To refinance a primary residence to rent with a higher rate in order cash flow in California?

Question

The heart of this question is the tolerance with different investor strategies regarding positive cash flow vs. appreciation potential.

This scenario is probably more common in California due to the difficulty in cash flow real estate. Thanks BP in advance for your insights.

Owner of SFH in Orange county CA. is looking to purchase new primary residence in the $1.9-2-3M range and rent existing property. Funds are available for down payment on new property.

Current comparable rents for existing property are around $3-3,400/month.

Current mortgage balance is $535K giving a monthly payment incl tax/ins. of $3,644. Mortgage is at 4% APR. Current equity is 40%

Options to consider:

1. Keep mortgage as is and rent the home with a negative cash flow of aprox --$244/month not including maintenance costs. (Note the property  is in excellent condition and was just completely remodeled.)

2. Pay $114k down on mortgage to equal $417k (max conforming loan balance) with money currently allocated for down payment for now home. Refinance at $4.25% (higher than original loan rate). This would yield a monthly mortgage payment with tax/ins of $2974 and subsequently a $426/month cash flow if rented in the above scenario.

Further discussion:

In option 1 the owner will pay approximately $83K over the life of the loan due to the negative cash flow. This assuming the rent stays the same for 30 years which I will obviously change. The total interest paid over the life of the 4% loan will be $372k. Total loan cost principle and int for the life of the loan is $906k.

In option 2 the owner would make approximately $153K over the life of the loan but need to pay in $114K now. The total interest paid on the higher 4.25% on the loan would be $322k. This scenario would also require the owner to wait at least 6 more months before purchasing new home to replenish the $114k for the down payment. Even though the interest rate is higher the amount paid over the life of the loan because of the lower balance is $50k less then option 1.  Total loan cost principle and int for the life of the loan is $738k.

The question is that because homes appropriate better in so cal and the rents are consistent, would it be acceptable to some investors on this forum to keep the current mortgage the same with a small negative cash flow but lower interest? Or it is better to pay down loan to max conforming, delaying purchase of new home and refinancing at a higher interest rate for a small cash flow?

Bottom line is it worth spending $114k and taking a higher interest rate to avoid a small neg cash flow on a property in an area that shows high appreciation values compare to the rest of the country.

Thanks again in advance and if any other investors see another option I'm all ears.

Rob K. · Answer

No Problem Matthew,

By the way you phrased your original questions, I am assuming that your intention is to hold your current primary as a rental long term when you move up to your new primary residence. I think this is a great way to start as an investor. It is how I started as a real estate investor many years ago. If you can qualify for the financing, you are getting rates today that could make you seem like a genius years from now.

On the tax issues, I understand how to spot them, but I am not a tax professional or CPA. Given your tax bracket and level of earned income, real estate investing is definitely something I think would help your tax situation. Maybe others more knowledgeable on the specific tax issues can chime in. Ultimately you will want to run your tax specific questions through your own tax professional. On your investor friend’s comment about interest rate deductions being cut back and limited, that will apply if and when they come through to primary residences where interest is deducted on schedule “A” of your tax return. Rental property interest expense is deducted on schedule “E” of your tax return where you can deduct all of your interest expense against rental income, and carry it forward to future years if you can’t deduct it completely in the current year.

The way amortization schedules work, with each monthly payment you make, you are paying slightly less interest and slightly more principal. Take a look at the last several months of your mortgage statements. I guess my point was you should not ignore the very real, if gradual, reduction in principal that occurs each month and not focus solely on the cash flow, especially if you can afford a slight negative before tax cash flow and achieve the benefits of lower taxes. When you refinance at the same term (e.g. 30 years) you are restarting the clock and lengthening the term of your loan. Again, run the numbers specific to your situation, but also ask yourself if you are OK with a small negative after understanding the effect on your taxes and the amount of principal reduction on your loan that is occurring.

