Planning our investment strategy

[Accent]

I've been following the MMM site and forums for over a year, but am posting for the first time as my wife and I are considering our real estate investment strategy for the next few years. We are really lucky in that the only home I’ve bought has appreciated significantly and also has a lot of cash flow potential, and I want to use that opportunity in the best way possible.

The details: I’m 32 and recently married to a great woman with the same financial goals. We’d both like to be financially independent by the time I reach 40, and one of us may stop working in about two years if we have kids then. We live in Washington, DC, in a house I bought in January 2011 for $355k before I met my wife.

Our neighborhood, which is mostly city rowhouses nearly identical to mine, has seen a lot of gentrification and renovated homes within a two block radius have sold for $650K-$700k in the past year. This year Redfin named it named the most lucrative neighborhood in the country to flip homes, with an average gain of $312K. My home was appraised at $504K when I refinanced in early 2013, but it hadn’t seen much updating or renovating.

The four-bedroom house is nearly 100 years old and in many places shows its age. The first thing I did when I bought it was convert the basement into a separate rental unit that I rent out for $1,175. Before we married I also rented out the extra bedrooms for about $800 each, so with my monthly payment of $1840 I was living for free and still getting cash flow. Since we got married and my wife moved in we only rent the separate basement unit out, meaning we have a monthly payment of $665. Right now we are focusing on completely updating the place in order to increase its value and make it on par with the newly renovated homes on the block.

Our financials: Since we got married we’ve been able to save between $4,000-$4,500 per month (about 60-65 percent of income) but that would go way down if we have kids. No debt other than the $1,840 mortgage payment.
Savings: $60,000
Vanguard VTSMX: $12,200
Simple IRA: $5,629
Mortgage owed at 3.75%: $327,000

My wife just got a 401k through a new job she started last month and I greatly increased my contributions to the IRA through my employer this year, so we are upping those savings.

The options: We’d like to move to a more rural and lower COL area in the next two to three years but stay within 150 miles of DC. We’d also like to invest relatively local, also within 150 miles and would rather buy and hold for the steady cash flow. So after completing renovations, here are the options I’ve been able to come up with, but I’d like to hear your thoughts.

A.   Move out of DC in two years and buy a fixer upper home with a conventional mortgage for us to live in. Rent out DC property indefinitely, which conservatively with basement unit could bring in $3,500 per month. Use HELOC on DC home to buy second investment property (likely SFH or duplex). Sell primary residence after fixed up in two to three years and buy new more long-term primary residence with capital gains. Use savings and financing to buy third investment property etc.

B.   Buy an investment property in regional city in 2015 using combination of savings and a HELOC. Move out of DC in two years and buy a fixer upper home with a conventional mortgage for us to live in. Rent out DC home for up to two more years, then sell and be able to still pocket capital gains as a primary residence. Then sell our new fixer-upper and do the same with the earnings. Use those capital gains and savings for buying more permanent primary residence and second and third investment properties.

Our monthly expenses are around $2,500 nowadays, and with a family I’d need a cash flow of probably $3-4K to declare FI. With option B we could likely get more cash to accumulate more diverse properties within the next 5 years, but I’m not sure it could equal the cash flow of the DC house.  On the other hand, the DC house is so old that I’m always afraid of large unexpected maintenance costs that could eat up profits quickly, and I also worry about a potential bubble. Part of me wants to sell it and get the cap gains to start diversifying, but I also think we are pretty lucky to have this property. What should I be considering?

[sammybiker]

No real comments on your options but I love the house hacking bit you did (basement rental + bedroom rentals) and great work on the equity gains.

[waltworks]

Several points, in no particular order:
-Convert VTSMX to VTSAX (all you need is a $10k+ balance so you're there) and save .12% or so in fees. Free, you can do it online from your Vanguard account in 45 seconds. Doesn't sound like much but it's free money.
-Your net worth is almost entirely tied up in RE and cash. I would NOT look to buy more RE - you need to diversify and put that $60k to work. More index funds, bonds, whatever. Max those pretax accounts if available.
-You need to start identifying specific properties that you could buy that would work for your strategy. Your DC place is a terrible rental (way under 1% rule, 100 year old house? Not a good combo) and you should probably look to lock in your gains if/when you move, rather than rolling the dice on more appreciation. I don't know your 150-mile-radius-from-DC market at all - it might be that there's not really much for a RE investor there and you are better off doing something else (or investing somewhere else).

