EDIT: Alrighty, I’m wrong about depreciation. Depreciation is still a thing, still affects your personal income taxes, but I’m heading right back to google to correct my own information. Guys, I wrote this whole thing off the top of my head based on what I have personally learned, and I sincerely apologize, I don’t mean to be handing out bad advice. Looks like I personally need to learn a whole bunch more about how depreciation recapture works.
EDIT 2: The VA and FHA loans can be good options. However, YOU need to shop all of your options. Do not just assume that the VA is the best way to go. If it is the best option for you, go for it. If not, go with other financing.
Edit 3: I’m pretty risk averse when it comes to over-leveraging. I’m never going to suggest that someone buy a house with nothing down, especially not while in the military and subject to a short notice relocation. If you do your own research and choose to buy with nothing down, that’s on you. I’m still not comfortable with it.
Alright… wall of text coming in. Take what you can and leave what’s not useful. Everything written here is what I’ve personally learned. I’m not a realtor or a professional property manager, but have been a landlord for 6+ years and have learned a lot. Most of those lessons learned had huge price tags on them, too. I purchased my first home in 2011, our second in 2014, and our third just last year. The first two are rented out. Not everything will apply to you, but here’s what I’ve learned along the way. Topics are written in the order that I thought of them, my apologies if it’s not 100% cohesive. As of right now, I have awesome tenants in both properties, but that hasn’t always been the case. My approach to real estate is to 1, protect my own investment and 2, to provide a good home to my tenants. I’ve made some more generous financial decisions to both of those extents, and while those decisions cut into my profits a bit, I have no regrets.
Purchasing your first home
Should I rent or purchase?
Don’t over buy on your first purchase.
I say again, don’t over buy.
If the market is white hot, it’s going to cool off. And you don’t want to be holding the chips when that happens. You really don’t have the time to sit on the house and let it recover, unless you’ve got money somewhere you’re not talking about. 2008 took about 10 years to fully recover from and to gain back the lost appreciation (most markets, at least) and you don’t have 10 years. If you do a zero down VA loan and roll the closing costs into the loan, it takes, on average, the first 18 months just to pay off the closing costs. Takes about 3 more years to get down to a break-even point with seller’s closing costs included, and about 5 years before you’ll make money. Yes, it seems like a lot of BAH to be “throwing away”, but look at the actual makeup of a newly amortized mortgage – most of your payment is going towards things other than principle.
If you bring a down payment to the table, you’ve mitigated that part of your risk, but you’re still exposed to lose money at the sale of the house. You’ve still got your purchase closing costs, which, on a $190k house are probably between $6000 and $9000, depending on your financing. Most of that is money that just evaporates.
If you can rent for LESS than the interest/insurance/taxes part of the payment and just dump the principal part into savings/mutual funds/TSP/IRA, you’ll come out ahead. Granted, that normally means renting a smaller apartment instead of living in a nice house, but it’s the sacrifice we make to be financially responsible.
Money in real estate is made 3 ways:
1, getting a good deal on the purchase.
2, holding the property for forever and getting the appreciation.
3, renting it out and making a profit off of someone else.
Normally, you want a good mix of all 3. The first takes PATIENCE when you’re looking to purchase, and from what you’ve told me, a good deal just isn’t available to purchase in Vegas right now. Strike one. Are you going to live in it long enough to ride out the bubble you see and make money when you sell? Meh, maybe not. Strike two. Do you want to landlord? If you’ve thought about it, scroll up and re-read again. If you’re still on board, then its a consideration
Renting is buying patience. Seems like in your area, patience is what you need. There’s always a house to buy in the future.
Rents do rise and fall, but they don’t rise and fall nearly as fast as real estate does in a white-hot market. Hence the 1% per month rental price as an approximation. If there’s a $200,000 house that’s renting for $1500 a month, and the house next door sells for $220,000, the first house likely went up 10% in value. However, your landlord isn’t going to jack your rent 10% in the middle of the lease just because Zillow thinks his house is now worth what the one next door sold for. If you rent, you’re protected from the competitive spikes in purchasing, and are more exposed to the long-term appreciation of pricing. Your landlord’s costs of ownership are fixed (unless he’s on an interest only loan, and then he’s stupid), so he can offer you rent at a fixed or gradually increasing rate. He’s not trying to compete with other buyers to purchase a first home like you are.
