Financial rules that might be slowing you down

[totoro]

Here are some rules we don't follow:

1. Don't buy a home more than 2 or 3 times income.

Leverage is valuable.  Your credit is an asset.  It can make you a lot of money.  Not to mention that many housing markets are now at a minimum of 5x income for the average two income family.

What matters is not the purchase prices vs. income, but the out of pocket after tax cost each month.   What also matters is neighbourhood and the higher the value the better where I live.  A multi-family property is a much faster and safer way to wealth creation than a SFH if you are prepared to hold for ten years or so and you are prepared to be a landlord. 

For those of you who are scared of a crash or interest rate hike my view is that you can mitigate risk with the rental income, longer term mortgages and buying the right place.  Sweat equity can be used here too.  I have not found anything that gives a better ROI.

Do a ten year forecast and you can see how it works or not for your situation.  Make sure you factor in all expenses and risks, as well as taxation.

2. Operational expenses are going to cost 50% of rents.

This is nonsensical given the variation in house prices and rental incomes for a similar home in different markets.  A house that rents for $3000 a month in LA might rent for $800 a month in Louisiana. 

What really matters is the condition of the major components of the home at time of purchase and their expected lifespan and your expected timeframe to hold the property (ie. are you going to have to pay for replacement).  In addition, buy in good neighbourhoods  with very low vacancy rates.

If you really want to know what your costs are going to be you need to do a capital asset inventory with present condition and expected lifespan and add some contingency.  The expected lifespan of housing components is here: http://www.nahb.org/fileUpload_details.aspx?contentID=99359

3. Banking on the 4% rule.

The 4% rule is eye-opening and miraculous but you first have to save enough to get to the amount you need and it is possible that it will not work for you if you have new dreams you did not include in your calculations.  In addition, it is possible that when you need more money one year the market will be down.  There is a lack of both speed and peace of mind in relying on this alone for me. 

There is a discussion on this here:  http://forum.mrmoneymustache.com/welcome-to-the-forum/forget-the-4-swr-or-any-swr-it's-all-about-income/

4.  If you’re not willing to pay cash for it, then it doesn’t make sense to buy it on credit.

The test for us is whether it results in a cash flow positive result at an acceptable level of risk.  Housing is one example of this.  Another might be business financing. 

Even if you buy with cash, a depreciating asset is going to cost you money.  Cars can made to work on a cash flow positive basis if you have an inexpensive fuel-efficient car and you receive reimbursement for mileage for work.   We have friends who rent out their second-hand still newish $10,000 travel trailer as accommodation in a tourist area for $800 per week for six weeks and they use it the rest of the time.  It doesn't get towed by renters as it is set up at a local campsite for them. 

If you are going to buy a depreciating asset consider whether you can make it cash flow positive.  If you can't, try to buy it at its depreciated value with enough useful life left unless other factors make it worthwhile to buy new like health and enjoyment.

[pablo suarve]

I completely disagree with each of your points and had a liquid net worth > 250k by age 29.  So clearly very different approaches work for different people.  I think a lot of it has to do with risk tolerance.  Violating any of the enumerated rules of thumb introduces an unacceptable risk to me.

[marty998]

Sorry Pablo, I agree with (most of) what Totoro has written.

On point 4, I would buy a cash flow negative rental because cap growth would far outstrip the cash loss. Over time what tends to happen here is you end up with a very small cash flow due to rents rising but hundreds of thousands of magic pudding equity.

[totoro]

I completely disagree with each of your points and had a liquid net worth > 250k by age 29.  So clearly very different approaches work for different people.  I think a lot of it has to do with risk tolerance.  Violating any of the enumerated rules of thumb introduces an unacceptable risk to me.

I'm fine if you disagree.  The post says might be slowing you down. 

I agree that risk tolerance is an issue.  I disagree that violating the rules always creates excessive risk.  Why?  Because I've done it without excessive risk in a high value market experiencing little or no appreciation.  It absolutely can be done and has resulted us paying zero for housing out of pocket while accumulating equity pay down and monthly cash flow. 

If we can do it in our market that most investors would avoid then many others can too.  The thing is that risk can be mitigated in many ways, including through knowledge and experience.  If the rules prevent you from thinking about long-term and about mitigation maybe they are worth examining? 

[totoro]

On point 4, I would buy a cash flow negative rental because cap growth would far outstrip the cash loss. Over time what tends to happen here is you end up with a very small cash flow due to rents rising but hundreds of thousands of magic pudding equity.

Agreed.  Can work particularly well in a high value property with high rents where you have other taxable income taxed at a high rate that you can use the loss against.

