Case study: Turning home to rental in Southern California... good/bad idea?

[Spondulix]

[edit: updated with case study info] Just exploring an idea... renting our home (in Los Angeles) and buying a second a few miles away. In theory, is it a good investment opportunity?

Market Value: 550k
Original Purchase price: 410k
Original Mortgage Amount: 328k
Interest Rate: 3.875%
Mortgage Term: 30 years
Term remaining: 25 years
Amount remaining on mortgage: $280k
Gross Rents: $2500-3000 (no utilities)
Principal and Interest (the P&I of your PITI - should match with the above info): 1425/month
Taxes and Insurance (the T&I of your PITI): 600/month
HOA costs: 0
Deferred maintenance notes: needs new roof (some point in the next 5 years.)

Second home would probably be $450-600k range, less than 10% down (if we did it now)

Reasons we're considering:

• We need a house with more space for a growing business, but we already have 50% LTV in our current house
• We've got a low interest rate and very low payment relative to rental prices in the area. After basic costs (mortgage, insurance, tax), we could net $500-1k/month (plus tax write-offs)
• We qualify for an FHA loan. I looked into a piggy back HELOC loan for the 2nd, but prefer FHA (fixed rate)
• Mortgage insurance on 2nd home would be $400/month at most (high, but likely net positive with rental income)
• The broker I spoke with said if you think of MIP like a mortgage rate, the MIP would be the equivalent of paying a 4.4% loan vs 3.6%
• I haven't done the math, but good chance we could refinance within a few years (having 20% into the new house). This is assuming rates are still below 4.4%.
• Being a landlord isn't an issue, and our house is in great condition (new AC, water heater etc), so a pretty good idea of expected maintenance and major expenses.

Reasons not to do it:

• Second home will be over 90% LTV (if we buy in the near future)
• I've always viewed PMI/mortgage insurance as wasted money... but is it leveraging debt in this case?
• A second house is a lot of eggs in one basket (SoCal real estate). The ratio of our home equity to retirement/investments is about 3:1 (which is already high - I'd prefer more in investments just for diversity)
  
• Earthquakes. We'd have insurance on both homes, but the deductible is 15%. The two houses would probably be within 5 miles of each other, so a big one could be costly. At least in the stock market, you aren't paying 15% just to recover after a huge loss.
• It's SoCal, where homes are stupid expensive (although the homes we are talking about here are under $600k, and demand for the area is rising).
• Signs of housing bubble (starting to see frantic "gotta buy" behavior like we saw in 2006-07. But maybe it's always been like that)
  
• 2nd home in SoCal could be a lot of work (and risk) relative to investing in the stock market (indexes are easy!). Our first home was purchased pretty close to the bottom - it's gone up 35% since 2009, which is still less than S&P returns.

What other considerations am I missing? My initial instinct is to wait til we have 20% to really consider it, and just power invest in the meantime. It doesn't help the business growth issue, but it's manageable (for the time being).

[waltworks]

Barring appreciation, the house is an awful, awful investment. Even giving you a few breaks for having a high-end property, you're still barely going to cash flow, if at all. And you are putting all your eggs in a SoCal RE basket. Probably not smart. Add in the PMI and it's a no-brainer to sell if you want to move.

-W

[Spondulix]

Thanks Waltworks! After I posted I started digging around the RE section, and realized how little I really know about investment RE - that in itself is a red flag to steer clear til I know more (It would be great to have a sticky about the 1% rule and 50% rule, cause I didnt know about either). So, thank you for the honest advice!

[NoNonsenseLandlord]

It's already a sunk cost.  A terrible investment if you have the money in your pocket.

I show about $2000 a month in PITA.  $2500-$3000 in rents.  You may cash flow $6K a year.  Not including vacancy, maintenance or property management.  Some of the PITI (the P part), is equity gain.  Appreciation at 5% is ~$25K a year.  The bay area is growing even faster.

You other option is to sell.  $550K less 10% selling expenses (commission, buyer closing costs, etc.) nets you ~$500K.  $220K after paying off the mortgage.  No capital gains if  you lived there 2 of the last 5 years.

Can you get $25K return with your $220K after the sale?  Will you have to pay for a property manger?  Do you have enough $$ to cover 2 mortgages in a vacancy situation?  Can you do any of your own maintenance?  Do you know how to screen tenants?

I am not saying this is a good investment, but it could be better than anything else you can get.  Of course, it's more risk too.

[Poorman]

A good rule of thumb is to sell if you wouldn't buy this place as an investment to begin with.

Personally, the returns aren't all that compelling so I would sell and use the equity as down payment for your next place.  Having a reduced LTV will lower your risk as a business owner and may provide more flexibility.  If you were already in the landlording business, I would suggest investing it in cash flowing property outside of the LA area (as waltworks was alluding to) but for everyone else just take the tax free money and put it towards your next place. 

Counting on 5% appreciation isn't a good idea.  You may get that much or more in the short term, but over the long haul LA averages about 4.2-4.4% and we've already experienced huge gains, which means future years will need to show flat or even declining prices to get back to the long term average.  In other words, there's too much risk this late in the cycle to be speculating on appreciation.  The time for that was 4-6 years ago.

[Spondulix]

Very helpful info - thank you! Yeah I think if we want to get into investment properties out of state is best (and we have family in investment RE, so might be able to piggyback off the areas they already know.)