Author Topic: Should I build this rental house as an investment?  (Read 3870 times)

sandandsun

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Should I build this rental house as an investment?
« on: January 14, 2015, 03:49:23 PM »
My wife and I own an extra lot beside our home in a nice subdivision of 1-2 acre lots.  There is no money tied up in this lot (gift) and we have no intention of selling it as long as we live in our current home (although we would likely sell if we moved/sold our primary home in retirement).  We have been content to simply own the lot and have extra space that is not occupied by others.

Both early 40's, probably FI now , but still working by choice to increase NW and SWR.  Will likely retire in 6-10 years, around age 50 for both.  Current home is paid for, no debt.
We have never been landlords and probably would not be considering it if the opportunity below had not presented itself. NO experience with renting, so want to know what you experienced landlords think about this situation...

Should we do this?:
I believe we would be able to build an approx. 2000 sq ft, multi-level, home with a small footprint on this lot (in the process of verifying, small footprint due to utility right-of-ways).  It would cost 200k and we would use the lot (I assume that is allowed?) as part of the down payment and kick in cash for whatever amount is needed to avoid PMI. So we are talking about a mortgage of 200,000 with a down payment of 40k.  On 30 yrs at 3.8%, payment is 926/month.  Insurance and taxes would be approximately 200/ month (that is an overestimate)- so 1126 approximate monthly carrying cost.  I realize I need to budget for upkeep, but not sure how much and, since this would be new, high quality construction, I hesitate to automatically add a rule-of-thumb-amount. 
Based on what I am seeing in our local market, rent could be 1800/month (probably more since lawn maintenance would be included).  There is VERY little in this area/price range that is available (something similar in a not-as-nice neighborhood rented for 1800/month within 3 days of posting a couple of weeks ago).
I have a life-long friend who is moving back to the area.  Retiring with a defined benefit pension and can afford the rent with no problem.  Has some disabilities so it would benefit us both to have her nearby (she would be home during the day, can keep an eye on things- and I can handle yard maintenance as I currently handle it for that extra lot anyway).  Additionally, we would have the house built with accessibility in mind (for both her and future occupants/possibly elderly parents down the road etc.).  We would charge her about 1600/month to cover outlay (1126) and save the rest with an eye toward early/15 yr payoff (that's what we did with our current home until we amassed enough to pay it off early).  She would be there for at least 5 years (until her son finishes HS) but probably longer based on human tendency toward status quo and it's a really nice area that I think she will love.

Is this a good idea? what are the cons that I am not thinking about?  Our real estate market never really tanked and houses sell pretty quickly- especially in my area that is an established subdivision with little turnover.  I have no doubt we could sell if/when needed at a slight profit, but wouldn't want to do that as long as we are living next door. 

what am I mostly worried about? If she did decide to leave and I had to rent it to strangers, I could likely get 1800/mo, but what are the hassles in that price range? I imagine there are many families who want short term rentals until they can find a house to buy?

Thanks y'all, in advance, for any advice you can share!


iamlindoro

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Re: Should I build this rental house as an investment?
« Reply #1 on: January 14, 2015, 04:06:50 PM »
A couple of things missing/off in your calculations to consider:

* 3.8% is the mortgage rate you might be able to expect with owner occupied, but not for an investment property.  I would figure 4.5% or higher.

* Your insurance also will need to be landlord insurance and include liability coverage, and may be higher than you expect.

* Figure 8-10% vacancy into your figures.

* I've seen maintenance/repair estimates range from 2-5%.  Figure on the lower end of this, but maintenance things *will* come up, even with new construction.  Eventually you will need a new roof, boiler, whatever, and this is why you budget repairs/reserves from the very start.

When I use 4.5% mortgage, 10% vacancy, 2% repair/reserves, $800/year in insurance, $2000/year in property taxes (1%), I get a cash return of 6.62% on a rent of $1800.  Not negative cash flow, but also a little worse than just sticking the investment in an index fund.  Total ROI is 12.48% after equity accrued.  Doesn't even hit the 1% rule, let alone 2% (.79%).

