Buying our first rental

Summary: I got moved back to the US in 2012, started a new job, and got married. This is a description of becoming real estate investors and the third in a three-part personal finance series that goes through my first $1mm, our first condo, and our first rental.

I was always more interested in buying a rental property than buying a place to live in. It always seemed so cool (do people say that anymore?) when someone has a rental property. You imagine them being able to sit back and just collect monthly checks.

Of course, it’s not as easy as it sounds. I know because my parents had a terrible experience owning a rental which taught me an important lesson. Don’t buy something too far away. You don’t want to be an absentee landlord.

The right price

During the search process, I came up with my own very rough rule of thumb to get an idea of the potential of a place. For every $100k in sales price, we needed to charge around $600/month in rent. That means a place that cost $200k would need a monthly rent of $1,200. On an annual basis that would $14,400 (12 months x $1,200 = $14,400) which would 7.2% of the $200k price ($14,400 / $210,000 = 7.2%).

Below is one example I found on Craigslist.

I want to emphasize that my rule of thumb is very rough. It got the job done for us but doesn’t take into account things like vacancy and repair costs (on the negative side) or tax benefits and building of equity (on the positive side).

I came up with a target price range of $200k-$400k. Once a house gets over a certain price, my thought was that people are starting to pay more for psychological, intangible value versus just the property’s ability to generate cash flow. Too low and the dollar return may not be worth the time and trouble even if the % return is higher.

The goal

My wife wanted a rental property because it’s tangible. I wanted real estate to diversify away from the stock market since my 401k is all in stocks. It was 2014 and I wanted to take advantage of the low rates. Real estate is a good hedge against inflation. If inflation goes up, so will the value of your real estate. Inflation also depreciates the value of existing debt so that in effect you’ll be paying back less than you borrowed but this is only true for fixed rate mortgages (https://inflationdata.com/articles/2017/10/25/ways-inflation-affects-real-estate-market/).

The search

While we looked at a lot of places, two areas looked promising. The first was Grosvenor. There were a lot of condos and it was convenient to the metro. The second place was a less well-known cluster of condos in Silver Spring right on the border with Chevy Chase. Originally apartments built in 1948, it was split into three condo associations, Rock Creek Village, Rock Creek Gardens, and Rock Creek Commons, when the condo conversion project went bankrupt in the 1980s. I only discovered the place when I was dropping off a co-worker who lived there. We ended up bidding on three different places until we put a 2 bedroom, 1 bath under contract in Rock Creek Village for $250,000 which was the list price.

Plot twist

So we did end up buying the place but we didn’t rent it. Instead we moved in. I mentioned in my previous blog that my salary wasn’t enough to cover our expenses. The rental cost less and we put more down which decreased our monthly mortgage payment enough to fit our budget. Second, it was closer to my office by about half. Finally, my wife was getting tired of urban life, i.e. passed out drunks and public urination, and she was very happy to get out of the city.

What we did is also an example of what I think is the basic premise of the book Rich Dad Poor Dad. You want your assets to be working for you. If you add up the value of the two condos it would be $660,000 ($410,000 + $250,000 = $660,000). One way to look at it is that we could buy a much nicer and/or bigger place. The way we look at is that our DC tenants will be building equity for us.

I’ve read in blogs that you should only buy rental properties that are immediately cash flow positive. My take is a little different. I’m mainly concerned that rent covers our costs. For our DC property, we could rent it for around $2,500 which cover the $2,100 mortgage and the $300 condo fee. Over time, the mortgage would stay the same but presumably we’ll be able to increase the rent.

Mortgage revisited

We went back to the mortgage broker we used for Petworth condo and got an interesting response. First thing you need to know is that you pay slightly more, like 50 bps (0.5%) and put more down (25%) for what they call an investor mortgage. Even though we had started out looking for to buy a rental, now we were buying the Silver Spring condo as our primary residence. The mortgage broker said his credit department would say either we had lied about not planning on renting the DC place or that we were lying about not renting the Silver Spring place. In the end, we had to find a new mortgage broker and there was no problem.

Another useful point to understand is that they won’t consider rental income when calculating how much you can borrow unless you claimed it in our taxes. That meant I had to apply for the new mortgage without the benefit the expected rental income on the DC condo. The nice thing is that once we included the rental income in taxes, for any future rental we bought, they would consider the expected rental income.

On a side note, I’ve always wondered how banks can give 30-year mortgages for such a low rate. Besides having your house as security, most people don’t keep their mortgage for 30 years. Two interesting characteristics about mortgages are that the can prepaid anytime with penalty and that they are not transferable so you have to pay them off when you move. Growing up, I remember hearing people moved every 7 years. I just checked and apparently that’s gone up but it’s still significantly less than 30 years (https://www.keepingcurrentmatters.com/2017/02/28/how-long-do-most-families-stay-in-their-home/). I’m really hoping to hold on to our mortgages for the full 30 years.

In addition to using an new mortgage broker, we ended up using a different real estate agent. We were very happy with our first agent but I had a close college friend who had been laid off from his job in renewable energy and he had just gotten his license. We were his first client.

Finding tenants

This is by far is the toughest part of having a rental. First you have to figure out the rent. We looked at sites like Craigslist and Zillow to get an idea. We also used Craigslist to find a tenant. We started at $2,700 before dropping it to $2,600 and then finally to $2,500. It ended up taking two months to find a tenant.

My wife and I disagree about this but I would rather leave some money on the table than have the unit vacant longer. The $200 differential for one year between the rent we wanted and got is still lower ($2,400) than the lost rent for one month ($2,500).

Repairs

My main takeaway here is that Youtube is your friend. There are basically three main areas that we’ve had to focus on, sinks, plumbing, and appliances. Some things just seem to keep happening. I’ve had to replace sink stoppers twice, two garbage disposals went bad, and I’ve taken apart kitchen sink faucets multiple times. All I’ve been able to figure out with Youtube. We’ve called in a professional to replace the garbage disposal (the first time, the second one I did), repair a leaking dishwasher, and unclog a washing machine.

Taxes and insurance

You always start a section labeled taxes with a disclaimer that I am not giving tax advice and you should always find an expert to ask questions. What I will point out is that while you can no longer deduct interest expense like you can on your primary residence, on a rental you can deduct depreciation (https://www.irs.gov/businesses/small-businesses-self-employed/tips-on-rental-real-estate-income-deductions-and-recordkeeping).

When we bought our place in DC, we got a first-time homebuyer tax credit. We had to stop claiming the credit when we moved out. We were lucky enough to be reminded by an agent in our building who noticed it when doing research for another client (https://www.compass.com/agents/dc/john-peters/)

Another change you’ll need to make is in your insurance. You’ll need to switch from homeowner’s insurance to landlord insurance. One thing we didn’t think about too much before is buying in the same jurisdiction. Out Petworth condo is in DC while our Silver Spring condo is in MD. That means we had to use a different insurance company and will also have to file taxes in both places.

Some people suggest creating an LLC to hold your rental investment to limit your liability. The downside is the extra paperwork and cost, e.g. you’ll have to create the LLC and file taxes for it every year. We decided not to create an LLC and instead purchased umbrella insurance (http://www.themoneycommando.com/umbrella-policy-vs-llc-asset-protection-part-1/)

Final thoughts

I hope you’ve enjoyed this series. It was such a learning experience for us I wanted to share it in case any of it might be helpful for someone else. Everyone’s situation is different but there are some things that are applicable to most situations. Happy to try to answer any specific questions in the comments section. My next blog series will be about my impact investing journey.

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