VA Loan
The VA loan… not my favorite topic. First off, you’re almost always better off going with conventional financing if you’ve got a down payment, and no one should ever purchase a home if they don’t have one. The VA loan brags about not having PMI, but the funding fee is essentially pre-paid PMI. On a conventional loan, you can request that PMI be removed once you hit 78% LTV, but there’s no option to un-do the prepayment of the funding fee.
The first time the VA loan is used, the funding fee is 2.15% of the loan. After that, it’s 3.3% of the loan unless the borrower brings 5% down. (www.veteransunited.com/education/library/va-funding-fee/)
The max amount of loan that the VA will insure is $453,000. You can have more than one VA loan at a time, but the two can NOT total more than that amount. With the median home price today, you’re likely going to be going with conventional financing on the next house, anyway. The other option is to refinance the soon to be rental with conventional financing and re-use the VA entitlement on the new purchase, but again, I tend to shy away from VA loans all together.
When I purchased my last home, my loan officer just assumed that I’d go with VA financing. I asked her to pull a quote for conventional and give me the break-even point. She didn’t want to, but I made her do it anyway. She was shocked that, wow, I was right about my financing options. Not to brag, but she’s used to checking boxes on paperwork, while I’m used to scrimping to make that precious SSgt pay last as far as possible.
I’m buying near a military base, it’s a good market, right?
Ah, but buying close to base is BAD for appreciation. Because of the high turnover of military personal, there’s always someone trying to sell their house. Always a lot of people, actually. This leads to high inventory and low demand. When there’s high inventory, people start dropping prices to sell faster. You’ve seen the opposite right now in Vegas – low inventory and high demand cause a price spike. Same math, different side of the equation.
With values depressed because of high inventory, sellers in a heavily military area will likely sell for their break-even point. If sales prices don’t go up, neither does value. Neither does rents, and so BAH remains flat. BAH remains flat, and the next guy can’t afford to buy your house for any more than you bought it for. It’s a vicious cycle and it’s common near bases. In this equation, the only people making any money are the real estate agents who have an unlimited supply of customers.
The plus side is that you can usually get a lot of house for the money near a base. The only real way to break that cycle is to have an outside economic influence bleeding off the extra inventory. This happens when a small(ish) base is located in an area with other good paying jobs. If the only places to work in a 20 minute radius are the base and retail, tread carefully.
Working with a realtor
Realtors are real estate professionals, and I always recommend a first time buyer work with a good agent. However, keep in mind that the realtor has a vested interest in you purchasing just as much home as you can. Same thing with the bank, they WANT you to borrow as much as they can reasonably let you have. Most people will make a decision about choosing a realtor based on personality and how well they “jive” with the person, but that’s the wrong answer. You want someone who no-kidding knows the local market and who can educate you.
It’s like working with a military recruiter. It’s their JOB to put you in the military and that’s the direction they’re going to steer you. And of course the recruiter is gonna tell you all the awesome things about the military – they’ve reenlisted and stuck around a while. Doesn’t mean it’s for every applicant, and it’s still the applicant’s job to do their own research. Same thing with the realtor.
Anyone can show you homes and point out how awesome a kitchen is. Anyone can give you a listing from the MLS. That’s not what you want. You need someone who can no kidding educate you and be your advocate.
Now you’re faced with the decision to sell or rent after your PCS. Here’s some thoughts:
Selling expenses
Look at your HUD/Closing statement from when you purchased the house, but look at the seller’s side of the page. Assuming you sell the house for a similar amount as you purchased (within 10% or so), you can assume that selling closing costs will also be within about 10% of those listed on the closing statement. Normally, you can assume that 10-15% of the value of the sale will be eaten up in closing costs and realtor fees. This could vary based on the terms of your sales contract, but most buyers push the seller to pay as much as possible. So, if your home is worth $200,000, you can expect to take home $170,000 – $180,000 after closing costs. If you owe more than that, then YOU will have to write a check to the bank for the difference at closing. It you owed $185,000 on the $200,000 home, and your net was $180,000, then you pay the bank the extra $5000 to close. Decide if it’s worth it to “feed” the home (more details later) month to month as a rental or if it’s better to take the lump sum hit now. If you rolled your purchase closing costs into the loan, did a zero-down VA, or have not owned the home very long, look at the numbers closely. The home may have appreciated enough to cover everything, it may not have.