As real estate deals go, this one is pretty poor.  If I were to invest the same $40K down, I'd buy 4 $50K houses in places that hit the 2% rule, and rake in an extra ~$150 a month on the same investment.

sandandsun

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Re: Should I build this rental house as an investment?
« Reply #2 on: January 14, 2015, 07:02:20 PM »
Iamlindoro- thank you for your reply!
A couple of probably silly questions:
-when I get the mortgage, why wouldn't I apply for it as though I will be occupying the home? Since it is being built next door, it's feasible that I might want to build a newer home for myself and then maybe I change my mind after it's built and stay put (with mortgage already in place at that point)?

- you wrote "When I use 4.5% mortgage, 10% vacancy, 2% repair/reserves, $800/year in insurance, $2000/year in property taxes (1%), I get a cash return of 6.62% on a rent of $1800.  Not negative cash flow, but also a little worse than just sticking the investment in an index fund.  Total ROI is 12.48% after equity accrued.  Doesn't even hit the 1% rule, let alone 2% (.79%)."
The property taxes on my own home (also valued around 200k) are about 1100/year. Insurance you are probably correct - mine is 75/month on owner occupied... What do you mean by "2%" rule?... Sorry If that's a dumb question - I'm new to this and don't really know the basics of what to look for re: ROI on rentals...
- also, I can't stick the down payment/equity in the market if that equity is in the lot I already own (although I'm still not clear if that equity can be used to meet 20% down?)... In that case it's a decision between doing nothing w equity/lot or using it as DP on mortgage.  I am guessing the lot is worth close to 40k- so I am guessing that I would only need to add a small amount of cash, if any, to get to 80% LTV ratio...

Thanks again for your reply- info from experienced investors like you is exactly what I am looking for!

iamlindoro

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Re: Should I build this rental house as an investment?
« Reply #3 on: January 14, 2015, 07:22:52 PM »
Probably not silly questions.  I'm new to many of these concepts myself.  I recently bought my first investment property, but tried to do a LOT of learning before I got there.  This site and particularly BiggerPockets were great resources, but I found that you simply have to start reading, and reading, and reading, absorbing information over time.  There's very little out there in the way of a "first timers guide to real estate investment."  I found that most books were interesting, but spoke too generally to be of much use to me.  I had to absorb the details by reading a lot of BiggerPockets forum threads.

-when I get the mortgage, why wouldn't I apply for it as though I will be occupying the home? Since it is being built next door, it's feasible that I might want to build a newer home for myself and then maybe I change my mind after it's built and stay put (with mortgage already in place at that point)?

This would be mortgage fraud.  Ultimately you're going to occupy one and rent the other.  You would probably have to endure some very pointed questioning in trying to get a loan to get the property built.  I'm sure it happens all the time, but it is technically a crime.

- you wrote "When I use 4.5% mortgage, 10% vacancy, 2% repair/reserves, $800/year in insurance, $2000/year in property taxes (1%), I get a cash return of 6.62% on a rent of $1800.  Not negative cash flow, but also a little worse than just sticking the investment in an index fund.  Total ROI is 12.48% after equity accrued.  Doesn't even hit the 1% rule, let alone 2% (.79%)."
The property taxes on my own home (also valued around 200k) are about 1100/year. Insurance you are probably correct - mine is 75/month on owner occupied... What do you mean by "2%" rule?... Sorry If that's a dumb question - I'm new to this and don't really know the basics of what to look for re: ROI on rentals...
- also, I can't stick the down payment/equity in the market if that equity is in the lot I already own (although I'm still not clear if that equity can be used to meet 20% down?)... In that case it's a decision between doing nothing w equity/lot or using it as DP on mortgage.  I am guessing the lot is worth close to 40k- so I am guessing that I would only need to add a small amount of cash, if any, to get to 80% LTV ratio...

I suspect what you'd actually need would be a construction loan, not a mortgage, but it's probable that you could refinance that into something more traditional once the building is done.  Since I haven't done exactly what you're proposing, I think what you're looking at is:

1) Go to a lender requesting a construction loan for the cost to build the home, offering the land and other assets as collateral.  Get approval.
2) Get house almost built, and apply to have the construction loan converted to a traditional mortgage.  At this time, it's likely the land and house would be packaged into a single "product," at which point the land value does actually become equity.

