Afford Anything - Ask Paula: Your Real Estate Questions, Answered

Episode Date: July 22, 2020

#266: Paul’s parents own a property worth $100,000, and they owe $80,000 on the mortgage. If he wants to buy this property from them, how should he do it? Max is torn between investing in a rental property or taking advantage of a mega backdoor Roth 401k through his company. Which is the better option? Ali is a travel nurse and wants to get into real estate investing. Should she buy a duplex that needs fixing up or a cheaper apartment that’s rent-ready? Kate and her husband own a townhome that has appreciated substantially, but they need a bigger house. They’re wondering: is it wise to keep it, rent it out, and use a cash-out refinance as a downpayment on their next property? I answer these questions on today's episode. Enjoy! For more information, visit the show notes at http://affordanything.com/episode266 Learn more about your ad choices. Visit podcastchoices.com/adchoices

You can afford anything, but you can't afford everything. Every choice that you make is a trade-off against something else, and that applies not just to how you spend your money, but how you spend your time, your energy, your focus, your attention, how you spend any limited resource in your life saying yes to one thing, implicitly means saying no to something else, and that opens up two questions. First, what matters most in your life?

And second, how do you make daily decisions and take daily actions to reflect that which matters most. Answering these two questions is a lifetime practice, and that is what this podcast is here to explore. My name is Paula Pan. I am the host of the Afford Anything podcast. Every other episode, I answer questions that come from you, the community.

And today, we'll be tackling questions with a real estate theme. Here's what we're going to talk about. Paul's parents own a property that's worth about $100,000, and they owe $80,000 on the mortgage. He's interested in buying this property from them. How should he do it?

Can he just take over their mortgage? Max is torn between investing in a rental property, out of state, building a rental property on his own lot, or taking advantage of a mega backdoor Roth 401K opportunity through his company. How should he choose? Ali is a travel nurse and wants to get into real estate investing. Should she buy a duplex that needs fixing up, or should she buy a cheaper apartment that's rent-ready?

And finally, Kate and her husband own a townhome that has appreciated pretty substantially. They want a bigger house, and they're wondering if they should keep their current home, rent it out, and use a cash-out refi as a down payment on their next property. We're going to answer these four questions right now, starting with Paul. Hey, Paula, this is Paul, calling in from the middle of a cornfield, or near enough. Bit different than the desert you're used to. I'm a fairly new listener to afford anything,

but I've been a fan of yours from a certain other podcast with Joe Salcii High and does. Oh, and let's not forget OG. Anyway, my question is this. My parents have a house, which I'll conservatively say is worth $100,000. They have about $80,000 left on their mortgage, and they're looking to downgrade in a few years. I might be interested in taking the house off their hands. Would a bank still expect me to put 20% down, given that I'll have instant equity based on the value of the house? Alternatively, are there other ways to go about this?

I've heard somebody in the real estate sphere mentioned taking over a mortgage, but I wasn't really sure what they meant by that. And they didn't go into detail, unfortunately. Thanks. And unlike the other podcast, I'll try to learn something from you. Paul, that's a great question. Now, let's talk about two concepts. We're going to talk about arms length transactions versus not arm's length transactions. And we're also going to talk about assumable mortgages versus not assumable mortgages. because a clear understanding of these two concepts will shed a lot of light on your situation.

So let's start with arm's length transactions. Now, an arm's length transaction in the world of real estate occurs when two parties who do not have any type of relationship with one another participate in a real estate deal. So if you buy a home from a total stranger, that's an arm's length transaction. A non-arm's length transaction, by contrast, occurs when the buyer and the seller have a personal relationship, such as deals between family members, deals between friends, deals between coworkers or colleagues, all of those are non-arm's-length transactions. The reason that's important enough to have a distinction and the reason that lenders care

about that kind of thing is because non-arm's length transactions often don't reflect exact market conditions. For example, in a not-arm's-length transaction, a seller might sell their home for less than market value. So Paul, with your situation with your parents, there are a couple of different options that we have available. Let's go through what some of these examples would look like. Now, just as a baseline, let's review what this deal would look like if you and your parents didn't know each other if this was a standard arms length transaction. In that type of situation, how this deal would most likely play out is that the seller would sell their home at fair market value, which is $100,000. The buyer would take out a loan with,

in this case, we'll assume 20% down, meaning that the buyer would borrow $80,000. Now, the seller has an outstanding $80,000 mortgage balance, but they sell their home for $100,000, so they walk away from the closing table with $20,000. Meanwhile, the borrower doesn't have any instant equity other than the value of their down payment. And that's what this deal would look like, just we're establishing that as a baseline in a standard arm's length transaction deal. Now, let's move to your situation where it's not an arm's length transaction and parties are willing to be generous with one another. There are a couple of different options at your disposal.

So option A, your parents could sell their home to you at fair market value 100,000, and if they have an assumable mortgage, you would then assume the mortgage. And we're going to talk more about this in a second. But first we'll go to option B, which is that the seller could sell their home for below market value. So, for example, they could sell this home to you for $80,000 instead of $100,000. And you do not assume the mortgage. You get a new mortgage. Perhaps the seller doesn't have an assumable mortgage.