Fair rental value
Industry standard is 1% of the property’s value each month as rent. This should (should) give you a pre-expense rate of return of 12% on your money before appreciation. However, that estimate is not accurate in every market. Work with your realtor or property manager to figure out a good price point to start at. I started a little bit high, then negotiated down to my bottom line. Price too high and you won’t attract a tenant. Price too low and you’ll attract the wrong kind of tenant. Factor in your own expenses, but if your expenses are high, you may have to “feed” the property (more on that later). Find out what houses near you are currently renting for, and get a good guestimate for what you could get for your home. Factor in any perks – like if the washer/dryer are included, if there’s a pool, if you allow pets, etc.
1% monthly works, sorta. In a high-rental but low-ownership neighborhood, rents may be more like 1.5% of the sale-able value. In a high value neighborhood, you’re likely not going to get quite 1% as anyone who can afford $5000 a month rent on a half million dollar home will just buy the thing themselves.
Rental expenses
Here’s what you need to factor in when estimating your monthly expenses: Mortgage payment Property tax increase (more below) Landlord’s insurance (more below) Vacancies Turnover cost Repairs HOA fees Extras like lawn care or pool maintenance
Vacancies
Industry standard is 8-10% time vacant, or about one month a year. Factor this into the price of your rent to maintain year-round profitability. You may have a year with 20% vacancy, and then your next tenant stays for 4 years. No telling what will happen. 1 vacant month each year is a generic estimate.
Turnover cost
Regardless of how awesome your tenants are, there’s going to be standard wear and tear on your property. Each turnover will require a deep clean New carpet and new paint will be required every 3-5 years, more often with kids/pets/smokers. If you’re not physically able to do this work, you’ll be paying out-of-pocket for a contractor to do this work, and it adds up fast (mine was $40 an hour). The longer this work takes, the longer your property is empty, and it’s hard to show a house that’s not in good condition. Some of the more egregious turnover problems can be taken out of the security deposit, but that could also be contested by the departing tenant.
Utilities during turnover
The property owner is responsible for turning on the utilities while the home is vacant. It’s very difficult to do turnover repairs without water or electricity, and almost impossible to show a home without electricity. Usually a phone call to the local utility company to re-open the utilities in your name is all it takes, but the utility company may require you leave a deposit with them. This is something your property manager can take care of for you if you’re no longer in the local area. Factor this into your cost of turnover.
Repairs
Industry standard is about 10% of the rent set aside for repairs – this number combines turnover repairs AND the day-to-day issues. This could vary widely, based on the condition of the home, price of the rent, standard of tenant, etc. The more expensive rent price attracts a more financially responsible tenant, who will either take better care of the home or be pickier about you repairing every little thing. Finding a responsible tenant who treats the property well and who does the little things themselves (I had a tenant who thought I owed him lightbulbs) will go a long way.
Listing fees
The typical realtor who’s listing your property for rent will take half the first month’s rent as the listing fee. Half of that remains with the listing agent, and half goes to the tenant’s agent. Factor this into your price of rent. Half the first month’s rent, paid once a year (estimate, with 1-year leases turning over once a year), is about 4% of the annual rent cost. This is normally in addition to monthly management fees.
Management fees
Usually 10% of the monthly rent in addition to the listing fees. Make sure you’re getting your money’s worth with this. If you’ve got a good tenant and can manage repair issues long-distance, you may only need to pay for listing fees. However, that leaves your property without an eyes-on look from someone other than a tenant, and that’s not wise. Either way, find a good handyman in the area and keep them on speed dial.
HOAs
Read your HOA docs and find out exactly what you need to do to rent the property. Your HOA may require board approval of your tenant. Get that process started early. If there’s strict lawn care or other appearance standards, it may be beneficial to hire a lawn care company and just include it in the price of the rent. Be sure to list HOA standards in your rental contract and leave the tenant responsible for adhering to them. HOA fees are normally included in the rent so that you guarantee that they’re paid.
In a condo situation, FHA financing regulations require a certain percentage of the complex to be owner-occupied or the complex will not be eligible for typical financing. Without the ability to get FHA financing, the units will be less sell-able, and therefore will drop in value. In an effort to preserve the sale-ability and value of the entire complex, condo HOAs will deny requests to turn an owner-occupied unit into a rental IF the complex is close to that percentage. When purchasing a condo with the intent to rent in the future, ask the HOA about this. HOAs are also responsible for the maintenance of the parking lot, exterior structure, etc, and if the finances are poorly managed, it could result in an assessment against each unit. This is yet another financial contingency you must be ready for.