[Spork]

...not trying to argue here... but I'm going to disagree on #1.  Yes, I understand leverage, but lower cost means lower taxes and (usually) less cost to heat/cool, less cost to furnish, less cost to light, etc.

I generally think this is a rationalization for a bigger/better house.... and THERE'S NOTHING WRONG WITH A BIGGER/BETTER HOUSE... it just doesn't usually come at a lower cost.  Now... if you're planning on flipping it and moving to a lower cost of living area... maybe this can work.  If you're planning on living there a long time... I'm not buying it.

[marty998]

On point 4, I would buy a cash flow negative rental because cap growth would far outstrip the cash loss. Over time what tends to happen here is you end up with a very small cash flow due to rents rising but hundreds of thousands of magic pudding equity.

Agreed.  Can work particularly well in a high value property with high rents where you have other taxable income taxed at a high rate that you can use the loss against.

Yep, one (wo)man's tax rort is another (wo)man's tax strategy.

...not trying to argue here... but I'm going to disagree on #1.  Yes, I understand leverage, but lower cost means lower taxes and (usually) less cost to heat/cool, less cost to furnish, less cost to light, etc.

I generally think this is a rationalization for a bigger/better house.... and THERE'S NOTHING WRONG WITH A BIGGER/BETTER HOUSE... it just doesn't usually come at a lower cost.  Now... if you're planning on flipping it and moving to a lower cost of living area... maybe this can work.  If you're planning on living there a long time... I'm not buying it.

Tell that to the Chinese who are buying up half the real estate in Sydney. Just when you think prices are stupid high, they take it to a whole new level.

[totoro]

...not trying to argue here... but I'm going to disagree on #1.  Yes, I understand leverage, but lower cost means lower taxes and (usually) less cost to heat/cool, less cost to furnish, less cost to light, etc.

I generally think this is a rationalization for a bigger/better house.... and THERE'S NOTHING WRONG WITH A BIGGER/BETTER HOUSE... it just doesn't usually come at a lower cost.  Now... if you're planning on flipping it and moving to a lower cost of living area... maybe this can work.  If you're planning on living there a long time... I'm not buying it.

I agree with you if we are talking about a SFH.  In higher value markets they pose too great of a risk for me. 

My proposition was that you can use rental income to create a win:win in this scenario.  Everything I own is multi-family.   They are cash flow positive.  When you look at the numbers I would say that a SFH is a waste of leverage and your after tax income in comparison.

[Daleth]

...not trying to argue here... but I'm going to disagree on #1.  Yes, I understand leverage, but lower cost means lower taxes and (usually) less cost to heat/cool, less cost to furnish, less cost to light, etc.

I generally think this is a rationalization for a bigger/better house.... and THERE'S NOTHING WRONG WITH A BIGGER/BETTER HOUSE... it just doesn't usually come at a lower cost.  Now... if you're planning on flipping it and moving to a lower cost of living area... maybe this can work.  If you're planning on living there a long time... I'm not buying it.

Lower cost also means smaller, which means less space (or none) that you can rent out or otherwise use to make money (e.g., you could use a workshop or home office to make money). I know someone who's house-hunting now and is very focused on having an extra kitchen that he can equip to professional standards--which obviously means more space and higher bills than most people need--because he is a professional pastry chef and will operate his business in that kitchen. Our house is huge and expensive, but since we've added a few more tenants and started holding a few events, the rentals are paying our entire mortgage (and taxes and insurance) for us.

I'm not saying your approach is wrong, I'm saying the approach that you criticize can work for some people. Specifically, it can work for people who actually will use the extra space to make money.

[totoro]

Lower cost also means smaller, which means less space (or none) that you can rent out or otherwise use to make money (e.g., you could use a workshop or home office to make money). I know someone who's house-hunting now and is very focused on having an extra kitchen that he can equip to professional standards--which obviously means more space and higher bills than most people need--because he is a professional pastry chef and will operate his business in that kitchen. Our house is huge and expensive, but since we've added a few more tenants and started holding a few events, the rentals are paying our entire mortgage (and taxes and insurance) for us.

I'm not saying your approach is wrong, I'm saying the approach that you criticize can work for some people. Specifically, it can work for people who actually will use the extra space to make money.

Exactly.  If you are living in the smallest space possible so you can pay off your mortgage you are leaving income potential on the table. 

Like Daleth our tenants pay 100% of mortgage and expenses for us and for the property as a whole and we live in an area that most investors would avoid due to high purchase prices.  We put $150,00 down and it generates enough to pay the mortgage and allow us to live for free - which is an approx. $1700-1800/month surplus which we are not taxed on and don't have to pay out for housing otherwise.