So in option B, you would get a new mortgage and you would ask the lender to count the gift of equity as the down payment. Now, gift of equity refers to when a friend or family member, or someone that you know sells you the property at a price that's below the current market value. And typically this occurs when the sales price is lower than the actual market price of the home. So if your parents were to sell you this home for 80,000, then that difference between what they sold it for and what it's worth becomes a gift of equity. And many lenders allow this gift to count as the down payment on a home. So if your parents choose option B, if they sell this to you for below market value, and you ask, the lender to count the gift of equity as the down payment, you have to go through some paperwork

requirements. So the seller must have an appraisal that's completed on the home. You'll need to fill out paperwork that notes what the appraised value is, as well as the price that the home is selling for. You've got to fill out a bunch of gift equity paperwork, and there must be a settlement letter that notes the gift during the closing process. So there's a bunch of paperwork that's involved in getting a gift of equity, but many lenders do agree to count this gift of equity as the down payment. So in exchange for having the patience to fill out a bunch of paperwork, you then could use that as the down payment if the lender agrees to it, which many lenders do. One thing to note is the notion of a gift tax.

So in the year 2020, an individual can give another individual up to $15,000 in one year and not have to fill out a gift tax return form with the IRS. But if one individual gives another individual more than $15,000 in the form of any types of cash or assets, so equity would be included in that, if you get more than $15,000 in one year from one person, then the IRS requires a gift tax return. Now, there's good news, which is that each spouse has this $15,000. annual exclusion, which means that if both of your parents are listed as the owners of that home, then each of them can give you a gift of up to $15,000, which means you can receive a total

of $30,000 from your parents without triggering the need for a gift tax return. And given the numbers that you cited, it sounds like you'll be receiving a gift of about $20,000, you'll be within that limit, assuming that both of your parents are listed as owners of the house. Now, I should also add that even if a gift tax return is required, this still falls under the lifetime exemption. So it probably would not be a taxable event. It would just be more paperwork, more paperwork requirements. But anyway, that's a moot point because in your situation, the gift that you'll receive will fall under that $30,000 annual exclusion held by both of your parents combined.

But going back to what I started saying earlier, remember earlier I said we've got option A, which is they sell the home to you for $100,000. they sell the home to you for fair market value and you assume the mortgage. That's one option. And then the second option is that they sell the home to you for $80,000 and you take out a new mortgage and you count that $20,000 difference between the fair market value of the home and the price that you bought it for. You count that as a gift of equity. So we've covered that second option. Now let's go back to that first option, which is that they sell you this home at fair market value and you assume the mortgage.

Let's talk about that. And to begin with, let's talk about assumable mortgages versus not a small. consumable mortgages, because that portion in your question when you said, hey, can I just take over the mortgage? That is fundamentally the question of, is this an assumable mortgage? And if so, can I go through the process of assuming it? So with an assumable mortgage, as I'm sure you might have guessed by this point, the home buyer can take over the existing mortgage that the seller holds as long as the lender of that mortgage approves. Now, the benefit of an assumable mortgage is that if interest rates have fallen since the original mortgage was taken out by the seller, then you, the buyer,

gets the benefit of keeping the lower interest rate. And I'll put an asterisk here. Occasionally, lenders can change some of the terms when the mortgage is assumed, but oftentimes, I won't say always, but oftentimes buyers are able to keep the original lower interest rate. And so if your parents have a lower interest rate than what you could get at the time in which you take out a mortgage, then you get the benefit of keeping that lower interest rate locked in. The other benefit is that as a buyer, you also get a fast forward in the amortization schedule, right? Because more of your payment will be applied to principal because you're taking over a mortgage that already has progressed along its amortization. So those are some of the benefits of taking over an assumable mortgage.

Now, the question, the first question I would want to know is whether or not that's the type of mortgage that your parents hold. Conventional mortgages, which are not federally backed, are typically not assumable. But federally backed mortgages, such as FHA loans and VA loans, are often assumable. So whether or not you can take over the mortgage depends on what type of mortgage your parents have. Is it conventional or is it federally backed? Now let's assume, for the sake of this conversation, that your parents have, have an FHA loan, which means it's a federally backed loan and we'll assume that it is an assumable loan. If you were to take over this mortgage, the FHA requires that both the buyer

and the seller meet certain specific criteria. So the seller, your parents, must have lived in that home as their primary residence for a set amount of time, and you as the buyer must go through the standard application process for an FHA loan, which means that the lender is going to check your credit score, they're going to check your debt to income ratio. They're going to look at your employment history, income information, asset verification for a down payment. Now, if you get an FHA loan, you'll be asked to fill out what's called an identity of interest form. And this is a form that asks for your relationship with the seller. And because this is not an arm's length sale between two strangers, this is a non-arm's length transaction,

you're going to have to divulge that on the identity of interest form. You're going to have to disclose that in writing on that particular. form. The FHA has more stringent requirements for non-arm's-length transaction deals. So typically, in a standard arm's-length transaction with a new mortgage origination, the FHA will require a smaller down payment, typically as low as 3.5%. But in your case, in order to be approved for a non-arm's-length transaction FHA loan, your down payment must be 15% of the home value. That's another way of saying FHA identity of interest transactions require that primary residence purchases have a maximum loan to value of 85%. They won't lend more than 85%. But the good news is that the FHA gift of equity

rules allows you as the buyer to have a down payment that's on paper only, meaning that if you do receive this $20,000, 20% gift of equity, then you'll meet the loan to value required. even the more stringent loan-to-value requirements that's associated with an identity of interest transaction. That's another way of saying you won't have to bring actual cash, actual down payment funds to the transaction because you'll be invoking the FHA gift of equity rule within this deal. So we'll zoom out again and look at this whole setup, right? So zooming out, your parents sell this home for $100,000. and they have an assumable FHA loan.