In a typical single family home neighborhood, the management of the HOA can still make-or-break the rental situation. Do your research and talk to the board.
Pool
A pool is easily $40,000+ worth of value in the home, and it’s likely to your financial advantage to properly maintain it. Tenants may or may not care for it the way you would, you have to make the risk management decision. Consider hiring a pool maintenance company and include it in the price of the rent. One less thing for the tenant to worry about, and you’ve got the asset covered. Similar consideration should be made to AC system maintenance – just have the AC guy come once a year for a tune-up and add it to the pile of expenses.
Pets
Your call on pets. Once pets live in the house, it’s going to be hard to rent to non-pet owners unless you replace all the carpet. Pets can also kill the lawn and/or landscaping. I personally have pets and have had my own pets in my homes, so I’ve allowed my tenants to also have pets. You can attract a tenant who’s willing to pay a bit more to have a good house with a good yard for their dogs. I always charge a non-refundable pet deposit, usually $250. That money will go towards cleaning or replacing the carpets or other damages directly from the pets.
Landlord’s insurance
You will need a new insurance policy on the property. A typical homeowners policy covers the home AND the contents, whereas a landlord’s policy covers just the home. As the landlord’s policy covers less, it’s generally cheaper than the homeowners policy. However, if you had any challenges underwriting your home (pool, trampoline, closeness to the water, unpermitted work, etc) you’ll have those same challenges underwriting a landlord’s policy.
Property taxes
Many states have a homestead exemption for a first home that’s occupied by the owner. Once you rent out your home, you will lose the homestead exemption the following tax year. You will have an escrow deficiency that year (make it up in cash) and then a higher payment after that year’s escrow analysis. Homestead exemption is typically $50,000 off the assessed value, so you can guestimate by adding that much to your value and then figuring out what the new taxes should be. For my house, it’s about $1100 extra a year, or just shy of $100 a month. Make sure you include this in your rent pricing, and do careful research into the property tax laws of your county.
Cash flow break-even rent pricing
Mortgage payment (including increased property taxes) , +10% management fee, +4% annual turnover, +10% expected repairs, +8% vacancy, +HOA fees, + extras (pool, lawn). I’m not factoring in pool or lawn expenses, as those are usually considered perks and added in afterwards.
With a property manager: payment + 32%. Without a property manager: payment + 22%. Without a property manager and self-listing: payment + 18%
Now, take that number, and compare it to the typical market rents of houses near you. Can you cover your expenses? Break even? Come out ahead? Will you have to “feed” your home? If so, how much?
Feeding the home
Feeding the home is when you’re spending more in expenses monthly/yearly than you’re making in rent. Sometimes this is due to a catastrophic repair event, sometimes this is due to market fluctuation. Sometimes this is due to over-leveraging in your financing (zero down loan) and a high interest cost. Whatever the reason, you need to make a risk calculation to decide to continue feeding the property extra money or to just cut your losses and sell the house. Here’s a few ways to look at it.
First, calculate your expected net loss at closing if you were to sell the property. Next, calculate how much you’d have to “feed” it monthly. Compare the two and find out your break even point. If you’re looking at a $5,000 loss at closing, but only feeding the house $200 a month, your break even point is 25 months, or 2 years. In that 2 years, your property values can go up, your cost of ownership can go down (mostly your monthly interest cost), and market rents may increase. So, 2 years from now, calculate if it’s worth it to continue keeping the property and move on from there. If you’re feeding it $100 a month in contrast to a potential $20,000 loss, feeding it is likely the way to go. If you’re feeding it $500 monthly while looking at a $2000 closing loss, you’re probably better off to just sell it and move on.
As you pay down the house, your equity increases and the cost of ownership decreases. Your return rates will therefore increase. If your monthly mortgage pay-off amount is around $450, but your feeding the house $200, your cash flow will show that you’re losing $200 monthly, but your network has an overall gain of $250 monthly. This can be a fantastic long-term strategy, if you’ve got the finances and budget to sustain it in the short term.
Catastrophic repair events happen, too, but these can increase the value of the property. For example, a new AC system may be $7000, but you’ll get that money back when you sell it. Its a factor in planning, but not really a month to month expense. More on that later.