Regarding your questions of the 2% rule, there are basically two rules that real estate investors commonly use to evaluate the merits of a potential investment:  the 50% rule, and the 2% rule. 

The 2% rule states that monthly rental should be 2% of the property's purchase price.  This is very, very hard to hit in some markets, and easy to hit elsewhere.  There are a lot of successful landlords who only hit 1.5% or even 1%.  Your deal looks to be about .79% (and that's without even counting the purchase price of the land itself).  This tells us that the same money invested in a 2% property would probably have much higher returns.

The 50% rule states that operating expenses for the property (maintenance, utilities, etc.) will average out to 50% of the rents collected in the long run.  Thus:

(Rent Collected / 2) - PITI = Cash Flow

Both rules are very simplistic, and there are exceptions to every rule.  They're just quick tools that RE investors can use to identify properties that are very likely to be good investments.

ShoulderThingThatGoesUp

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Re: Should I build this rental house as an investment?
« Reply #4 on: January 15, 2015, 05:58:20 AM »
How much could you sell the lot for?

sandandsun

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Re: Should I build this rental house as an investment?
« Reply #5 on: January 15, 2015, 07:09:42 AM »
Thanks for your reply! responses below!

Probably not silly questions.  I'm new to many of these concepts myself.  I recently bought my first investment property, but tried to do a LOT of learning before I got there.  This site and particularly BiggerPockets were great resources, but I found that you simply have to start reading, and reading, and reading, absorbing information over time.  There's very little out there in the way of a "first timers guide to real estate investment."  I found that most books were interesting, but spoke too generally to be of much use to me.  I had to absorb the details by reading a lot of BiggerPockets forum threads.



Quote from: sandandsun on January 14, 2015, 07:02:20 PM

-when I get the mortgage, why wouldn't I apply for it as though I will be occupying the home? Since it is being built next door, it's feasible that I might want to build a newer home for myself and then maybe I change my mind after it's built and stay put (with mortgage already in place at that point)?




This would be mortgage fraud.  Ultimately you're going to occupy one and rent the other.  You would probably have to endure some very pointed questioning in trying to get a loan to get the property built.  I'm sure it happens all the time, but it is technically a crime.



Quote from: sandandsun on January 14, 2015, 07:02:20 PM

- you wrote "When I use 4.5% mortgage, 10% vacancy, 2% repair/reserves, $800/year in insurance, $2000/year in property taxes (1%), I get a cash return of 6.62% on a rent of $1800.  Not negative cash flow, but also a little worse than just sticking the investment in an index fund.  Total ROI is 12.48% after equity accrued.  Doesn't even hit the 1% rule, let alone 2% (.79%)."
The property taxes on my own home (also valued around 200k) are about 1100/year. Insurance you are probably correct - mine is 75/month on owner occupied... What do you mean by "2%" rule?... Sorry If that's a dumb question - I'm new to this and don't really know the basics of what to look for re: ROI on rentals...
- also, I can't stick the down payment/equity in the market if that equity is in the lot I already own (although I'm still not clear if that equity can be used to meet 20% down?)... In that case it's a decision between doing nothing w equity/lot or using it as DP on mortgage.  I am guessing the lot is worth close to 40k- so I am guessing that I would only need to add a small amount of cash, if any, to get to 80% LTV ratio...




I suspect what you'd actually need would be a construction loan, not a mortgage, but it's probable that you could refinance that into something more traditional once the building is done.  Since I haven't done exactly what you're proposing, I think what you're looking at is:

1) Go to a lender requesting a construction loan for the cost to build the home, offering the land and other assets as collateral.  Get approval.
2) Get house almost built, and apply to have the construction loan converted to a traditional mortgage.  At this time, it's likely the land and house would be packaged into a single "product," at which point the land value does actually become equity.

That's correct- I have confirmed that I will need a construction loan that will be converted to a traditional mortgage at, or near, completion of the home. 

Regarding your questions of the 2% rule, there are basically two rules that real estate investors commonly use to evaluate the merits of a potential investment:  the 50% rule, and the 2% rule. 

