Help with deal analysis on first house hack

[Steven DeMarco]

I'm looking at a SFH + ADU in Salt Lake City, UT as a potential house hack. Before I put in an offer, I want to run the numbers by some professionals.

The property is 4BD/2BA in total, with 2BD/1BA upstairs and 2BD/1BA downstairs with separate entrance. Current list price is $564K, my offer would be $515K using a 3.5% FHA loan. My estimated mortgage would be $3380/mo. Currently the upstairs unit is rented at $1395, which is below market rents (Rentometer average is $1650). I would owner occupy the downstairs unit in Year 1, per FHA guidelines.

Currently I pay $2150/mo. in rent. So in Year 1 for house hacking and keeping the existing lease in place, I'd be saving about $165/mo. in rent ($1980 in total rent avoidance for Year 1).

In Year 2, if I decide to move out, I have to take the following measures to break even.

- Raise rents for each 2BD/1BA unit to $2050 (a 47% increase of current lease). This puts rents at 75th percentile according to Rentometer and brings total rental income to: $4100/mo.

- Reserve only 9% for maintenance, capex and vacancy: -$369/mo. ($4428 for the year)

- Spend only 8% for property maintenance: $-328/mo. ($3936 for the year)

- Pay the monthly mortgage obligation: -$3380/mo.

So for Year 2, that leaves me with a net cash flow of $23/mo.

In order for the deal to work, I'd have to be slim on my reserves (only reserving $369/mo.) and have to find a nimble PM company (for 8% or less of monthly rent). I've done some research and it's possible to find solid PM company for 7% - 8% of rents in the SLC area.

What are your thoughts? Can I make this deal work with slim reserves and by raising the rents to 75th percentile? This would be my first house hack and second real estate investment. I have a strong W2 with good savings and could potentially float additional capital expenses if/when they come up.

[Ryan Thomson]

@Steven DeMarco What are your goals? Are you currently renting?

Once you know those, it will be easier to answer the questions you've asked. Le'ts assume your goals are a good ROI (better than other investments you have access to) and that you renting currently.

With those assumptions here is my advice. 

Don't pass up a good first investment bc it doesn't currently make sense to move out and scale to the next one. That may take a couple years. I'm guessing any house hack in your market doesn't make positive casfhlow if you move out of year one. 

[Ryan Thomson]

House hacking is tough to cashflow in year one (with current house price run-ups and interest rates) for a couple reasons:

1. You are living in one of the rentable units

2. You are only putting 5% down so your loan amount is much larger and therefore your mortgage payment.

I would consider your net worth ROI. What I mean by this is considering how much your down payment returns to your net worth (appreciation, loan paydown, tax benefits, AND rent avoidance). Don't forget to include rent avoidance in your numbers! You have to live somewhere.

You may need to lower your return or cashflow expectations so you can get into a house hack that will allow you to avoid throwing rent money away every month. You know this, but don't forget all the other ways real estate makes you money. Paying down your mortgage and owning an asset that will appreciate over the long term.

[Ryan Thomson]

And here is a longer read on why house hacking is still a great ROI even if you are not casfhlowing:

It has become increasingly difficult to cash flow with house hacking. Despite this fact, the return on your investment (ROI) is incredible enough that it still warrants exploring buying real estate with the house hacking strategy. Home prices have increased substantially in the last couple years and interest rates have doubled. It is difficult to cashflow in year one of your house hack for a couple additional reasons: 1. You are living in one of the rentable units 2. You are only putting 5% down so your loan amount is much larger and therefore your mortgage payment is higher.

In this article we will dive deep into the 4 big ways that house hacking makes you money, even if it doesn't cashflow. You need to consider how much the down payment returns to our net worth. To calculate your Net Worth ROI for house hacking, you'll need to consider four factors: appreciation, loan paydown, tax benefits, and rent avoidance.

Appreciation:

Appreciation is the increase in value of your property over time. On average, real estate appreciates at a rate of around 3-4% per year, although this can vary greatly depending on location and other factors. For example, if you buy a house for $500,000 and it appreciates at a rate of 4% per year for five years, it will be worth $608,280. This increase in value would add $108,280 to your net worth.