Granted, all of these numbers are looked at before the emotional factor of personal finance is considered. If it’s worth it to you to spend $200 a month to keep your dream home for 2 more years until retirement, then that’s an emotional decision. A perfectly reasonable one to make, if that’s what you want to do. Just factor everything in together when looking at the big picture.
Tenant screening
Obviously, selecting good tenants is key to maintaining a good rental relationship. I had tenants who ended up growing pot in my house and cost me a significant amount of money. Renting to military families is also hit or miss, I’ve had fantastic military families in my homes and challenging military families in my homes. Even if you list the property yourself, run a full background check and look at their financial ability to pay you. I don’t pay too much attention to their credit score (unless there’s a glaring problem), but do look at their ability to PAY their rent on time.
Managing the tenant relationship
There’s another person living in my largest financial asset. I try my best to be open and accessible, without getting too buddy-buddy. If there’s an issue with the house that falls on the landlord’s responsiblity, I’ve tried to err on the side of the tenant. For example, the month that my tenants had to heat their house with their stove while we installed a replacement HVAC system, I covered their natural gas bill. With good tenants, the good will generally pays off quite well.
Income Taxes
You will pay income taxes on your rental profit. That’s after deducting your expenses. Rental property expenses are not deducted in the same way as your primary mortgage interest – that’s the difference between taking the standard deduction and itemizing. I normally take the standard deduction, as I don’t have personal expenses worth itemizing. However, your rental property is treated like a small business and rental expenses will count against your rental income to get the bottom line.
The following expenses are deductible: Insurance, interest, property taxes, utilities, listing fees, management fees, HOA fees, repairs. You can also take depreciation (more later on that.) Upgrades and capital improvements are not deductible, but can be straight-line depreciated (I’ve never done this myself.) If, say, the roof goes bad and you spend $10,000 on a new roof, that’s deductible. If you ADD on a deck, that’s considered an improvement.
The main out-of-pocket expense that you can’t deduct is the principle part of your mortgage payment, as that’s not an actual expense. That money still go towards increasing your net worth by increasing your equity in the property.
I do my own taxes every year with the $79.99 version of TurboTax and a few hours worth of research. Good record keeping during the year is essential, especially when adding up all of those Lowes receipts for repairs.
Depreciation
Oh, boy… Depreciation is the idea that an asset has a limited lifespan, and after a certain amount of time, the asset will be worth zero. The IRS allows you to take a fraction of that every year, and consider it an expense against your income. (www.investopedia.com/articles/investing/060815/how-rental-property-depreciation-works.asp) Taking depreciation will reduce your income taxes, however, you will pay capital gains taxes on the depreciated amount when you go to sell the property.
With long term capital gains set at 15% (for most people), chances are that you’re better off taking the depreciation if your current marginal (not effective) tax rate is above 15%. There’s no telling what tax rates will do in the future, though. If/when you sell the property, hopefully you’ll have the cash available to pay the taxes at that time.
Depreciation can be compared to the tax advantages of a retirement account. It’s is more like the Traditional instead of the Roth, where you take the tax break now but pay for it later.
When you sell the property (either because you wanted to or because you’re dead and the estate is selling it), the capital gains taxes are paid as follows: Net of sale (market rate minus selling expenses), minus original purchase price, plus depreciation taken.
If the house purchased for $100,000, depreciation will be around $3000 a year. Letssay, 4 years in, you’ve depreciated the house by $12,000. Your basis in the home is now $88,000, NOT the original $100,000. You sell it for $150,000, net $127,500 (15% of $150,000). $127,500 – $88,000 = taxable gains of $39,500 x 15% = taxes of $5925. Without depreciation, the taxable gains would have been $27,500 and taxes of $3300.
The emotional factor of landlording
My husband and I rented out our first home after we upgraded to a larger one. A few months later, he was at the home fixing a minor issue and saw how our tenant was taking care of the property. The place was dirty, smelled bad, and overall not well kept (bad tenant screening on my end). This was OUR home, the home we brought out daughter home from the hospital to, the home that we shared our wedding night in. Seeing it treated poorly by a stranger was a punch in the gut. No amount of money was worth seeing our memories misstreated like that.
Or is it? You’re going to have to decide what your emotional investment into the property is and if you can allow it to become someone else’s home. This isn’t a financial decision as much as it is a personal one. The personal influence can cause you to make a less than optimal financial decision concerning the property, so just keep that awareness as you make those critical decisions.