The 2% rule states that monthly rental should be 2% of the property's purchase price.  This is very, very hard to hit in some markets, and easy to hit elsewhere.  There are a lot of successful landlords who only hit 1.5% or even 1%.  Your deal looks to be about .79% (and that's without even counting the purchase price of the land itself).  This tells us that the same money invested in a 2% property would probably have much higher returns.

Wow- I don't  think I would ever be able to hit that in the South/Southeast... so, on a 200k property, the rent would have to be 4k/mo? or even on a 50k property, would need to be 1k?  that's never gonna happen around here... 50k properties might gross 600/mo...

The 50% rule states that operating expenses for the property (maintenance, utilities, etc.) will average out to 50% of the rents collected in the long run.  Thus:

(Rent Collected / 2) - PITI = Cash Flow

that seems crazy high- I know a rental has more wear and tear, but that just seems more than I would ever spend on upkeep... does that include taxes/insurance?


Both rules are very simplistic, and there are exceptions to every rule.  They're just quick tools that RE investors can use to identify properties that are very likely to be good investments.
« Last Edit: January 15, 2015, 07:17:40 AM by sandandsun »

sandandsun

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Re: Should I build this rental house as an investment?
« Reply #6 on: January 15, 2015, 07:15:59 AM »
How much could you sell the lot for?

Not sure- its not something I would consider selling as long as I am living next door (which will likely be 10+ years)... maybe 30k?  It has utilities located in odd places and likely has a smaller than average available footprint (in the process of confirming that), so it would not sell for as much as another lot without those issues.  Subdivision is full, as of 1970's, except for this one lot. It's a desirable location, lots of new subdivisions springing up, but those either have very small lots, or those with similar sized lots have houses in the 400-600k range.  So the appealing thing about my neighborhood is the affordability of houses (200-300k) with the large lots (1-2 acres) that an older subdivision offers...

ShoulderThingThatGoesUp

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Re: Should I build this rental house as an investment?
« Reply #7 on: January 15, 2015, 07:30:59 AM »
If you want the lot to have the lot, OK, I don't get it. But if it's an investment, would you buy that lot to build a house on it? That's a $70k upfront opportunity cost. So cut the income percentages mentioned above nearly in half.

waltworks

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Re: Should I build this rental house as an investment?
« Reply #8 on: January 15, 2015, 08:10:47 AM »
Bad idea for lots of reasons from a rental RE perspective (then there is the mortgage fraud angle, ugh). Are you an architect/GC/construction industry person? If not, add 20% to your cost estimate for the construction, at least.

Really, you should just go read the other rent/sell/buy/etc threads here and you can see the 1%/2%/50% rules argued to death. It's what you should have done *before* you posted, of course, but better late than never. Suffice to say that people with extensive landlording experience have found those rules to be very close to accurate in general. Lots of people who don't own any RE and have no experience think those rules are crazy. You can decide who you want to believe.

-W

sandandsun

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Re: Should I build this rental house as an investment?
« Reply #9 on: January 15, 2015, 08:44:45 AM »
Shoulderthingthatgoesup- lot was a gift- no money invested in it- and I do not want to sell/have neighbor/another owner nearby as long as I am living there fulltime. I like the option of having a second home next door for elderly parents if/when needed.

Waltworks- I wasn't suggesting mortgage fraud- I was rather asking why I wouldn't keep the option open of it being primary residence when constructing the home (since I have no mortgage on current home, could move into new one if we like it better upon completion). Cost estimate included all design services- that was quote from local builder who works in this price range extensively (100/sq ft, based on material grade I am looking at)...

thanks for the advice- I did peruse the other threads briefly, but wasn't really sure what I should be searching for. I'll go back and do that- this was my first OP and sorry to have bothered everyone prematurely.

SunshineGirl

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Re: Should I build this rental house as an investment?
« Reply #10 on: January 15, 2015, 09:10:17 AM »
Gosh, I think it's an idea worth exploring, certainly with the tenant you have in mind. Have you talked to her about it, and is she willing to sign a long-term lease? Have parents expressed an interest in such an arrangement as they age?

