31 y/o case study!

[Evildunk99]

Hello mustachians, first time / long time! 

About me:  31 y/o, married, living just outside of Philadelphia (Conshohocken).  I'm excluding wife's situation until she finishes paying off student loans.  My short term goal is to use savings + Roth IRA to purchase a 2nd home, so I can rent out my current house, and hopefully snowball that into a passive income stream to achieve FI.  The current house would cash flow ~$800 in rent, and the Roth IRA is not transferable to my 401k :(  This was from a past job that did not offer a retirement solution. 

Income:

- Gross:  $4,450 / mo ($60k / yr) + $10k bonus
- Net:  $3,150 (see deductions below)

Deductions & Tax:

- Taxes = $940
- Health Insurance (high deductible) = $100
- Roth 401k Contribution = $220
- HSA = $30

Expenses:

- Mortgage (PITI @4%) = $890
- Utilities = $350
- Car Insurance = $150
- Phone = $60
- Staple expenses* = $200
- Discretionary expenses** = $700

Total Monthly Expenses = $2,275

*Staple expenses include: gas, groceries, work lunches, car maintenance, & toiletries
** Discretionary expenses include: home improvement, entertainment, vacation, gifts, clothes, and misc.

Assets:

- House = $225,000
- $401k = $28,000
- Roth IRA = $30,000
- Car = $10,000
- Savings = $9,000
- Checking = $4,500
- HSA = $4,000
- Brokerage = $2,000

Liabilities:

- Mortgage = $140,000



Additional comments: 

- I've seriously considered getting an e-bike to commute to work during fair weather days, but the prices seem to outweigh the benefits for the 15 mile each way commute I have.  Would love to pursue that further if e-bikes come down in price!

-  The home repair expenses will come down significantly in a few years, but in the mean time are necessary to attract future renters (it's a fixer).

- By renting out my house, my savings rate would jump from ~33% to about 45%, and higher depending on how quickly I can snowball additional rental properties.

Is my plan feasible?!

Thanks fellow mustachians!!

Ryan

[Ben Kurtz]

My short term goal is to use savings + Roth IRA to purchase a 2nd home, so I can rent out my current house, and hopefully snowball that into a passive income stream to achieve FI.

Read the "Evaluating a Rental Property" post at the top of the landlording forum and then check back here.

The current house would cash flow ~$800 in rent.

I take this to mean gross expected monthly rent is around $1,700; yielding net $800 in cash flow after paying the mortgage (PITI). This of course excludes vacancy and expenses beyond taxes and insurance. By the 1% rule, the value of the rental property should not exceed 100x the effective monthly rent, or $170,000 in your case; however, you value your house at $240,000. By your numbers, houses in your neighborhood are too expensive to make effective rentals. You're far better off from a cashflow and investment growth point of view investing in something else, like an index fund in your retirement account. This dynamic is frequently true in coastal metropolitan areas with high housing costs, which often (in the U.S.) correlate to high buy-vs-rent values and ineffective rentals. The other rule of thumb to keep in mind is the 50% rule -- you will end up paying half of your gross rents in operating expenses (although this tends to be a bit lower in areas with expensive houses). By this rule you will see very little or no free cash flow from the property -- though you would slowly benefit from mortgage paydown and any value appreciation over time.

Bottom line: Houses in your neighborhood are marginal rental investments. Not terrible, but not great. Probably makes sense to own your own home (on the buy-vs-rent your personal residence calculation), but additional houses are not the thing to make your top investing priority. If you have the skills and time to buy fixer-uppers and improve them at below-average cost you could probably come out well on local houses, but that's not passive investment -- that's a second job and your profit is part hourly wage for your time.

Turning to your personal budget, you don't have a huge amount of accessible, liquid assets. I would not recommend raiding the Roth IRA to buy a second house in order to get into the landlording business. I certainly would not touch earnings, which would trigger taxes and penalties, but even the principal that you can pull out tax- and penalty-free is probably best left in the Roth. A Roth account has great tax and other attributes that it would be a shame to lose.

If you are really itching to invest in rental property, I would suggest jumping in only (1) when you have 30% of the cost of a house saved up in the bank as a down payment and renovation reserve and (2) when the value of your retirement accounts equals the value of the equity in all the real estate you own. When you build up a serious amount of wealth you can decide if you want to tilt things more towards securities or real estate, but until you've established a track record you should keep a good portion of your long-term savings in conventional retirement investments.