The lender approves the loan assumption, and you assume a loan of $80,000. Now, assuming that this home appraises for $100,000 or higher, so that's its fair market value, the lender uses the FHA gift of equity rule to determine that you have 20% equity, and given that you have that instant equity, this spares you from the need to come up with cash for the down payment.

Now, that equity comes from your parents, as a gift of equity. It requires its own paperwork, but the FHA does allow it. So, yes, that's a very long way of answering your question, but essentially the answer is yes, you can take over the mortgage, assuming that they have an assumable loan, and yes, you can use the instant equity that you'll receive at the closing table as your down payment, assuming that the lender approves the use of gift of equity as a down payment. So, That was a long answer to a short question. And at this point, you should have a pretty thorough understanding of a lot of the concepts that are involved here.

Again, just to review what we covered, we talked about arm's length transactions versus not arm's length transactions. We talked about assumable mortgages versus not assumable mortgages. We talked about the concept of gift of equity. We talked about gift tax returns, including the annual exclusion. And we discussed FHA identity of interest transactions. and the 85% loan to value ratio that they require. So, this is the podcast where you learn something. Thank you for asking that question, Paul,

and please at some point call us back and give us an update, let us know what happened. And if you decide to move forward with it, congrats on buying that house. We'll come back to this episode after this word from our sponsors. Fifth Third Bank's commercial payments are fast and efficient, but they're not just fast and efficient. They're also powered by the latest in payments technology built to evolve with your business. Fifth Third Bank has the big bank muscle to handle payments for businesses of any size.

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I've been on the path to financial independence for about a year and all the actions I took. or thanks to you and the FI community. My wife and I are both Mexican-40K. We have an emergency account, and we invest our after-tax savings in VTSAX. We live in the Bay Area, and we just refinance our mortgage to a 3.25% rate. My question is about a conflicting situation.

On one side, I would like to invest in real estate, either by building on our current lot, a one-bed, one-bath for short-term rental or buying long-distance out-of-state. On the other side, I have the great opportunity to have access to a mega-backdoor Roth through my company for 1K, but it would lock the money until my retirement. Do you have any advice on which option I should invest first? Thanks a lot for your help. Max, thanks for calling and congratulations on.

on being on the path to financial independence, on maxing out your 401k, on having an emergency fund, on having a mortgage with a very low-interest loan, you have a lot of great things that are already set up. So let's talk about your question. You've got three options. Build a short-term rental on your current lot. Buy a rental out of state. Or use a mega backdoor raw.

These options are all very different. And I'm sure you can guess what I'm going to say, which is, in the world of finance, When faced with questions like these, there's no single right or wrong answer. You can think of this almost like choosing a career. When you choose a career, you choose a career that fits you. There isn't a right answer or a wrong answer. In any objective form, the only thing that makes it so, the only thing that makes it right or wrong, is whether or not it's a good fit for you.

And choosing investments is similar to choosing a career in that same way. So here are some of the factors that I would consider as you're thinking about these three. options. First, of course, returns. And when we talk about returns, that conversation needs to include the form that those returns take, because any asset, whether it's an index fund or a rental property, any asset yields returns in two ways. There is the appreciation of the asset itself, and then there is the dividend or the income stream that the asset pays out. Money in a mega backdoor Roth, which presumably would be invested in index funds, is money that would be in invested in such a way that most of the returns would come in the form of long-term capital appreciation.

Historically, what we've seen in index funds is that the main driver of growth is appreciation. And the dividend, while very important, and reinvested dividends are certainly also a huge driver of growth, but the dividend is a relatively smaller share of the return as compared to the appreciation. So for example, if over a long-term aggregate average an index fund grows, we'll say 8%, then 2% of that might come from the dividend yield, while the other 6% comes from appreciation over the long term. Those are just hypothetical numbers, but that's an illustrative example of how the dividend in an index fund plays a much smaller role in the composition of the total return. Rental properties behave differently. Rentals offer returns in a form that is buying. towards the income stream. And when I say income stream, I don't necessarily mean cash flow. We'll talk more about this in a second. But cash flow, especially in year one, year two,

cash flow is heavily influenced by the type of financing arrangement that you have. Again, we'll elaborate on that idea in a second. But when I say returns or dividend or income stream in the context of a rental property, fundamentally what we want to know is what is the cap rate on that rental property? Because the cap rate is a measure of, the dividend that you receive relative to the value of the asset. Now, whether or not that dividend materializes in the form of cash is dependent on the type of financing that you're in, but before we go into a conversation about financing, we must weigh whether or not the underlying asset itself is worth holding.

And to answer that question, we need to know what type of dividend would this underlying asset, this rental property, pay out if it were unleveraged. And that dividend coupled with any market appreciation that it has, even if that market appreciation is no more than an inflationary increase and nothing else, the combination of those two things yields the total return on a rental property. And so assessing the type of returns that you could get, and that's very much going to depend on what type of properties you're looking at if you were to build a short-term rental on your current lot, all right, well, what do short-term rentals of the size that you're considering, one bed, one-bath, in the location that you're considering? How much do short-term rentals rent for?