Internal financial management
Per most states’ state law, rental security deposits must not be commingled with other monies. I keep a separate savings account with the security deposit and just don’t touch it. Any interest that the deposit accrues is owed back to the tenant at the time that they move out.
I have a separate checking account for my property. Rents are paid in, expenses paid out. That way, everything is in ONE location and it’s easy to figure out exactly what our profit/loss is. If you’re managing a property locally, get a debit card on that account for Lowes purchases. I also keep a savings account for each property for escrow and repairs. (one property is paid for, so I maintain a manual escrow account, the other is a straight emergency fund.)
I structure my personal budget to pay my mortgages and rental expenses out of our base pay, and then use the rents to put money into retirement, savings, and my daughter’s college fund. That way, if (when) there’s a vacancy or a problem, I’m not coming out in the red during those months. We can at least cover our expenses on our base pay, even if there’s a month or two where we don’t quite get to retirement contributions.
In addition to emergency funds set aside directly for the property, make sure you can handle the one-off catastrophic emergency.
Catastrophic emergency
Last year, I lost $22,000 in rental real estate, between rehabbing my first home, fixing up the second, recovering from crappy tenants in the second, and worse. The city hit my sewer main, said it was my fault, and I was out $10,000 in a single month. 3 years ago, the heater in my first house went out in December, and I wrote a check for $7000. I currently have $16,000 invested in 3 different sewer main re-builds under two different houses. (never, EVER again buying anything with cast iron pipes.) These things happen, and we dealt with all of this on SSgt pay. Thankfully, most of those losses have been made up over the next 1-2 years’ worth of rent, but you NEED to have the cash on hand to be able to cover these types of emergencies. Good credit is also helpful – I had to borrow $10,000 once to cover turnover and repairs, but ended up coming out on top in the end. Ultimately, your rental property is likely a significant chunk of your net worth, and while it may hurt to spend ten grand on a repair issue, that’s only 5% of the value of a $200,000 home. Not worth losing a whole asset over 5%.
The hassle factor
Landlording is not easy. Dealing with people, finances, local real estate markets, construction type repairs, etc. It’s a package deal. Some months I spend 30 minutes on it and make a decent amount of money. Some months it’s 30 hours a week and I lose money. Overall, I’ve done pretty well, but it’s the law of averages.
Purchasing the next home with a rental
SOOOO… you’re on the brink, ready to rent out your current house and go buy another one. Here’s some things to think about:
Financing considerations
So, you’ve PCSed and now want to buy a new house at your next duty station. That’s great, now you need to convince a loan officer to give you another mortgage for another property.
First, you’re going to have to be able to afford a second mortgage with your current debt to income ratio. If your rental mortgage is all the debt you have, you’re probably in a good spot. Add in some vehicle or student loan debt, and now it doesnt look too good.
You can use you rental income to compensate for the rental mortgage, but the bank will want to see 2 years tax returns with the income. Depending on when you converted it to a rental and what time a year you want to buy, 2 years tax returns can take closer to parts of 4 years to document.
Purchase conservatively
The bank will do all they can to max out your DTI (debt to income ratio) to earn just as much interest off of you as they can. By choosing a smaller/cheaper home for your initial or second purchases, you can reign in the budget. Think of who you’re going to rent to when you PCS, and make sure you can afford to rent within BAH rates. Just because the bank says you can borrow a half million dollars on a mortgage doesn’t mean you should. And if you do, you will have zero room to finance the next property. Scroll back to the top where we talked about not over-buying.
Leverage ratios
Alright, heading into the weeds here… The more you’ve borrowed against a property, the higher the leverage ratio. This isn’t generally a problem if you’re living in your own home and plan to remain there for quite some time, but it does become a factor when the bank starts looking at your suitability for the next purchase. (www.thebalancesmb.com/top-don-ts-in-using-real-estate-leverage-2867098)
If you owe $90,000 on a home worth $100,000, your leverage ratio is .90, that’s very high. If you owe $90,000 on a home worth $400,000, your leverage ratio is now 0.225. That’s very conservative. With the same debt to income ratio, the real estate owner with the lower leverage ratio is going to be a much safer customer to the bank. You can better your leverage ratios by 1, paying down the house or 2, letting it appreciate. The first is within your control, the second is not.