When your wife is free of her student loan and fully contributes to the household budget I would expect that it won't take long to start saving up some serious cash, and then you will be in a position to give this a try if you really want to. But at present I don't think you have the reserves or the liquidity to be plowing everything into a somewhat marginal rental market.

[Wayward]

I don't have advice about the house, but one thing stands out to me: it may be more beneficial to have a traditional (pre-tax) 401k, instead of the Roth
https://forum.mrmoneymustache.com/investor-alley/investment-order/msg1333153/#msg1333153
https://www.madfientist.com/traditional-ira-vs-roth-ira/

Otherwise, great job on the expenses! 

[Evildunk99]

Thank you both for the detailed responses!  I will give both articles a long read.

The way I understood the 1% rule is that it's used as a tool to gauge a purchase decision, or to make the rent vs. buy decision.  I will find out in the referenced articles I'm sure.  In this case I already own the house, and market rents have risen substantially since I purchased it.  $1,700 is the current market rent, against the $890 / mo mortgage which is how I arrived at the ~$800 cash flow figure.  It was purchased for $171k if that matters in the analysis.

The 2nd house would be in a cheaper neighborhood at the expense of a longer commute, and only after additional savings are accumulated.  Forgot to make that point, whoops :)

[Ben Kurtz]

The way I understood the 1% rule is that it's used as a tool to gauge a purchase decision, or to make the rent vs. buy decision.

There is a 1% rule in landlording which basically says that the monthly rental rate should be no less than 1% of the sticker price of the house, for it to be worth buying for use as rental investment.

Currently, you own your house (subject to a mortgage) as a primary residence. At the time you bought it, I would guess that it made sense to buy it as a primary residence as opposed to continuing to rent your living space. But that was then. In the future, if / when you move house, you will have to decide what to do with your existing house. You could keep it vacant (probably a bad idea), keep it as a rental, or sell it and re-invest the money in something else. When deciding whether to keep it as a rental or sell it and re-invest the money, given that you are already moving it is valid to use the 1% rule to re-analyse the situation: If I had an equivalent amount of cash in the bank, would this house pass the 1% test such that I would be happy to invest my cash in this house for use as a rental? If the answer is "no," then you should think long and hard about selling rather than keeping it as a rental (especially because gains on the sale of a primary residence usually get excellent 0% tax treatment).

If you sell, you will have a pile of cash left over after paying off the old mortgage and paying selling expenses. For many people, this pile of cash is necessary to make the down payment on the purchase of a new primary residence, so people don't much think about it. But if you have been saving consistently such that you can make the down payment on a new house with fresh savings, then you have the choice of investing this money wherever you think best: You could max-out your 401k at work while using this cash to live off of; you could put this cash in a brokerage account and buy index funds; you could put this cash into investment real estate that you think is attractively priced; you could reduce your mortgage on your new house. There are reams of posts discussing what investments make the most sense depending on your situation in life.

Given what I've said earlier, I think you're best off building your non-real estate savings for now so that you have a good amount of net worth spread across real estate equity and investment securities -- for example, $100,000 worth of equity in your own home and $100,000 spread among retirement and brokerage accounts. You are then well positioned to take the next $50,000 you save up and invest it in a rental property. I would caution you strongly against over-extending yourself in real estate before you have a good cushion in liquid assets and a good deal of experience in making rental properties work.

Finally, before moving further out of town and making your commute longer, think long and hard about the true costs of commuting. There are a number of blog posts and forum posts here to help you tease out some of the hidden costs. At a minimum, each mile driven will cost around $0.50 in direct automobile-related costs (people who drive frugal old cars can get that number down to $0.25 or $0.30, but your $10,000 car is probably not cheap enough), and you should value your time fairly and in proportion to your salary, especially if you are also thinking of using your time to support your landlording endeavor -- say $30 per hour. So trading 10 miles / 15 minutes each way for 20 miles / 30 minutes each way would be going from a $25 per day commute cost to a $50 per day commute cost ($10 out of pocket goes up to $20; $15 in time value goes up to $30). It might not be worth it.

[Evildunk99]

Your excellent response presented a a number of options I hadn't considered, thank you!  I think I had some ideas ingrained in my head that created some tunnel vision for me. 

[marty998]

Why are you excluding your wife's situation just because she has debt? Are you keeping separate finances?

Couples have the natural advantage of economies of scale, and we cannot judge the full picture here without seeing her "component" savings/investing capacity.

Why do you want to purchase the additional property on your own without her?