Just like other assets (bonds, stocks, mutual funds), home can also be used a potential avenue for investments.
We need to be aware of Investment Rule 1: Do not use borrowed money for investments. If we (say) have borrowed money at 6% to fund a share purchase. The share is expected to give us 20% returns. On the face of it this look like a great strategy but it comes with its own share of risks. What if the share goes down by 5% due to factors that were not prevalent when we thought we would gain from the investment? Now we are left with our $100 coming down to $95 and we need to repay $106. We are left with an $11 hole to fill up.
Home purchase is different from Equity purchase on several aspects:
- The fluctuations are more evened out compared to stocks.
- We can most likely get a home mortgage or Home Equity Line of Credit (HELOC) at a much lower rate, the asset usually doesn’t depreciate with age (unlike a car where the more we use the more its value depreciates).
- We would have done a more thorough research prior to investing as we are investing a large amount of money. We will still have to shell out taxes and maintenance expenses.
- Moreover, we are mentally prepared that real estate investments are longer term investments and when we invest, we are not planning to exit in a hurry.
- We will give some more time to exit at the price that we want.
- In addition, we can earn rent from the investment property which will cover in most part our EMIs, Taxes and Maintenance expenses.
- So we will end up with a better cash flow when we invest in the property and hope for capital appreciation when we sell the property.
Key Considerations
Moving to less liquid investment
The money for your down payments will most likely come from your less liquid investments like stocks, and mutual funds. You are expecting to gain of 15% (3% CAGR) from your property over a 5 year period. You need to be aware that your liquidity will be squeezed during this time and that you have enough liquidity to address your short and medium term needs. If you are in need of cash, you cannot rely on liquidity from your home as this would be a long drawn process and if the timing is not right, it may result in a loss or a nominal gain that you hadn’t hoped for. Another alternative is to refinance your investment home and get some cash back at closing. This too is not a good strategy as it will increase your monthly mortgage payments.
Appreciation Potential
When you are choosing a property for investment, you need to look at the appreciation potential and whether you will be able to get a good rent. You need to get a good deal with the new home that you are planning to purchase. Keeping a 7-10 year time horizon for your investment, you need to determine the factors that would positively and negatively impact its salability. None of us have an insight into the future but doing a good due diligence will definitely help selecting the right home to invest.
Rental Income from other Home
Your rent should allow you to make monthly payments on your 30-year mortgage. If it stands this litmus test then it would be a good investment. The only payments that you would have to make would be the taxes, and HOA fees. Intuitively this would also mean that you will be able to get the loan for free for the period you are renting.
Keep in mind that you may have to pay the broker fees for getting you in touch with the right tenant and also maintenance fees to keep the home in good order. This may include small expenses like changing light bulbs and batteries or include major expenses like changing HVAC system. Usually, to protect you against the major expenses it is recommended that you buy home warranty for the rented home.
In your terms and conditions with the tenant, you can include clauses on who would incur costs of home warranty, petty expenses, etc. Usually, if you are staying far off from your home, it would be better to have the tenant take care of these expenses and you can compromise bit of the rent to stay away from this hassle.
Home Mortgage Rates for other Home
Timing the new home is another important aspect. If you are able to get a great mortgage rate it would directly go into your savings as your monthly outgo will reduce. We are all not that lucky most of the time and would have to compromise a bit there.
Usually the home mortgage rates are very low for your first home. If you are planning (and you will need to declare) to fund an investment home, the banks would charge a higher mortgage rate. A hack (if possible) is to show the new home as a primary home when applying for the mortgage and mention to the bank that your existing home will be converted to an investment home. Usually the banks will not mind this (in fact they would love it) as you would be generating additional source of income and their loan becomes less risky.
Another option (if you would like to keep just one mortgage is to combine the mortgages by refinancing your additional home and using the cash from closing to completely fund the investment home. This may not always be possible so you can take a HELOC on one of the homes so you have the sufficient funds for financing both homes. HELOC also has its own benefits as we had seen earlier one.
Getting Ready to Sell
When you have decided to sell the home, you need to do a due diligence and find out whether any additional work needs to be done so you can get a better value from your home. Sometimes a few upgrades like repainting, re-carpeting don’t cost you a lot but will give you a better value for your home. Note that the brokerage you would pay when selling is usually 4%-6% so you will need to factor in that much reduction from your sales proceeds. Try to look at options where you can directly sell the home without a broker. If you decide to go with this option then I would strongly recommend you use services of a closing and title transfer agency to complete the transaction for you. Else you will end up in legal battle battles that would wash away more than the 6% that you are trying to save through this process.
Benefits & Caveats
Additional Source of Income
I had covered earlier that the investment would suck the liquidity from your portfolio. Here’s some good news – you will be able to get back a part of that liquidity through your rental income. Sometimes this income is offset with mortgage payments.
Taxes and Insurance
Additional source of income will attract additional taxes. Your rental income will be clubbed with your other sources of income and this may take you to a higher tax bracket. Be aware of this additional expense. In addition to this, you need to factor for property taxes for the additional home. Note that when you file your returns one of the homes will not get a tax exemption on the property taxes. Needless to say you will claim exemption on the higher of the two taxes. Insurance expenses will get added. You will usually get a better bundled discount from the insurance company if you take them from the same company. Usually the insurance and property taxes will be included in your mortgage payments. If they aren’t or if you have any other alternate source of funding like HELOC, then you need to factor in for these payments from your account.
Maintenance Expenses
What people tend to ignore is the maintenance expenses of both homes. These include both regular payments and ad-hoc expenses. Your utilities will increase. Usually these get paid by the tenant if you have rented them out. There are payments needed for upkeep of the house like lawn mowing, painting, repairs. Keep some money aside in your funds to factor for these expenses and more importantly factor for these expenses in the spreadsheet before you buy your home.