-W

[Accent]

Thanks for the comments and the insight. I'll convert the Vanguard account this afternoon. My wife and I are also working on maxing our IRA and 401K, wish we had gotten on that years ago but we'll make up for it. Your point on diversifying more in stocks and bonds is something to definitely consider... Since I've been a landlord successfully for over three years at my current house and have gotten lucky with appreciation it makes it seem like a great thing to dive into, but I shouldn't forget about diversification into other things. 

Walt, you said my DC house is a terrible rental. Since purchase price was $355k, if I can bring in $3,500 per month conservatively wouldn't that (almost) meet the 1% rule? Or is the rule based on the current value of the house? Also, given that the monthly mortgage, tax and insurance payment is only $1,840, even budgeting $500 monthly for maintenance and repairs I would still cash flow $1,160 per month. It seems like I'd need to buy at least three cheaper properties that are great deals to get to that number, which seems like a bigger headache. I'm trying to decide if that's worth it. I could potentially beat that return by putting all my gains in the market, but that could be too much volatility for us.

We are in the first stages of looking at nearby RE markets to get into that would meet the 1% rule and has houses we easily buy with cash and a HELOC, but have a lot more research to do. For example, Baltimore is about 40 miles away and has some small homes under 100k that could rent for $1,000 and up.

[waltworks]

Without a long lecture on the 1% rule:
-1% rule is based on the VALUE of the house. That is your money (that you'd have if you sold it). Is it working as hard as it could for you?
-Examine your  assumptions about management costs, vacancy, maintenance, legal costs, extra insurance costs, etc before you're so sure on the cash flow number. Even if you clear $1000 a month after everything - that's a horrible return on the ~$350k or so it sounds like you have in equity. And it's risky, in that the house is very old and could have some major problem come up that could simultaneously cost a lot of money and make it uninhabitable for some period of time (or the DC market could tank).

You should *definitely* max your IRAs and 401k for the year with some of that $60k in cash. The real estate strategy going forward is up to you, but you should do a LOT more reading so you understand what you're getting into.

-W

[Accent]

Thanks a lot for your thoughts Walt... The part on whether the equity in the house is "working as hard as it could for me" got me thinking more broadly about the possibilities. I've been reading and thinking more in the past few months about investing and RE but realize I have a lot more to do before making any big decisions. In the meantime my wife and I are focused on living below our means and saving as much as possible.

[waltworks]

It would probably be a good idea to post a case study at some point on one of the other boards (ie Ask A Mustachian/Investor Alley). It sounds like you guys are super frugal and great at saving - but you need to put your spare cash to work and it sounds like you're overly cautious there (having $60k in cash and not bothering to max tax-advantaged accounts is a double-whammy bad move, for example).

If you're comfortable with it, a case study might be very useful to you. If you're not comfortable posting one, reading others may give you some ideas, too.

-W

[GrayGhost]

What you seem to have going for you is a lot of discipline, and a very highly valued house. Unfortunately, you don't have many assets right now, and that's a big problem if you want to retire in eight years. $180k just won't cut it at all.

Anyway, I echo what Walt says about your home, it doesn't meet the 1% rule (not even at the purchase price) and now that the value has gone up, it doesn't meet it at all, and once you take into account opportunity costs, that's a serious sign to sell. And that's what I'd do--improve and renovate, and then sell.

I do really dig the idea of buying, improving, and selling houses every 2-3 years. This can be a great way to accelerate the march to early retirement. What I don't dig is the desire to use HELOCs. Sure, you can get great returns since your leverage is off the charts, but your risk, naturally, is elevated, and that's not something I'd recommend for a guy who wants to retire in eight years.