[brewer12345]

Eh, the only rule that ever worked for me was, "always remain agile, mobile, and hostile."

[Jamesqf]

I generally think this is a rationalization for a bigger/better house.... and THERE'S NOTHING WRONG WITH A BIGGER/BETTER HOUSE... it just doesn't usually come at a lower cost.  Now... if you're planning on flipping it and moving to a lower cost of living area... maybe this can work.  If you're planning on living there a long time... I'm not buying it.

Lower cost also means smaller...

Got to disagree with both of those.  First, bigger is not necessarily better (see e.g. "The Not-So-Big House"), nor is better necessarily more expensive, since better depends on a lot of subjective factors.  As for instance a McMansion in a gated community might be bigger & more expensive than my current house, but would be much worse for me in quality of life terms.

Following on from that, location contributes a lot to the price of a house.  For instance, my place might go for about $300K in the current market.  Magically move it about 5 miles to the south, and the price would be double that.  A few miles the other way, and it'd go for under $200K.

[happy]

I think the most important rule of all is "Do your own math".  By all means check it, and compare it to known rules of thumb, but once you are sure it works, don't let rules stop you. Otherwise MMM would never have got to his own space.

[Thegoblinchief]

Rules? Where we're going, we don't need rules.

Butchered movie references aside, sure I agree, but the rules of thumb are there for a reason. Every time you "violate" one, triple check your math and assumptions.

Better yet, have a community like this one do a due diligence check. It can be very easy to miss things that an outside eye can catch.

[totoro]

Yes, you have to identify all the variables first - which requires some applied study.  After that, it is a math and financial forecasting exercise.  I agree the talented posters on this site can really help with both.

If find it interesting that, while the question as to how to maximize utility in relation to transportation has been covered very well here, the maximization of the primary residence as a way to create wealth has not been examined as closely despite the fact that a strategic choice can make and save you far more over time than reducing car costs can. 

[Daleth]

If find it interesting that, while the question as to how to maximize utility in relation to transportation has been covered very well here, the maximization of the primary residence as a way to create wealth has not been examined as closely despite the fact that a strategic choice can make and save you far more over time than reducing car costs can.

I so agree. And I think there are a few key guidelines to keep in mind if you want to use your home as a way of creating wealth. In no particular order:

- Remember that it's much easier to get favorable financing--by which I mean mortgages with terms and interest rates similar or identical to the standard single-family residence mortgage--for multi-units that contain four units or fewer. Once you hit 5 units, you're in a totally different financing landscape: much shorter terms, higher interest, and usually you can't get an interest rate that is permanently fixed.


So your ideal situation, if you want to live in a multi-unit and have renters pay your mortgage for you, is a place that is 4 units or less when you buy it. And remember it doesn't have to be ideal when you buy it; for instance, you could get a 4-unit of 1BR and 2BR apartments, then after purchase combine a 2BR and 1BR to make a big one to live in, and rent the remaining two smaller ones if that works better for you.

- Avoid homeowners' associations, condo parks and co-ops like the plague. HOA's/condos/co-ops mean lots of rules that almost seem designed to make it impossible to make money from your home--rules prohibiting home-based businesses and even home offices; rules about how many people can live in a house; rules about subletting, Air B&B, etc.; I've even seen HOA rules that prohibit having actual guests, including members of your own family, stay with you for more than 5 nights in a row!

And on top of that, you're actually paying extra, in HOA/condo/etc fees, to have these rules imposed on you and to be surrounded by neighbors who mostly like these rules... meddlesome neighbors, in other words, some of whom can be counted on to report you if you violate them. If you even remotely consider buying a place that is subject to HOA or condo rules, at least get a copy of the rules and read them very closely--preferably with the help of a lawyer--before you commit.

- If your plan includes any type of home business, then before you buy, take a look at the local zoning code (again preferably with the help of a lawyer) to determine what you have to do or not do in order to be able to run your business from the home. Especially pay attention to whether the type of business you want to run is permitted "as of right" or only conditionally, upon application. Most of us here would probably be looking at what's sometimes called "no impact home businesses"--ones where you and possibly family members are the only employees and there are few to no daily visits from customers, vendors, etc.

Ideally you do want to make sure your business is legal to run in your home, because if it's not, that would be a loophole any insurance company would jump on to try and get out of covering you when you need it (e.g. when a customer is somehow harmed by your business or even by slipping on your icy sidewalk when they come over for a meeting). Whether that ideal is necessary/important in your situation depends on the facts and your risk tolerance.