Interest expense
The single greatest expense in the first year of home ownership is the purchaser’s closing costs. Beyond the first year, the greatest expense on a financed property (barring an enormous catastrophic event) is the interest expense. The lower your interest expense, the higher your profit. You can lower your interest expense by 1, getting a better rate and 2, borrowing less. You can borrow less by either putting more down on the home, or by paying it down early.
Paying off a house early
So, this one is highly controversial in the landlord business. Some folks will say to borrow as much as possible against a rental property because the interest is completely tax deductible and you can leverage your cash to purchase multiple properties. It’s also possible (some years) to make a better rate of return in the stock market. While both of these schools of thought have validity, it’s overlooking the factor of RISK. I’ve personally paid off a rental property and it was one of the greatest feelings in the world. Sure, I’m not making quite as much on that money as I could, but the risk on a paid for property is much lower than with a financed property. It also doesn’t count towards my DTI any more, and isn’t much of a hassle factor in future property financing decisions. At a minimum, paying off the house will give you a return equal to the interest rate, minus the marginal taxes you would have paid if you had taken the deduction. However, if you achieved a greater rate of return elsewhere, you’d also owe taxes on that, at either capital gains rates or your personal marginal tax rate.
If your goal is to churn and burn and just buy as many properties as possible, you’re likely going to finance all of them as much as you can. If your goal is to retire from the military with one or two investment properties, then work towards paying them off at a reasonable rate.
Conventional VS creative financing
Creative financing is an option, but not one that most of us use. This would be something like, say, getting a loan from your uncle’s IRA to buy the house, and then you pay your uncle the interest. This is do-able if you’ve got rich friends/family who are willing to invest in your mortgage. However, loans like this require much more documentation when you’re looking at the next deal. Because banks are used to dealing with conforming loans (the fancy term for loans that fit all the rules), they may balk at a lender with a creatively financed asset in their portfolio. You’ll have a greater burden of paperwork and proof to demonstrate your continued creditworthiness.
Rental VS Owner occupied financing
You can borrow money to purchase a rental, but the interest rates are usually a full or two full percentage points higher. On $100,000 borrowed, each full interest rate percentage is $1000 a year or $83 a month. Obviously, that amortizes, but that’s the starting expense at month 1.
Refinancing a rental as a rental
Once the home is no longer owner occupied, it doesn’t fit the criteria for owner occupied financing. A re-finance at that point (to pull cash out, clear the VA entitlement, or re-structure of payments) will likely cost that $83 per month per $100,000 borrowed. If you live in a home that will be a rental and you need to update your financing, do it before you move out.
Larger down payment
You can always entice a bank with a larger down payment. The more money you put down on the next deal, the lower their risk is. Borrowing less also raises your DTI by a smaller amount, and that can help get you approved. Coming up with a larger down payment while turning your current property AND PCSing can be challenging, so plan ahead.
Here’s another thing to think about with the down payment: Your down payment is your buffer between you and the real estate market fluctuating. If you have 5% equity in your house, and the market drops by 5%, you’re basically imobile. If you have 25% equity and the market drops 5%, you’re still down by that much of your net worth, but the remaining 20% equity gives you the ability to cover closing costs if you choose to sell, cover a dip in rents, etc. Better to lose money you have than money you don’t.
Let me say that again – Better to lose money you have, than money you don’t.
Balanced portfolio
Guys, rental real estate isn’t the whole thing. For the average homeowner, our home makes up the largest asset in our portfolio. If the house is paid for, it’s probably the most significant portion of our net worth. As soon as it’s rented, you now have one single asset worth a LOT of money, and all of your net worth is in the same asset class.
Don’t forget to contribute to retirement through tax advantaged accounts (IRAs, TSP, 401Ks, etc). There’s been seasons in our life where we had to stop retirement contributions to get over a hump, but that should be the exception, not the norm. Do your own research if your rental property income changes the equation for you while deciding between Roth and Traditional contributions, but chances are, it shouldn’t make that big of a difference.
Liquidity
This is a problem, too. $100,000 worth of home may be worth $100,000, but it’s very difficult to convert a house that another family is living in, into cash. Borrowing against the property is an option, but only if your DTI can support it. Selling the property, at a minimum, will take 60 days. Maintain the amount of liquidity in your overall net worth (mine is in my emergency fund) to balance the amount that’s non-liquid. Your personal liquidity needs are dependent on your financial situation and your risk tolerance, but it is a factor to consider.
If I missed anything… ask, and I’ll find an answer. Hope this is helpful to someone here.