Real Estate Investment - Leverage Primary Home to buy Rental?

[uncle_scott]

I want the brain trust's opinion on an investment scenario I am considering.

My wife and own our first home as a rental that provides a decent cash flow, and a tax deduction through depreciation. We purchased a new home 14 months ago in an appreciating area with a good interest rate. Our new property has significantly increased in value over the past year, and I want to tap into the equity to buy another rental property.

I am considering a cash out refinance, or a HELOC (I have contacted my lender, and asked for them to run some numbers). I then want to use that cash to fund the purchase a small duplex in the next town over. I was the Planning Director (gasp government employee here ) in that town, and I know the rental market well. I believe that I can purchase a rental home that will immediately cash flow, and if it is a duplex then it is slightly less risky as one side of the home would nearly (if not completely) pay the mortgage, while the other side is the cash flow generator.

We have an emergency cash cushion for our first rental, and we do not tap into the cash flow money for any personal expenses. In fact, I have been letting it accrue to purchase another rental in the future. Our regular jobs pay well and cover all of our existing needs and debts including any increase in the new leveraged refinance or HELOC loan. This idea is stuck in my mind because we still have low rates, and the housing market has driven our house value up. This would save me considerable time rather than waiting until I have saved up the cash to put down on my second rental property.

What would you do? Am I crazy to further leverage my existing home for the sake of buying a rental, or is this in the 'risky but possible' category if I buy the rental property well?

[look 171]

Sounds good, but I just don't like the idea of a HELOC. The floating rate part. That can bite you in the ass if interest rate sky rockets. If you ever got in trouble, will you be able to dump the duplex without getting hurt too much? Keep in mind that a duplex is a harder sell then a single family home. Will you be ably to get a convention loan to buy this duplex? I would rather go that route.

[WPOZZZ]

How much is the duplex? Outright purchase, or mortgage?

[uncle_scott]

WPOZZ - The duplexes I am looking at are around $150000. They would have a mortgage with a 20% down payment. We will be able to financially qualify for the new loan on the rental property based on our income. The 20% down is the part I would use the HELOC or the cash out refinance for. I will eventually be able to save for it based on rental #1 cash flow, but that will take approximately 4 years. If possible I would like to buy now knowing that I will hold it.

Look171 - If worse came to worse, I would dump our first single family rental. My whole goal with rental property is to buy, hold, sell - until I eventually have the money to buy a 4-plex or greater. I see the most cash flow benefit from a multi-unit. They are just very expensive to get into from the ground floor.

[MRM]

Conventional wisdom is that you do not put your home at risk for investment purposes. Your home is exempt if worse comes to worse, but your investments are not. Most financial planners would probably encourage you to be debt free on your primary residence and leverage your investment properties.

[MT930]

I would not ever leverage my home on a residential or commercial rental or project.

It's the only safe harbor when things go bad. Wait save the cash sell something but don't let a bank put a hook in your house. Rule one in R/ E Investment 101.

I watched a few very nice personal homes go away that were hooked to commercial projects and multi family projects in the last rodeo 2009-2011.

Doing it with a variable interest rate makes even less sense.

[1990C4S]

What percentage of your investments will be in residential real estate under this scenario?

I'm a big fan of diversification.

[uncle_scott]

MRM, MT930 - Your points are well taken, and I understand that this is risky to gamble any portion of my primary house on a separate real estate transaction.

1990C4S - I have a well-funded 401k after 10 years in public service, and I have a state retirement pension of 2% per year averaged over my highest three year's salary. I will have a fully funded pension and retirement at 30 years, but I want to diversify my overall investments.

Real estate is a 'side business' if anything. My long term goal is to acquire enough cash flow properties that my monthly expenses are $0, and then I just sit and hold the properties indefinitely.

I still consider myself to be a young guy at 31, and I am due to have my first children, twin girls (holy crap, that is scary!!) in April this year. The future scenario would be to sell off a few rental homes to pay for their college in about 20 years. All the while staying the course in my normal day job to make my payments, earn a paycheck, accrue 401k match, and meet my pension requirements. I guess you have to have something to do too, and I enjoy urban planning, so I can't complain.