Also, you said you could build a house for about $200K. If you were to sell it right away, what could you sell it for, do you think? (not that you would - I'm just wondering)

Yours is a special situation which seems like kind of hybrid-investment/personal project, and you're FI, so you can make your own rules for what would work for you. Once you're FI, what you most want is not to lose that status by making unwise decisions, so often "do nothing" is the best course. 

iamlindoro

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Re: Should I build this rental house as an investment?
« Reply #11 on: January 15, 2015, 09:25:26 AM »
Wow- I don't  think I would ever be able to hit that in the South/Southeast... so, on a 200k property, the rent would have to be 4k/mo? or even on a 50k property, would need to be 1k?  that's never gonna happen around here... 50k properties might gross 600/mo...


Interestingly, the South/Southeast is actually one of the spots where the 2% rule is *most* doable.  Yes, a $50K Property for $1K a month, and 200K for $4K.  It's very possible that your specific market doesn't make the 2% rule easy, but there are definitely place where it's doable.  It's also the reason that most real estate investors try not to buy at retail price.  Most find a distressed property and perform needed (but not luxury) renovation to get it ready for rental.  Commonly this is going to be in the lower end of the market-- they would buy a run down single family home for ~15-20K in a neighborhood where comps are $50K.  Do 10K of renovation, and get 6-700 in rent a month.  Bam, over 2%.


that seems crazy high- I know a rental has more wear and tear, but that just seems more than I would ever spend on upkeep... does that include taxes/insurance?


I know it seems that way now, but this rule is extremely well tested by time across many property types.  Eventually, things like roofs fail, boilers die, uncovered natural disasters occur, etc.  You may go YEARS with no or low maintenance costs, and then have a single event which averages everything out to at or near 50% expenses.  If you don't plan for it from the beginning, you risk being wiped out.

sandandsun

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Re: Should I build this rental house as an investment?
« Reply #12 on: January 15, 2015, 09:31:58 AM »
SunshineGirl- thanks for responding! What you mention are the things I am seeing as pros- yes, my friend would be there for at least 5 years, probably a lot longer.  I would likely even sell to her eventually (but I don't want to do that now as I don't want her selling to new neighbors should she dislike the area and decide to move... plus she has a 400k home she needs to sell before moving and isn't in the position to buy/build right now).  My questions about renting are really more from the "what if that situation didn't work out" perspective (just to be sure I wasn't making a bad financial mistake).

Once built, if I sold the house it would probably sell for 270+, conservatively (but obviously I wouldn't sell unless I needed to/decided to move).  My parents will pretty much move as needed when that time comes- if we decide next door would work I could do that- there is also a new, skilled care facility literally about a half mile from my house.  That's probably 10+ years down the road though...

I think the main problem is that I posted the question to the landlording forum where the focus is on ROI... and I am not, and don't really want to be, a landlord in the traditional sense.  I was mostly trying to determine if this was a really bad idea with my friend as the renter and see what I am not thinking of :)

sandandsun

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Re: Should I build this rental house as an investment?
« Reply #13 on: January 15, 2015, 09:34:52 AM »
iamlindoro- thank you again for your reply and your information.  I do trust your numbers and rules- I am just new to the whole idea of landlording and it seems crazy that someone would pay 4k a month in rent for a 200k property... that doesn't happen around here, but I could see that in more urban/populated areas it certainly might... thanks again!

iamlindoro

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Re: Should I build this rental house as an investment?
« Reply #14 on: January 15, 2015, 09:40:16 AM »
iamlindoro- thank you again for your reply and your information.  I do trust your numbers and rules- I am just new to the whole idea of landlording and it seems crazy that someone would pay 4k a month in rent for a 200k property... that doesn't happen around here, but I could see that in more urban/populated areas it certainly might... thanks again!

No problem!

Remember that the key is to get it for far less than retail.  You're trying to get 2% of *your* cost, not 2% of market value.  This is why you buy distressed properties in decent areas and do renovations-- building a property, you would pay retail and in almost any market 2% would be hard to hit.  However, if you have a property worth 50K that you are only 30K into, and you can get $600 rent (which is easily doable in a lot of places on a 50K property), you're already hitting the 2% rule.  The key is to find someone else's problem and turn it into your profit.