What amount of occupancy do they typically have? Slash what amount of vacancy? What are the operating costs? What are the additional taxes or licenses that would be needed? If you were to outsource the management of it, what are the management fees? Those are all of the questions that would go into determining the returns on that short-term rental. Similarly, if you were to buy a rental out of state, same deal. The numbers on a long-term rental are slightly simpler to calculate simply because the occupancy or vacancy doesn't swing quite as much. When you have a short-term rental, there may be seasonal variation. There's the additional risk that city council might pass a law that restricts what owners can do with short-term rentals. With short-term rentals, you introduce a whole gamut of

additional volatility into that mix. With a long-term rental, some of those risks are mitigated. Vacancy tends to be a bit more predictable. Operating costs tend to be a little bit more predictable. But a rental out-of-state encompasses such a wide variety of different types of properties that if I were in your shoes, I would run the numbers on a few potential out-of-state rentals that you might be interested in buying. Are you interested in Class B duplexes in Phoenix?

Or are you interested in Class A single-family homes? Carson City. What kind of returns do you expect that you would be able to get? How does that compare to a short-term rental on your property? Those are some of the preliminary exercises that I would be doing as I tried to narrow down between these three options. Now, before we move off of this conversation about returns, I do want to touch back on something that I'd mentioned earlier, which is cash flow. So many people get hung up on what the cash flow in year one is going to be. Here's the thing. You need a strategy and a big picture overarching vision before you can start making decisions about what you buy, what type of financing you use, all of that. Because if your

goal is maximum immediate cash flow, if your goal is to maximize the cash flow of year one, then you would be making very different decisions from an investor whose goal is to build equity over the span of the next 10 years and maximize both equity and cash flow in year 10 rather than in year one. So an investor who wants to maximize cash flow in year one might go an all-cash route. For example, that investor might buy a rental property or a couple of rental properties free and clear in Youngstown, Ohio, pick up a handful of single-family homes at $40,000 bucks a pop, rent them out for 600 or 700 a month, cash flow 300 to 400 per door, unleveraged. That's a strategy that would maximize immediate cash flow, but it comes at the cost of future

equity growth. A, because the economic conditions in Youngstown, Ohio are unlikely to result in significant market appreciation. B, because it's an unleveraged deal, which means that there's no equity growth through principal payoff. C, because it's an unleveraged deal, which means that the total number of doors acquired in year one is less than the number of doors that could have been acquired if leverage were involved. But for an investor whose goal is cash flow in year one, that's totally fine. That's the goal. And those tradeoffs are worthwhile. But you take a different investor whose goal is cash flow in year 10, that investor might use the same amount of cash to leverage into eight single family homes in Youngstown, Ohio. And in year

one, their cash flow might be next to nothing because most of the cash that they collect is going back into principal payoff and mortgage payoff. But by year 10, they would have built significant equity in their holdings. And then if they wanted to retire in year 10, they might sell half the holdings, use that money to pay off the other half, and then boom, now they've got even more properties held free and clear, enabling them to retire in year 10. So the reason that I say that want to form a strategy ahead of time is that the choices that you make, the type of property you acquire, the number of properties you acquire, whether or not you use financing, and if so, how much, and to what degree, all of that is going to be based around your goals.

I mean, you mentioned that your goal is financial independence, but there are so many routes that you could take for that. I mean, does that mean that you want to acquire as much as possible right now so that in 10 years, you can have good cash flow, or does that mean that you want to prioritize bigger cash flow immediately so that you can then use that cash for market contributions? So as you're thinking through those three options, those are some of the factors to consider as you're contemplating returns. It's not simply a question of how great of the returns, but also what form do the returns take with regard to capital appreciation, dividend or income stream, and cash flow and the

timing of that cash flow. So that's what to think about as you consider the returns on each of the three options. Now, returns are only one factor to consider. You also, of course, want to consider risk. And risk, I read an article recently by writer Morgan Houssel, who was a previous guest on this podcast. He defined risk as containing three distinct components. There is, the range of likely outcomes. There is the probability of any given outcome within that range. And then there is the risk of ruin. What happens if the worst of those potential outcomes comes to pass? And so those three characteristics of risk, the range of outcomes, the probability of any given outcome within that range, and your ability to survive the worst of those outcomes,

that's what you want to think about as you think through all three of the options as well. So returns are something to consider, risk is something to consider. Another thing to consider is diversification. If right now all of your money is in index funds or retirement accounts, then there is something to be said for diversifying into real estate, simply so that you have a greater mix within your basket of assets. Another factor to consider, of course, are tax consequences, and those can be incredibly complex as real estate has its own host of tax advantages in terms of depreciating properties.

or using 1031 exchanges in order to defer capital gains taxes indefinitely. So real estate has its own tax advantages. Of course, the mega backdoor Roth also has its tax advantages. So how do those stack up against one another? That's something to consider. But that being said, don't let the tail wag the dog. Don't let the tax tail wag the investment dog. Choose the best return, the return that fits you in terms of your goals, your strategy, your overall framework.

in the context of the type of risk profile that you're comfortable with, choose the investment that fits you and then tax optimize it to the best of your ability to do so. Dog first, then tail, investment first, then tax optimization. Another factor to think about is liquidity. In a megabackdoor Roth, you trade off liquidity, as you mentioned in your question. You're trading away liquidity in order to capture those tax advantages. With a rental property, you have greater liquidity. Insofar as there are no age restrictions or governmental time restrictions on how long you have to hold a given asset, like to that extent you have greater liquidity with real estate.

