.

And then there is the occasional "Tenant from H***", someone who simply doesn't pay, or does considerable damage (while paying or not).

All of these would affect your "cash flow", in this case increasing your out-of-pocket costs each month/year.

And since you don't have any positive cash flow at all, how would you cover these?

Have you ever been a landlord/lady before?

Rental property can be a good way to pay down a mortgage, or even generate a profit. However, you are starting out carrying a loss every month, which isn't typically wise, unless you have some reason to think that rental rates are rising (pretty quickly) in your neighborhood.
It can also be a major headache or even nightmare.

This might not be the best way to start.
(And we are generally "pro-rental properties", when chosen wisely. Not every "primary residence" makes a good rental at the time.)

RM
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Re: Primary residence to investment property

Postby nimo956 » Thu Jul 25, 2013 2:35 pm

mamarachel wrote:
nimo956 wrote:A lot of people on this site recommend looking at the cap rate for your property. This is the gross rents less non-financing expenses over the total purchase price (including closing costs).

Gross Rent = 1225 * 12 = 14,700
Non-financing Expenses = (389 * 12) + 2100 + 650 = 7,418
Purchase Price = 143,000

Cap Rate = (14700 - 7418) / 143000 = 5.1%

I'd say that's a fairly average/mediocre cap rate. I've seen people quote cap rates at 10%+, but those seem to be in more undesirable areas.


It's even lower than that isn't it because wouldn't T&I be considered a non-financing expense?


I included the annual taxes and insurance as part of the non-financing expenses (see bold):
Non-financing Expenses = (389 * 12) + 2100 + 650 = 7,418
50% VTI / 50% VXUS
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Re: Primary residence to investment property

Postby WhyNotUs » Fri Jul 26, 2013 11:26 am

mamarachel wrote:Can you all help me evaluate the numbers on this property? Am I doing this right?


I get slightly different numbers than you but your numbers are similar enough that it does not matter. You have a healthy maintenance and capital improvement reserve on a new building so that is all good. You are accounting for being vacant one month per year, good! Do the comparables you used to get $1225 include water, sewer, garbage? If the market will allow shifting those to tenant that you might be able to get to positive cash flow.

The cap rate and debt coverage ratio are not too exciting for a real estate investor but it sounds like you looking to repurpose existing property rather than scouting for investments. You have so little cash in this deal that your cash on cash will look good even if it is a small number.

Not many people would go looking for this deal, but you are using the right kind of numbers so you know what you are getting into.

BTW, if you are buying a new principal residence then make sure owning this property will not mess up getting that loan.
I own the next hot stock- VTSAX
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Re: Primary residence to investment property

Postby mamarachel » Fri Jul 26, 2013 2:07 pm

ResearchMed wrote:You aren't including anything for repairs, and there's almost always something that needs fixing occasionally. And sometimes it can be costly.
It's less likely to be catastrophic (like a new roof) with relatively new construction, but there still *are* repairs needed sometimes.
Do you have reserve $$ set aside for this, or easily accessible?

Have you checked about insurance rates when it isn't your primary residence?

Are there any restrictions about rentals, in condo association or homeowners' association?

Also, it would be prudent to account for vacancies between rentals. In the best of circumstances, there would be time needed to clean and perhaps re-paint, etc.
In less good circumstances, it could take a while to find another renter.

And then there is the occasional "Tenant from H***", someone who simply doesn't pay, or does considerable damage (while paying or not).

All of these would affect your "cash flow", in this case increasing your out-of-pocket costs each month/year.

And since you don't have any positive cash flow at all, how would you cover these?

Have you ever been a landlord/lady before?

Rental property can be a good way to pay down a mortgage, or even generate a profit. However, you are starting out carrying a loss every month, which isn't typically wise, unless you have some reason to think that rental rates are rising (pretty quickly) in your neighborhood.
It can also be a major headache or even nightmare.

This might not be the best way to start.
(And we are generally "pro-rental properties", when chosen wisely. Not every "primary residence" makes a good rental at the time.)

RM


I am accounting for an 8% vacancy (1 mo), 8% for regular maintenance items and rolling over in a fund for more major items, and 8% for "updates" which would include things like carpet / appliances, countertops in the cash flow monthly. The property cash reserve would be setup as follows (potentially in an LLC):

$1500 Legal
$1224.65 Vacancy (basic op costs montly)
$5000 Catastrophic

Total cash in the account for the property will thus be 8724.65, set aside in advance.

Yes, most properties in the neighborhood are rentals already (75%) with no rental restrictions.

Once I consider my tax impact and the fact that the mortgage principal payment far exceeds my initially negative cash flow it seems to make sense.
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Re: Primary residence to investment property

Postby mamarachel » Fri Jul 26, 2013 2:13 pm

WhyNotUs wrote:
mamarachel wrote:Can you all help me evaluate the numbers on this property? Am I doing this right?