On my comment on appreciation in my last paragraph, I believe that the idea of appreciation based on price increases in real estate assets over time is commonly misunderstood in the sense that many think in terms of our currency as a fixed medium against which all other assets are measured. No one has a crystal ball, and I do not want to pass judgment on a politically tinged subject where economic views diverge, but the fact is that the dollar went off the gold standard in the early 1970s. Since that time, real estate has gone up in nominal dollar value a great deal because of inflation; our currency buys less than it used to. But has real estate gone up in value in real terms? Taking aside productivity gains from better constructed housing, is the value of a dwelling really worth any more than it was in 1970 in real terms? Maybe not, or a lot less than the “appreciation” that appears to have occurred.

But the person who got a 30 year fixed loan back in 1975 to buy their residence, moved a few years later and kept it as a rental and dutifully paid it off in full in time? The fact that it started with negative  cash flow in the late 1970s turned out to be meaningless. The value of the dollars used to pay the fixed loan over time decreased year after year and before to long became an insignificant expense while rents increased. This is where the true increase in wealth occurred because of inflation.

Again, not to get to political, but it would seem our government and monetary system has been highly incentivized to fight the deflationary effects of the 2007-08 financial crisis with every tool at their disposal and that is what has occurred over the last 6-7 years. It would appear to me at least that they are winning. If inflation is what our future holds, than using “good” debt over the long haul will again be a wealth builder as “appreciation” in nominal terms occurs.

Matthew G. · Answer

Thanks Rob.

You definitely make very good points and your questions are great at triggering objective thinking. Your expertise is clear in reading your reply. To answer your questions tax bracket is at 48%. 99% of current income is taxed at earned income rates. Some passive gains (not much) could be off set. Current yearly interest is $22K. An investor told me once to not count on the mortgage interest deduction when making a decision on real estate investing since the government could take it away. Perhaps that was not good advice. I'd say the mortgage interest deduction adds about $850 a month to the investment. Adding the depreciation would make it even better.

I didn't even consider the capital gains exemption scenario. A good estimate for capital gains on the primary would be $120-150k.  My thoughts were that it was not significant enough to off set the potential to keep the property as a rental. But I may be off here? Selling the primary would also allow me to leverage and additional $230k that was put down initially. This would allow me to put over $1m down on the new property. However this seems too conservative and I think I would be missing leverage potential?

Regarding amortization schedule this is something I should focus more on as I learn and invest in more properties but the current schedule is showing principle payments at $940/month. To date there would be a 19 month amortization difference between this loan and the new one. I'm not sure how to calculate its significance to making a decision either way other than that.

Your last paragraph has a lot of layers and insight to it an I want to make sure I'm understanding it fully. This is the main reason for having a buy and hold investment strategy? Would you mind elaborating a little more for a new investor?

Rob K. · Answer

In looking at these kind of decisions, I think you need to consider all of the potential advantages of longer term real estate investing: rental income, income tax benefits, loan principal reduction and potential appreciation. From what I can tell, you are only looking at cash flow before taxes and the long term nominal cost of your financing alternatives.

What is your tax situation and bracket? Do you have other passive gains you could offset against rental losses? It may very well be that your after tax net cash flow will be positive under your option one after deducting interest on your existing loan under Schedule E and you begin depreciating the primary residence you will be placing into service as a rental.  On the other hand, assuming you have a potential for up to a $250-500K capital gains exclusion on sale of your principal residence, are you comfortable giving this up by your decision to rent your current primary instead?

With a current mortgage of $535K per month at 4%, what is your level of current principal reduction per month and how will this change if you restart your amortization from scratch on a refinance with principal pay down?  If you are reducing principal, it is a benefit to be considered as part of looking at your -$244 per month cash flow.

In considering appreciation and the long term costs of financing scenarios, be careful of looking at the nominal costs with the assumption that “a dollar is a dollar”. Southern  California property values are more volatile than many other parts of the country, but how much of that appreciation occurs in real dollar terms? An argument can be made that much of the appreciation over time in real terms of the value of the property will be relatively low, and the increase in nominal values is because of inflation.  Under this scenario, the real increase in wealth is because of the decline in value of the dollars you are paying on the loan overtime, and the payments you make 10-20 years from now on a fixed mortgage at 4% will be only a small fraction of what they are today in real terms while the property itself is a hedge against inflation, and rents increase because of inflation. So I would say don’t get to hung up on the amount of interest you are paying on the loan over time under either scenario without anticipating changes due to inflation.