But that being said, real estate in general is not considered a highly liquid asset class given that so much of your assets are held in equity. And therein, again, is the tradeoff between, you know, when you think about all of these factors that we're considering, reward, risk, tax consequences, there is a liquidity tradeoff. involved with all of it. All of these things exist in a tension with one another. I mean, if you really want to maximize liquidity, cash in a savings account is the most liquid possible way to hold your assets. But of course, cash in a savings account, that cost of that liquidity is the opportunity cost of not investing cash. So of course, if you want to make returns, you're going to need to constrain your liquidity to an extent. But again, how do you want to do that? And how does that fit in with your overall strategy? You mentioned that you're pursuing financial independence. I don't know what your timeline for that is. I don't know if you plan to retire from your current job when you reach FI or not. But you're young. You're 34. So if at the age of 44 or 49 or 51 when your youngest leaves for college, if at that you and your wife want to quit your jobs, which you may or may not, then having some of your

assets outside of traditional retirement vehicles can be a low hassle way of being able to access those assets when you're in your 40s or early 50s. And of course, as I'm sure you know, there are ways that you can access assets that are tied up into retirement accounts, but those can get complex. And so the simplicity of of being able to access assets that are not in restricted accounts, the simplicity of being able to access assets when you're not dealing with the necessity of making sure that you have all of the eyes properly dotted and the T's properly crossed. Otherwise, you know, and if you don't, then there could be the threat of IRS penalties. That's certainly an argument in favor of

keeping assets in a form that you can access if you're trying to tap a retirement vehicle prior to traditional retirement age. So liquidity and access to funds, that's another factor that you would want to consider. On top of that, though, another factor to consider is time commitment. You have two young children, ages two and four. So what level of time commitment are you able to give or do you want to give right now? And hand-in-hand with time commitment is also your level of interest and enthusiasm for any of those given investments. If you are incredibly enthusiastic about being a short-term rental host, well, then the time commitment isn't going to feel like such a drag.

It's not going to feel like a second job because you're so darn excited about it. But if the level of interest or enthusiasm isn't there, then every little thing that you have to do in service of that project, feels like a second job and it weighs on you. And so you're not only your time commitment, but also your level of interest and enthusiasm in all three of these options is also going to be a good indicator of which one is the best fit for you. Again, similar to picking a career, which one is the best fit for you? It's the career that really sparks your curiosity. So those are the factors that I would consider as I'm thinking through those three options that you're weighing, a short-term rental versus an out-of-state rental versus a mega backdoor Roth.

I'd be thinking about the returns and the form that those returns take and leverage and whether or not leverage would be used in order to impact return. I'd be thinking about risk and the range of likely outcomes, the probability of those outcomes, the risk of ruin or the worst-case scenario. I would be thinking about how leverage impacts your risk profile as well. I'd be thinking about diversification, thinking about tax consequences, thinking about liquidity. thinking about your time commitment and your level of interest and enthusiasm. And I'd contextualize all of that within a bigger picture strategy around your goals. How much money do you want to have in passive income by what date? How important is cash flow now versus cash flow in

the future? How important is the ability to access funds before you reach traditional retirement age? All of those which tie into your overall career, to go back to the career analogy, it really ties into your overall career plan and life plan and financial independence slash early retirement plan, all of that will play in in order to form the comprehensive whole. So start with that big picture strategy and then weigh all of these factors in light of that. And that will give you your answer. So thank you for asking that question. And best of luck with whichever you decide. And please call us back, leave us a voicemail. Let us know which direction you decide to go in and why. Thanks, Max. We'll come back to the show in just a second, but first, our next question

comes from Allie. Hey, Paula, my name's Allie. Love the podcast. Listening to it since my financial advisor slash cousin told me about it when I told him I was thinking about real estate investment. I have a question for you. My situation is pretty unique. I'm a travel nurse. So the majority of my money comes from housing stipends and per diems, where my hourly rate is really low, my taxed income. So in order to get my housing stipend, I have to be 50 miles away from my home. Right now, I'm using my home in Indiana and working in Minnesota, but looking to move to Minnesota full time. So at the moment, since I'm in contract, I cannot use the house hack and buy a property as my home. So what might be the better situation?

I have two options right now of buying my first rental. There is a duplex that needs some work. It needs to be updated that is listed for about $205,000. I could definitely rent it out. If I lived in it, the other half for over $1,000. The other option is living in an apartment that's about $1,100 that I love where some of my friends live and buying an apartment that's about $99,000 that's ready to move in, ready to rent right away. It does have an HOA fee of about $250 a month, and that includes heat and a few other things. So my question is if you think that it would be smarter for me to buy the duplex,

which I could gain equity in by updating. I'm very interested in flipping also, so this could kind of get my feet wet in the flipping and the renting of real estate investment. Or should I, for my first adventure in real estate, rent an apartment by myself and then just get a one-bedroom apartment that I could rent for probably 1,200 that is listed for $99,000. Any information helps. Thanks so much. Allie, first of all, congratulations on being in the position that you're in. You're choosing between what sound like two excellent rental properties.

So that's a great problem to have. Let's talk through these two rental properties that you're considering. So first of all, you said there's a duplex that is a fixer upper. It's listed for $205,000, and you could rent half of that duplex for over $1,000. And so right away what that tells me is that that duplex meets the 1% rule. The 1% rule for people who are listening who are not familiar with it is a broad, generalized concept that states, when you are evaluating rental properties for purchase, look for properties in which the gross monthly rent is at least 1% of the purchase price. So for every $100,000 worth of property, you should collect gross rent of at least $1,000 per month.