[look 171]

It is only 30k for a 20% down, so I should take a really hard look even if its floating rate. I was under the impression that you were going to pull out the whole shebang and pay for the duplex in full. I really think you are on the right track at such young age. I bought my place when I was 29 so you are light years ahead of me. I think you can play it pretty safe and if push comes to shove, you sound like you can hack the payment for a couple months should you get a dead beat tenant. I have the same plan, sell off some of y stuff and sent them off to college. its going to be a scary 100k per year by then.

How much does a unit rent for? Now its time to do this, if you ask me due to the low interest rate.

[wdfifteen]

Leverage will get you riches or it will put you in the poor house. Borrowing money on your residence for a down payment is an aggressive move that is not for the faint of heart. It's a gamble that I never hesitated to take before I had kids. But - twin girls on the way? Time to think of them.
Money problems are the #1 cause of family problems. The affect on them is a risk the banks don't take into consideration but it is a real risk. Time to be conservative.

[uncle_scott]

Look171 - The current property I am looking at is being lived in on one side, and rented for $675 on the other side. Payment on $130,000 at 5% is $700, add Insurance, and Tax of $200 a month and we have $900. Even conservatively saying $600 per side for rental, we would cash flow at $300. That isn't large money, but it is enough to cover costs and continue building a reserve. If I can get $700 per side, then I would be at the $500 per month mark cash flow, and that is really my goal. I want to own 10 properties that all cash flow $500 per month. That would be a nice self-filling nest egg, and would eventually pay all of my day-to-day bills if I needed it to.

wdfifteen - Excellent point. I am not planning for more than my wife and I. Stability it key.

[fintstone]

Use the Vegas nightmare scenario. If you buy this third property and all three drop 50% in value over the next 6 months (and a third of the people in town move away to look for work), how long can you make the payments if all your tenants either exit or stop paying? You can't sell or refinance because you are suddenly way underwater on all of them. What if this upheaval also impacts your employment and your pay is cut and/or you lose your job?

[MRM]

There's a concept in philosophy called Pascal's Wager, after the famous mathematician, physicist and philosopher. He's the guy Pascal computer language was named for, but you're not old enough to remember that. (BASIC - Beginner's All-purpose Symbolic Instruction Code, COBOL - Common Business Oriented Language. Fortran - a made up word that doesn't mean anything. C? Way too advanced and complicated to teach a grasshopper, but I digress).

Anyway, Pascal's Wager is basically that the bigger the downside risk, the more conservative you should be. At its extremes, even an infinitesimal risk should prevent you from trying something that could result in a catastrophic outcome, no matter how remote the possibility. Pascal argued that the risk of not believing in God was the loss of your immortal soul, while the cost of believing in God was fairly nominal. Therefore, a rational person should believe in God.

Pascal's Wager can be applied to your situation. Losing your house would be catastrophic. No matter how unlikely the outcome may be, you don't accept the risk to catastrophic outcomes. You're too young to place your home at risk. Pay off your mortgage so you own your home free and clear. Put enough money into the bank so you can survive a year-long downturn. Then leverage the Heck out of all your investment properties. That's where you should be aggressive and where you will reap the reward.

EDIT. $500 per unit per month profit is way too thin to risk on. That margin is lost with a sneeze. You're risking tens of thousands of dollars for a $500 a month upside profit. That's way too thin.

[Rick Lee]

I'd be surprised a mortgage co. will let you used borrowed funds for a down payment. Usually they want to see seasoning of DP funds. And the HELOC will show up on your credit report as a debt long before your rental income appears in the income column. If you have enough liquid cash to make the DP that way and then can time both loans to close on the same day, the two lenders wouldn't know about each other's loans. But that's some tricky stuff.

[uncle_scott]

It might help if I give a few more specifics. I am certainly not saying that I would leverage my entire primary home value, and any new home loan included in my primary home would be paid for by me through my normal income. Here are the estimated numbers simplified, but fairly close.

Current home loan $310,000
Current home value $385,000 (based on recent sales in the neighborhood)
Cash out refinance loan at 90% LTV $346,500 Payment increases approx. $200 per month
Cash pulled out of home $36,500

That gives me the 20% downpayment I need on a $150,000 duplex as well as a $6,500 buffer for property improvements (appliances, carpet, paint, etc.), and so far it has cost me an appraisal, and $200 per month. I self manage my other property, and would intend to do the same here, so there are no additional management fees.

