How to analyze current home as possible rental property?

Question

Hi, I am a new BP ... person.  I've just recently gotten the idea to invest in Real Estate.  I intend for my focus to be Buy & Hold, with the eventual aim of maximizing cash flow as a source of passive income.  I've educated myself a little bit on property analysis.

I expect my first rental property will be the house I'm currently living in.  So, I decided to "run the numbers" on it, to see how well it might perform for me.  But, the problem in my head is that I can think of multiple ways to characterize my investment in it, and I'm not sure which way is correct.  (Or, maybe they are both wrong, and some 3rd way is correct?)

Here are the deets: I bought it 19 years ago, for $200K. If I believe Zillow, it has a market rent estimate of $1800, and is worth $300K. My mortgage payoff is currently $85K.

FIRST CHARACTERIZATION: Completely ignore the nearly $330K of PITI that I've paid in the past 18 years as an unrelated sunk cost. Pretend that I'm buying this property waaaaay under market for $85K, with no money down, no closing costs, and $10K of make-ready (out-of-pocket). If I refinance that remaining $85K at 4.25% for 30 years, and factor in all my known expenses, and assume 6% vacancy & 7% management, then:

• cash flow $4150/year ($345/mo)
• CoCR 41.5%
• ROI 72.27%
• Cap rate 10.79%  (ridiculous, because assumes $85K market value)

SECOND CHARACTERIZATION: Recognize the cost of the property is $300K, but I have a $215K down-payment.  (Everything else the same as the above.)  Then:

• cash flow $4150/year  ($345/mo)
• CoCR 1.84%
• ROI 4.87%
• Cap rate 3.06%

As you can see, these both result in the same cash flow.  But the performance metrics look vastly different.  The problem in my head is that I care about the metrics, since the point is to decide how good this property is.  To me, the second characterization feels more honest considering the property since the day it was built.  But its CoCR (which I think is the metric I care most about) seems pathetic.

I guess I would summarize my questions as:

1. What is the right way to analyze a property that shifts from personal residence to cash flow investment, after decades of principal paydown?

2. Is my projected cashflow as depressing as it seems?  (Works out to be just 19% of gross rent.)

Brenden Mitchum · Answer

@Ryan Bissell

With $345/mo cash flow, why wouldn't you just refinance? That's a perfectly good amount of cash flow for a SF as long as you have factored in all expenses and vacancy.

If you are hesitant to jump into something large, you could do one of three things. Go small with that 4-plex, partner up with someone and go bigger, or pay for a mentor to walk you through the process. This will just be up to you and your risk profile. But don't be afraid of going big. Every day people are doing their first ever deal as an apartment complex.

The bottom line here is that you have tons of options and it sounds like you already know the worst one is to refinance and purchase another primary residence so that's a great start and better than most!

Ryan Bissell · Answer

Thank you for the reply, @Brenden Mitchum.We are looking to move for personal reasons.  That decision made, I'm just trying to decide what to do with my current home.  I think the default option (for most people) is to roll their realized equity from the sale of their old home into their new one.  I could definitely do that, but since I've recently gotten the real estate bug, I was just considering converting it to a rental, as another option.  If I pulled the equity out of it, I would not expect it to cash-flow (because as its loan currently stands, it would only generate $345/month.  Any kind of cash-out refinancing would reduce that.)

1031'ing my $200K of equity into a large investment property is an intriguing idea! However, since I've never owned an investment property, the idea of starting with something as bold as an apartment complex sounds very intimidating.  I think I'd love to be there some day, just not sure such a big bet is appropriate for a complete beginner.  Maybe a 4-plex would be a better start for me?

Brenden Mitchum · Answer

Hey @Ryan Bissell, welcome to the BP community!

The issue here is that you lived in this property for 19 years already. This means that there is just no way it can really be analyzed as an investment property since it is not an investment. Primary residences are simply not investments (unless house hacking) despite what society leads us to believe. Ignore the ROI on it because that really does not matter at this point since you've already dumped the cash into it.

So rather than looking at it as a rental investment, look to how you can use it to make a real investment. Now are you looking to move out simply to make it an "investment property" or are you moving out for another reason? If the former is the reason, why not stay in your home, refinance or heloc and use all that equity you've been building to buy a real investment property? If the reason you are moving out is something else, will the property cash flow if you refinance or heloc? Perhaps you would be better off selling the home and using a 1031 exchange to purchase an investment property? With over $200k of profit you could purchase a pretty major investment property like an apartment. Now you have gone from having this liability on your hands to a cash flowing investment property.

I hope this helps and makes sense. If you have any questions or just want to chat, please feel free to message me anytime!