So for a $200,000 property, you should be collecting gross rent of at least $2,000 per month. And that's exactly what this duplex would do if you can rent $1,000 for both sides. And even if you yourself were to live in one of those sides, it would still meet the 1% rule because the fair market value of the property, the fair market value of the rent that if you were to move out and replace yourself with a renter, the fair market value of the rent of that unit would be sufficient for those two units combined to meet the 1% rule. Now, you mentioned that this property is a fixer-upper, and if it needs extensive renovations in order to get it rent-ready for the first tenants, that, depending on the cost of their renovations, might throw it out of 1% rule range. but the impression that I get, and I might be wrong,

but the impression that I got from your voicemail is that it is rent-ready, that it's going to need some long-term repairs, but it seems to me that it's immediately habitable, which means that the purchase price, the acquisition price of this duplex, should approximately be aligned with the 1% rule. Now, that being said, let's talk about the other option,

which is to rent an apartment for yourself and then buy a apartment, a different apartment for $99,000 that's move in already. This place that's listed for $99,000 that rents for $1,200 per month, those are great numbers. You're exceeding the 1% rule. You're at 1.2% and that's for a place that is not a fixer-upper. It's totally ready to go in great condition. I mean, wow, that sounds like an incredible property.

You mentioned that it has an HOA of $250 a month? that's fine. I am not worried. People often ask me about, like, well, what do you think of places that have HOAs? Ultimately, what matters is the total amount that you spend on operating overhead. So the way that that operating overhead shakes out, like, I'm not concerned about any one particular line item. I'm concerned about the aggregate operating overhead as a whole. fundamentally the cap rate on a property, which is the dividend that the property pays you, that cap rate essentially asks the questions, hey, how much money could you gross in rent? What's the potential gross revenue?

And then what's the vacancy? What's the operating overhead? And when you subtract that out, how much are you netting? What is your net operating income? And how does that compare to the cost? of the property. Fundamentally, those are the questions that the cap rate equation asks. And it ultimately doesn't matter how the line itemization of those operating overhead expenses pay out. Ultimately, it doesn't matter if your operating overhead contains an HOA payment

or not. What matters is the total operating overhead cost, like how big of a chunk of the gross rent is that taking? So whenever people ask me about a particular line item, you know, people will say, what do you think of a place that has an HOA? Or people will say, hey, what do you think of places in Texas? Because Texas has really high property taxes. Any time that somebody asks a question about a specific line item, I tell them exactly what I just told you, which is, it's not about the particular line item. It's about the total operating overhead. And if you know that one given line item is going to be high, that doesn't matter if that's a lot. If that's that high line item is offset by lower operating overhead expenses in other line items.

So don't get too caught up in any one given category. Think in terms of the whole. Now, I want to address two other things that you said in your voicemail. You mentioned that the apartment is near friends and you know that you'll love it. You'll love the experience of living there. That says a lot. There is a lot of power, a lot of energy, a lot of vitality that comes from loving where you live. I read this the other day. Someone said, let the heart lead and the mind execute.

And I really love that phrasing because if we try to rationalize ourselves into a decision about our personal lives that quote unquote makes sense on paper, but our heart's not in it, ultimately it's going to backfire and ultimately getting out of the wrong situation ends up being more expensive than just not going into the wrong situation in the first place. So let the heart lead and the mind execute is a sound strategy for making good long-term decisions. You've mentioned you've always been interested in flipping houses. And yes, buying a duplex that's a fixer-upper would give you the opportunity to get your feet wet in that. But you will have many, many opportunities.

If you continue investing in real estate, you'll have many opportunities to buy. fixer uppers, you'll have many opportunities to force appreciation. Given that you know that you'll love living in this apartment and given that where you live is constrained by the nature of the work that you do and where you live is constrained by the per diem factors, the compensation structure of the type of work that you do, it makes a lot of sense to me that you should choose where to live based on where you want to live slash where makes sense for your job, your day job, in terms of its compensation structure. Let your personal housing be your personal housing and then use this apartment, which has great numbers, a $99,000 apartment that rents

for $1,200 a month that's in excellent condition. I mean, the numbers speak for themselves. If you can get those types of returns without sacrificing your enjoyment of your own personal residence and without compromising the compensation structure of your job, that sounds like a total win. It's a win at work. It's a win for your life. And it's a win for your first rental property. So is the duplex a cool opportunity with great numbers? Yeah, sounds like it. Given the fact that you have an opportunity to make great returns on a rental property while also living in an apartment that you're really going to enjoy and having flexibility to live in a location that fits with the type of work that you do. I say, go with the apartment.

And if you've been listening to this show for a while, you know, I oftentimes, when people ask about a choice between two or three options, I often don't pick one of them. I talk through how to make the decision. But in this particular case, the benefits of buying that $99,000 apartment seem so clear that I'll just come right out and say I'm in favor of that one. They both sound like great choices. They both have their relative merits. Whichever one you choose, you're going to be making good money.

you're going to be getting your feet wet with your first rental property. So whichever one you choose, like I said at the beginning of this answer, you are in a position where you're choosing between two fantastic options. That's a very enviable position to be in. So congratulations on being where you are. And best of luck with buying your first rental. Our final question today comes from Kate. Hi, Paula.

First off, I wanted to thank you and you're behind the scenes team for a wonderful podcast. Your tagline, we can do anything but not everything, resonates with me a lot. I'm a firm believer. One can achieve anything. And your podcast encourages people to do just that. I love your systematic, informative, and logical approach to answering people's questions. And I hope you will answer mine. My question is around real estate and taking advantage of the current market situation due to COVID-19.

Here is our background. We bought our first townhouse in September 2008. We got it brand new for 395K with 3%. down. We still live in the same townhouse and now have about 50% equity. The townhouse appreciated and value quite substantially and is worth 585K. We have two kids in elementary school and are in need of a bigger house. We would like to stay in the same town. It's a high cost of living area but with very good schools. With everything going on right now, we would like to take advantage of both, historically low interest rates and the potential correction of housing prices.