I get slightly different numbers than you but your numbers are similar enough that it does not matter. You have a healthy maintenance and capital improvement reserve on a new building so that is all good. You are accounting for being vacant one month per year, good! Do the comparables you used to get $1225 include water, sewer, garbage? If the market will allow shifting those to tenant that you might be able to get to positive cash flow.

The cap rate and debt coverage ratio are not too exciting for a real estate investor but it sounds like you looking to repurpose existing property rather than scouting for investments. You have so little cash in this deal that your cash on cash will look good even if it is a small number.

Not many people would go looking for this deal, but you are using the right kind of numbers so you know what you are getting into.

BTW, if you are buying a new principal residence then make sure owning this property will not mess up getting that loan.


Comparables do not cover WSG and are at $1200 with quick turn-arounds (same day or same week occupancy). Just for ease of management, we'd prefer to charge a bit more and cover these expenses because unpaid water, sewer bills are the responsibility ultimately of the property owner (via lien), and the last thing I would want is a tenant hording trash in the garage.

We will be at 30% down on the principal residence, and this potential rental property has an LTV of 75% now, I don't see any impact on obtaining a loan for the principal residence. I think putting it in an LLC helps that even further, but that's just what I've heard. If it did impact that, we'd just sell it anyway.

Insurance has been quoted for a rental situation, and it includes a $1M liability umbrella as well.

My excitement actually comes at the 5-year mark, when the principal pay-down is more accelerated. In reality, my "cash" into this deal is very low because I don't consider the time we occupy the space as an investment. Our mortgage is below market rent. Our alternative would have been to be renting this entire time.
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Re: Primary residence to investment property

Postby Saving$ » Fri Jul 26, 2013 4:51 pm

mamarachel wrote:Comparables do not cover WSG and are at $1200 with quick turn-arounds (same day or same week occupancy). Just for ease of management, we'd prefer to charge a bit more and cover these expenses because unpaid water, sewer bills are the responsibility ultimately of the property owner (via lien), and the last thing I would want is a tenant hording trash in the garage.


Your concern and solution make logical sense, but you will soon learn that many tenants are not logical. If you are over market, you need potential tenants to actually read your ad to understand why, and understand that you are actually under market once you factor in the WSG they would be required to pay in other rentals. Tough sell.

If you get past that, you have a tenant with no skin in the game for WSG usage. All their friends will be at your place doing their laundry, etc. Your usage will go way up.

You can try to say WSG remain in your name and tenant reimburses you, but that is a pain. You can try to say WSG included in rent based on a usage "allowance." You need to be careful how you word this because in most municipalities it is illegal to "resell" usage. So you create a large allowance and a fine if they go over. That sort of works. You are best off getting friendly with the clerk at the city and just checking every few months to make sure tenant has paid the bill, and/or requiring copy of bill from tenant every 6 months so you can see they are caught up.

You have identified a risk of being a landlord in your early assessment of this deal, and there are many more risks. There are few easy answers; that is why not everyone does it.

If you want to be a LL, you need to be willing to give up a good bit of your time, you need to be willing to learn how to fix things (plumbing, minor electrical, locks, etc.). You must also be able to be firm, not fall for a sob story, etc.

Also, you MUST include Seattle's CPA's issue in your math. So if you sell right now, and for example net $20k over your basis, that is going to be tax free. Let's assume the property never gains another cent, but you decide to sell in 6 years. You have lost section 121 deduction, so you owe taxes on the $20k gain. Figure out how many years of profit that will eat up; that is how many years until you are even tax wise. You will never get that opportunity back.

Another factor in your math, if you are younger, should be recapture taxes. You will get an annual write off on depreciation at your marginal tax rate that will make even your negative cash flow positive. But if you later decide to sell, you must pay recapture taxes, and those will be at your marginal tax rate at the time you sell. If your rate has increased, this is not mere cost deferment, but an actual out of pocket cost. Make sure your math accounts for that.
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Re: Primary residence to investment property

Postby mamarachel » Fri Jul 26, 2013 5:59 pm

Saving$ wrote:
mamarachel wrote:Comparables do not cover WSG and are at $1200 with quick turn-arounds (same day or same week occupancy). Just for ease of management, we'd prefer to charge a bit more and cover these expenses because unpaid water, sewer bills are the responsibility ultimately of the property owner (via lien), and the last thing I would want is a tenant hording trash in the garage.


Your concern and solution make logical sense, but you will soon learn that many tenants are not logical. If you are over market, you need potential tenants to actually read your ad to understand why, and understand that you are actually under market once you factor in the WSG they would be required to pay in other rentals. Tough sell.

If you get past that, you have a tenant with no skin in the game for WSG usage. All their friends will be at your place doing their laundry, etc. Your usage will go way up.

You can try to say WSG remain in your name and tenant reimburses you, but that is a pain. You can try to say WSG included in rent based on a usage "allowance." You need to be careful how you word this because in most municipalities it is illegal to "resell" usage. So you create a large allowance and a fine if they go over. That sort of works. You are best off getting friendly with the clerk at the city and just checking every few months to make sure tenant has paid the bill, and/or requiring copy of bill from tenant every 6 months so you can see they are caught up.