Loan paydown:

Loan paydown is the reduction of your mortgage balance over time. Every time you make a mortgage payment, a portion of it goes towards paying off the principal balance of your loan, which increases your equity in the property. Over time, your mortgage payments will consist of less interest and more principal, which means more of your payment is going towards building equity. This reduces the amount of debt you owe and increases your net worth. For example, if you have a 30-year mortgage for $500,000 with a 6.4% interest rate, after five years you will have paid off around $31,807 of the principal balance. This reduction in debt would add $31,807 to your net worth.

Tax benefits:

Tax benefits are the deductions you can take on your income for expenses related to owning and operating a rental property. This includes things like property taxes, mortgage interest, repairs, and depreciation. These deductions can significantly reduce your taxable income and increase your net worth. For example, if you own a rental property that generates $20,000 in rental income per year and you have $15,000 in deductible expenses, your taxable income would be reduced to $5,000. In the 40% tax bracket this reduction in taxable income could save you around $2,000 in taxes per year, which would add $2,000 to your net worth. You have to actually be cash flowing for this benefit to take effect. Or be a real estate professional and be able to deduct against your professional source of income (another topic for another day).

Rent Avoidance:

Rent avoidance is the amount of money you save by living in one of the units you own instead of paying rent elsewhere. One of the most significant advantages of house hacking is rent avoidance. When you own a house hack, you are not only generating rental income, but you are also avoiding paying rent. When running numbers on a house hack include how much you are currently paying for rent (or how much you would pay to rent a comparable property) vs how much of the PITI and budgeting expenses are left for you to cover. For example, let's say your alternative to buying a house hack is renting a one-bedroom apartment for $2,000 per month. Let's say that once your tenants pay you rent you still have about $971 in PITI. You need to budget and an additional $929 to set aside for future budgeting items (vacancy, maintenance, and capital expenditures). Your total expenses to live in this house are $1900/month. Renting would cost you $2,000/month. Your rent avoidance is $100/month, $1,200/year, and $6,000 over 5 years.

Taking these four factors into account let's calculate your net worth ROI for house hacking.

Your net worth ROI calculation over 5 years would look something like this:

Appreciation: $108,280

Loan Paydown: $31,807

Tax Benefits: $0 (b/c you aren't cash flowing)

Rent Avoidance: $6,000

Total Net Worth Increase: $146,087

To calculate your net worth ROI over 5 years, you would divide your total net worth increase by your initial investment (your down payment of 5% or $25,000). $146,087/$25,000=584% This is an incredible return on investment. You will be hard pressed to find a better return elsewhere in the world. Simple Interest Rate of Return = 48.67%/year.

Let's change things up a little bit and say your situation isn't so rosy. Let's say you can only rent the other side for $1500 and that your current rent is only $1,000. The payment you still need to pay (after rental income) for PITI and budgeting items is no longer $1900 but $2,400/month. Your alternative to buying is renting for $1,000/month. If you decide to buy this house, you are negative $1400/month for five years. Does it still make sense to house hack? $1,400 x 12 months x 5 years = -$84,000.

Net Worth ROI Calculation (new situation):

Appreciation: $108,280

Loan Paydown: $31,807

Tax Benefits: $0 (b/c you aren't cash flowing)

Rent Avoidance: -$84,000

Total Net Worth Increase: $56,087

ROI = 56,087/25,000=224.35%

Simple interest rate of return = 18.7%/year

House hacking can be a great way to build wealth and get into the real estate game. While it may not always provide immediate positive cash flow, the long-term benefits of owning a property that is generating rental income while also providing a place to live can be significant.

When considering the ROI of house hacking, it's important to look beyond just the monthly cash flow. By factoring in appreciation, loan paydown, tax benefits, and rent avoidance, you can see a substantial return on your investment in the long run. Additionally, when compared to the alternative of paying rent every month and not building any equity or wealth, house hacking is a clear winner.

[Steven DeMarco]

@Ryan Thomson, I've seen this copy pasta before :) My current goal is to buy a property to house hack in Salt Lake City. Year 1, I want to avoid some portion of my current $2150/mo. rent payment and have the property self-sustain in Year 2 when/if I move out.