As such, we would like to purchase a house sooner than we had originally planned, meaning to do so in the next two years. We are looking to purchase a house for up to $1 million, but 20% down. We would like to purchase a new house without selling our townhouse and would like to convert it into a rental property, keeping it for a long period of time until kids go to college or until retirement. We're a dual-income household in early 40s, making $225K combined before taxes. We have no debt other than our mortgage and have excellent credit.

We have 284K in equity, 50K in cash in emergency fund, which covers six months of living expenses. We also set aside 20k in reserves for our townhouse. We are now saving $3,700 per month for a down payment on a new house. We are considering of doing a cash outre fee on our townhouse to pull money out for a down payment. Our current mortgage is 3.65% and we are four years in $4,000. to a 30-year term. With that, we have a few questions. When should we do a cash-out reply? There is a belief that interest rates will stay at current lows for another 12 months or so. Ideally, we don't want to miss the opportunity to refi at a low rate, but at the same time, don't want to keep

cash for too long before we buy. Once we refi, where should we park cash before we are ready to buy? How should we calculate if keeping a townhouse is a financially sound decision? All the calculators online are based on purchasing a rental property, while in our situation, it's keeping an existing one and renting it out. And the last question, how should we calculate optimal amount to pull out for cash refund? We can pull up to 160K. Obviously, the more we pull the faster we can come up with a downpink. But the more we pull, we might not be getting a positive cash flow when renting the townhouse out. Thank you. Kate, first of all, congratulations on everything that you've built so far. You're debt-free other than your mortgage. You have

excellent credit. You have a lot of equity. You have a six-month emergency fund. You have, in addition to a personal emergency fund, you also have cash reserves for a property that you plan on turning into a rental. And you have a down payment fund set up for your next home. So you're doing a lot of great stuff in terms of getting yourself into a solid financial position. Now, to address your questions, you asked four questions. The first one was, when should you do a cash-out refi? As you mentioned, there is an idea, a projection that interest rates will stay low for maybe another year, and you don't want to miss the opportunity for a low rate, but you also don't want to hold cash for too long. Now, we have no idea what the Federal Reserve is going to do in the year 2021. We have no idea how long interest rates will stay low. if they will stay where they are, if they will go even lower. I mean, they're at historic lows right now. They're at the lowest that they've been in a generation.

What would they go even lower? Or will they climb? I mean, we don't know. Ultimately, anytime we're trying to make a projection about the future, the answer is always we don't know. But I think it is fairly safe to say that for as long as anybody can reasonably foresee, interest rates will most likely remain low for a while. We are in a recession.

the nation needs economic stimulus. When that happens, the Fed sets rates low. And will it fluctuate by a handful of basis points? Sure. But I don't think that we have any imminent worries of rates becoming excessively high, not that we can reasonably foresee it this time. And so my answer to your question of when should you take a cash out refi, I would recommend taking it two to three months before you plan on buying your next

property or two to three months before you plan on making offers. The reason for that is, as you said, you don't want to hold on to that cash for too long before you buy because the moment that you take at cash out refi, you're going to have to start paying on that loan. You're going to have to start making installment payments on a cash out refi. And it sucks to make mortgage payments on a mortgage that hasn't turned into a house yet. You're making mortgage payments on a loan that you took with the cash just sitting there in a bank. So wait until you're two to three months away from buying your next property and take the cash out refi at that time.

I don't think that you need to like clamor to capture low rates now while you still can. Because despite the fact that lenders who make their money when you take out a loan are going to try to press for a more hurried refi, all of the economic indicators, as far as we can reasonably foresee indicate that there's no rush. Now, your second question you asked, once you take out this cash out refi, where should you park the cash until you buy? In the bank, do not get fancy with it, do not try to invest it, do not put it in an index fund or even in bond funds. Keep it in a savings account. Yes, that means that you will be receiving a lower interest rate than the amount of interest that you are paying on that amount of loan. And that's

precisely why you don't want to take out that loan until two to three months before you're ready to buy a property, because you don't want to be holding onto that cash for very long. But keep it in a savings account where it's going to be safe, because the type of risk that you expose any amount of money to should be reflective of your timeline to use of that money. And in the world of investing, if you're planning on using money within the next one year, two years three years, that's considered short term or immediate term. And the way that you hold those assets should reflect that. So keep it in a savings account. That addresses question number two. Now question number three, you said, how should we calculate if keeping the townhouse is a

financially sound decision? Because all the calculators online are based on purchasing a rental property. So the way that you would calculate that is the cap rate. The cap rate is a measure of the dividend payment that you receive from the home. So the cap rate as a percentage tells you what type of a dividend, an unleveraged dividend, you are receiving from this home. And that dividend plus any market appreciation, even if you assume that it keeps pace with inflation and nothing more, which means historically about 3%, that cap rate plus appreciation is your total unleveraged return on that property. Now, the reason that you want to calculate that is because that's exactly,

the number that you would look at if you were looking at an index fund. You know, if you're looking at an index fund, you're going to look at historically, what have the total returns been? And those total returns appear in two forms. There's the appreciation on the fund itself, and then there's the dividend that that fund has paid out. And those two factors combined create the total return on an index fund. A house, a rental property, is evaluated in the same way. you look at historic appreciation and just to be safe, to be conservative, you can say that it's going to keep pace with inflation but no more. Nationally, homes have appreciated at about a 5% rate. So if you want to use a slightly more aggressive number, you could use the national average.