You have identified a risk of being a landlord in your early assessment of this deal, and there are many more risks. There are few easy answers; that is why not everyone does it.

If you want to be a LL, you need to be willing to give up a good bit of your time, you need to be willing to learn how to fix things (plumbing, minor electrical, locks, etc.). You must also be able to be firm, not fall for a sob story, etc.

Also, you MUST include Seattle's CPA's issue in your math. So if you sell right now, and for example net $20k over your basis, that is going to be tax free. Let's assume the property never gains another cent, but you decide to sell in 6 years. You have lost section 121 deduction, so you owe taxes on the $20k gain. Figure out how many years of profit that will eat up; that is how many years until you are even tax wise. You will never get that opportunity back.

Another factor in your math, if you are younger, should be recapture taxes. You will get an annual write off on depreciation at your marginal tax rate that will make even your negative cash flow positive. But if you later decide to sell, you must pay recapture taxes, and those will be at your marginal tax rate at the time you sell. If your rate has increased, this is not mere cost deferment, but an actual out of pocket cost. Make sure your math accounts for that.


All great points, thank you. I obviously need to sit with a CPA.
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Re: Primary residence to investment property

Postby Twins Fan » Fri Jul 26, 2013 7:15 pm

As someone that got stuck as a landlord who turned my old primary residence into a rental, I will share some experiences whatever they may be worth. The I "got stuck" rundown... divorce, moved out of state to be close to my kids, couldn't sell because home was underwater compared to what I owed, yada yada.

Mine is a single family home in Colorado.

At first (3 years ago), the rental amount I took in was about $400/mo. less than the mortgage payment (PITI total). Ouch!! Although it was a nice (as could be) write off/loss at tax time. But, I could float the difference, Colorado is a recourse state, so couldn't walk away, didn't really want to anyway as that isn't me, and I couldn't get it refinanced. For most of the last few years, I was hoping ot get rid of it ASAP. But, this year I was able to refinance it and the rental income now covers the mortgage payment.

I use a property management company to run the show on mine. Have you looked into that? As I said, I am now out of state from my rental, so it's really the only option for me. But, I am very happy with my property management company. They do a very good job, run the show, and I have no issue with them taking 10% of the rent since they do such a good job. An option to look into...

The resident pays the water, sewer, and garbage in CO all under their name too. It's a rule or law or something. I'm not sure, just what the property management folks told me and I said, sounds good. So, that may be different everywhere? And, yours is a condo/townhome deal, so that may make it different also?

You said yours is newer construction... Mine was built in 1999, so somewhat new. In three years, I've had maybe $400 in maintenence costs. I had to replace the screen door (which was pretty chewed up when I moved out anyway), pay for a outlet/electrical repair, and a shower faucet repair. Does that mean I will never have any big repair bills? No, but as you can see, my repair costs for the past 3 years have been pretty minimal.

Part of the lease (prop mgmt again) says the tenants will have the carpets cleaned at their expense before they move out, and there's the deposit (one months rent) there to take care of any minor damages if needed.

In 3 years, I have only had one month where I had no tenants. Mine is in a good location just South of a smaller Air Force base, so that helps (constant flow of renters). And, the property management company comes into play there, as they do all the advertising and finding renters. Then they just clear it with me before anything is finalized.

I believe the recapture of depreciation tax later on is a flat 25%, not based on marginal rates. Look that up to be sure though. I have before, but it was a while ago and I'm not exactly sure there.

Anyway, I went from wanting to get rid of my rental property ASAP to now thinking I will probably keep it since things are looking up. Is it an ideal situation for me? No, and I have never done any of the math on it since I moved out, and probably don't want to. But, the property/home value has gone up now, rents in the area have gone up, and I think eventually it will be profitable for me. So, I think I will stick it out.

One thing brought up that you may want to give some serious thought to, is the capital gains exclusion on selling your primary residence. If you are able to sell and profit now, you can do so without paying any taxes on the gains. That goes away pretty quick once you have not lived there for 2 or 3 of the previous 5 years. One of those (2/5, 3/5), I don't remember which it is right now.
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Re: Primary residence to investment property

Postby donall » Fri Jul 26, 2013 8:24 pm

Property taxes often increase when renting (Non owner occupied) along with insurance. Another person indicated depreciation of the building, which is value of the building divided over 27.5 years. From what I know one has to take the depreciation. Capital improvements (new kitchen appliance, etc.) are also depreciated (various years depending on improvement). Depreciation is recaptured when selling. Is your income low enough to even use the benefits of a negative cash flow?

Not sure why one would take a personal residence ($250K/person exclusion) and turn it into a taxable asset paying capital gains on the recaptured depreciation. Usually it is done the other way.

I think that the metrics in no way make up for the possibility of having the tenant from hell.
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