In the spirit of trying to learn and incorporate everyone's feedback, I'm going to take a stab at applying your though process to my scenario. You are running most of the numbers assuming that the investor is living in the property for 5 years. I could see myself reasonably living in my house hack for up to 2 years (for other tax benefits as well, like avoiding capital gains if selling). Therefore, I'll run these numbers as if I live there for 2 years.

Appreciation Gains (using 3%): $30,450

Loan Paydown: $11,074

Tax Benefits: $0 (no cash flow)

Rent Avoidance: $10,080

Total Net Worth Increase: $51,604

Down payment of 3.5%: $18,025

Closing Costs: $12,000

My total capital investment would be: $30,025

Simple interest rate of return: 85.9%/year

I recognize that I didn't set anything aside for maintenance, capex reserves, etc. but that was a fun exercise. Do you think I missed anything?

[Ryan Thomson]

@Steven DeMarco I think its such helpful info I'm putting it everywhere :) 

Glad you ran through the exercise! I think its a helpful one. The ROI is unbeatable. Did you lump your negative cashflow in this situation? If not, you'll need to include that.

[Steven DeMarco]

Quote from @Ryan Thomson:

@Steven DeMarco I think its such helpful info I'm putting it everywhere :) 

Glad you ran through the exercise! I think its a helpful one. The ROI is unbeatable. Did you lump your negative cashflow in this situation? If not, you'll need to include that.

Boy did I just go deep down the rabbit hole on this one! To update my calculations, I revised my scenario a bit. I would be living in the house hack for only one year. Also, I've updated purchase price according to where I'm at with negotiations. After moving out and renting both units, I'd be cash flow negative for 2 years (Year 2 and Year 3) before finally becoming cash flow positive in Year 4. I expanded the horizon to 10 years. Ultimately, this would be a buy-and-hold for me for the long-term (past the 30 year mortgage) but for argument's sake, I've done calculations on the 10 year horizon.

I'd only be putting 3.5% down and buying down my interest rate, which brings total capital invested to $46K. ($19K down payment, $15K closing costs and $12K to seed my reserves fund - more on this later). Also important to note, I would be saving money each month in rent avoidance and I'd be putting 60% of my rent savings into a reserve fund. By the end of Year 1, I will have roughly $22K of a reserve fund to float any vacancies, maintenance, capex, PM fees, etc. and the next two years of (relatively minor) negative cash flow.

Some assumptions:

- I'd be raising rents 5% annually from Year 2 through Year 4, then raising rents 3% annually from Year 5 through Year 10.

- I'm assuming annual appreciation at 3%.

- Upon move out in Year 2, I'd be saving 8% of expenses for maintenance/capex items, 8% for vacancy and 10% for PM fees.

Through that 10 year period, I will have no less than $18K in the reserves fund so feel comfortable weathering most storms of vacancy, repairs, etc. I will have accumulated $310K in net worth on my initial $46K investment, which is a 563% return, 21% annualized. 

More details: 

- I'd be "funding" my reserve fund in Year 1 only, with a one-time investment of $12K and then monthly installments over the course of the first year living there to re-invest my rent savings. Total balance of reserve fund would be $22K at the end of Year 1 when I move out and rent both units.

- Appreciation of 3% annually would bring the $545K property value to $732K property value, a total NW increase of $187K.

- Loan paydown would bring the $525K loan down to $434K, a total paydown / NW increase of $91K.

- My net worth increase includes positive cash flows from Year 4 through Year 10, a total NW increase of $32K.

- I'm not considering any tax savings during positive cash flow years. Maybe I should do a third iteration with those tax savings?

So yeah, in summary, I can invest $46K and realize a 21% annualized return to bring my total NW up by $310K. With a responsible amount of reserve funds in the beginning, a few years of negative cashflow is a no brainer to realize this NW increase.

[Ryan Thomson]

@Steven DeMarco YOU GET IT! Congrats on doing the exercise and really getting the long-term perspective of real estate investing. You will be MILES ahead by buying a home instead of sitting and waiting and hoping for a deal that will casfhlow in the first year.