If you want to use a more specific number for your area, based on that neighborhood or that city, you could do that. But I like to be conservative and just use an inflationary increase as the most conservative appreciation projection. And so that inflationary increase plus the dividend, which is the cap rate that your home pays, that will tell you what type of unleveraged returns you will receive from that rental property, from that townhouse. And that ultimately is going to be a much more important figure than the 1% rule. People often ask if my current home does not meet the 1% rule, should I sell it, instead of holding it? The answer is no.

The 1% rule is a useful evaluation metric when you are trying to sort through a universe of thousands of properties that you're looking at for the purpose of purchasing. But the 1% rule no longer applies once you already own the home. So you are absolutely correct in that the equations, the online calculators, the tools and formulas that people use when they're evaluating whether or not to buy a rental property is different than the formulas that we use when we're deciding whether or not to hold a property. And in order to evaluate that, take a look at the cap rate and then contextualize that in terms of its total return, and then ask yourself if that is a cap rate and a total return that you'd be happy with.

Now, to your fourth and final question, you asked, How should we calculate the optimal amount to pull out for the cash out refi? And you mentioned that you can take up to $160,000, meaning the more money that you pull out of that townhouse, the faster that you get that down payment for your next property. But, of course, taking out a bigger loan is going to have an impact on the cash flow that you get ultimately. So let's walk through some numbers. You mentioned that you're currently saving $3,700 per month for your next property. after 12 months of doing this, you'll have saved $44,400. And so those savings, those 12 months of savings,

plus the $160,000 that you can borrow from the townhouse equals the $200,000 that you need in order to make the 20% down payment on a $1 million property. So if you wanted to take out that full amount, if you wanted to take the full $160,000, then within a year, less than a year, at this point, because you've already been saving for that down payment for a number of months, within a year's worth of savings, you would have enough money to be able to buy that next property. And so I would reframe this question. Rather than framing the question as, how much money should we pull out?

I would reframe it as how soon do we want to buy the next house and how will this affect our cash flow on the townhouse? because if you buy your next home in two years, then if you continue saving that $3,700 per month, then in two years' time, you will have saved $88,800, which means that you would only need to borrow around $120,000 from the townhouse. And yes, this will absolutely improve your cash flow on the townhouse,

and you can run a mortgage calculator, an online mortgage calculator, to find out exactly by how much money per month will borrowing 120K instead of 160K improve your cash flow. But the tradeoff for that improved cash flow is added uncertainty. Where will the market be in two years? You know, the sooner that you do something, sooner time horizons have a greater degree of certainty. They have a greater degree, we have a greater amount of information that we can extrapolate to the near future.

The further away into the future, something is the less certainty that we have. And that uncertainty could go in any direction. It could be positive or negative. It might be the case that in two years, the market will be much more friendly towards buyers. Maybe. Or it might be the case that in two years, the market will be much more unfriendly towards buyers. We don't know. And so, and that's the point.

The point is the further into the future you go, the greater the uncertainty for better or for worse. And so I think the question becomes, how soon do you want to purchase this next property? set that time frame, and based on that time frame, you will then know how much money you want to borrow against that townhome. And once you know that, once you set that as your intended target, you can then use a mortgage calculator to see how this will affect your cash flow. And if it affects your cash flow too negatively, meaning if you end up with negative cash flow or if you end up with break even, then you can adjust your time frame accordingly. But start with an intended time frame and then make adjustments along the way as needed. So congratulations on everything that you've built. Congratulations on being in such a good financial position.

And best of luck with the purchase of the next home and with turning your current home into your first rental property. For anyone who is interested in learning more about rental property investments, we had a free e-book. It's called Seven Expensive Mistakes that Rental Property Investments. often make. It's available for free at affordanything.com slash mistakes. That's afford anything.com slash mistakes. Check out that free book and learn how to avoid some of the most expensive mistakes that in particular a lot of beginner rental investors make. Again, afford anything.com slash mistakes. That's our show for today. Thank you so much for tuning in. My name

is Paula Pant. This is the Afford Anything podcast. If you enjoyed today's episode, please do three things. Number one, hit subscribe or follow in whatever app you're using to listen to this show so that you don't miss any of our awesome upcoming episodes. Number two, share this with a friend or a family member. You can send them a link to this episode at Affordanithing.com slash episode 266. And number three, leave us a review in whatever app you're using to listen to this episode. If you're sitting at your desktop or a laptop, you can go to, or if you're on your phone and you want to type in a URL into the browser, you can go to afford anything.com slash iTunes. That will take you to the page on the Apple podcast website in which you can leave us a review there. And we use these reviews

to book awesome guests onto this show. We've got some great guests that are coming up. So make sure that you are subscribed to this show so that you don't miss any of those awesome upcoming episodes. Thanks again for tuning in. My name is Paula Pant. This is the Afford Anything podcast. And I will catch you in the next episode. Hey, my lawyer says I'm supposed to give you a disclaimer. So here we go. This is for entertainment purposes only. Nothing that you hear on here is intended to be advice. And before you make any moves, talk to a real professional, talk to a tax professional, talk to an attorney, talk to a licensed financial advisor, talk to people who actually have credentials and who know what they're doing, because that is not us. Please do not think of us as experts or professionals. We are not licensed in any way. We are just random people with access to the internet. So just imagine that you're listening to a comedy show. Imagine that this is the least funny comedy show that you've ever heard.

It's purely entertainment. Don't make any moves without checking with the pros. All right, you've been warned.