The rental property will cash flow somewhere from $500-700 per month depending on renters. The home I am in now is not the end all be all home. Eventually we will sell and buy another property. We are essentially utilizing some of the equity early in this scenario as opposed to selling to cash out. and then deciding where to put that money at the time of sale. With the addition of the rental income my monthly payments do not increase, and I am able to purchase the property years earlier than I would be able to by saving through my current rental.

Do those numbers make it any less risky seeming, or is my judgment clouded by the possibility of getting into another investment property before I am actually ready?

[fintstone]

The only way it seems risky has less to do with the numbers you post, and more to do with your income and just how sure a thing that is. As long as you can make all the payments for an indefinite period of time...there is really no risk. But otherwise, all three of your properties are in the same market (and your employment) and there is no diversification. Things will likely go well...but when/if they go bad, they go bad fast and hit everything. You still have to make the payments regardless. Note the Vegas situation above. My new home dropped from around $700K in value to about $285 over a 6 month period...and both my wife's job and mine were suddenly scheduled to go away in just a few months. 10 years later, it is only worth about $420K. My options were painful. I could stay there...and my wife and I would have each taken at least a 50% pay cut (if we found work at all). Gradually our savings would run out and our salaries would not cover our bills. The other option would be to quickly find other, more commensurate work elsewhere and leave the house vacant (which we did) and live in a much lesser lifestyle until the economy recovered and we could sell or rent the home. Of course we still had to make the payments.

Fortunately for me, my other rentals were in other states that were not hit quite as hard in the housing slump (most only lost about $100K in value and rents were stagnant) and I had a good deal of equity in them already. Now those are doing very well.

Like your plan, I did have the first one paid off in time to use for my daughter's college...but, she got a scholarship and didn't need it.

[wayner]

Just wondering what the tax implications are of selling an appreciating asset that has been depreciated for tax purposes??

[fintstone]

Depreciated amount is essentially treated as gain (subtracted from cost basis). If you pay $100K for a house and depreciate it fully, then sell it for $150K (profit of $50K), then you are taxed on $150K gain.

[WPOZZZ]

You have a good head on your shoulders, especially investing towards your future at your age. I know you want to set things up for your future, but with twins coming in a couple of months, I would hold off. You don't need that kind of stress. Perhaps after things settle down, you can revisit investment scenarios.

[berettafan]

Originally Posted by MRM

There's a concept in philosophy called Pascal's Wager, after the famous mathematician, physicist and philosopher. He's the guy Pascal computer language was named for, but you're not old enough to remember that. (BASIC - Beginner's All-purpose Symbolic Instruction Code, COBOL - Common Business Oriented Language. Fortran - a made up word that doesn't mean anything. C? Way too advanced and complicated to teach a grasshopper, but I digress).

Anyway, Pascal's Wager is basically that the bigger the downside risk, the more conservative you should be. At its extremes, even an infinitesimal risk should prevent you from trying something that could result in a catastrophic outcome, no matter how remote the possibility. Pascal argued that the risk of not believing in God was the loss of your immortal soul, while the cost of believing in God was fairly nominal. Therefore, a rational person should believe in God.

Pascal's Wager can be applied to your situation. Losing your house would be catastrophic. No matter how unlikely the outcome may be, you don't accept the risk to catastrophic outcomes. You're too young to place your home at risk. Pay off your mortgage so you own your home free and clear. Put enough money into the bank so you can survive a year-long downturn. Then leverage the Heck out of all your investment properties. That's where you should be aggressive and where you will reap the reward.

EDIT. $500 per unit per month profit is way too thin to risk on. That margin is lost with a sneeze. You're risking tens of thousands of dollars for a $500 a month upside profit. That's way too thin.

A good post.

I would however point out that increasing equity through principal pay down or increased value is a type of return. We can't ignore that.

Lots of good advice in this thread.

Keep in mind every dollar you spend on something besides your mortgage is, in effect, leveraging your residence.