How to know if negative cash flow rental property is a good investment?

Question

I am completely new to the concept of investments and investment property. I've done research on rental properties and negative cash flow but am unclear how to actually measure if something is a good investment. Plus most examples consider buying a house and don't assume you already own the house and paid closing, down payment, etc.

I currently have a 15 year loan (14 yrs left) on a new build house I purchased for 274K with 10% down near the Austin, Tx area.

I am moving across the country to a home probably 100-150k 30 year loan and don't know if I should rent out my current house or sell it (the realtor thinks I can sell for for 290K and cover realtor costs to get what I paid last year).

I'm also currently around 60K in debt (student loans, car, and credit card).

Everyone I know says to sell it because I have debt working against me and it would be a negative cash flow, but from what I've read the Austin area is appreciating 5% and in 14 years, at most, I could have a paid off home bringing in a significant amount of money or sell for a significant amount.

The mortgage is $2500, rent would be around $1900, and a rental management company would be about $250 a month. About $1100 goes to equity each month of the mortgage right now, $600 to taxes, and the rest to interest.

Could someone guide me on how to get started in investment property and measuring if something is a good or bad idea (all recommendations I've received are from people who do not invest in rentals).

Answer 1

First, to get approved for another mortgage your debt to income ratio typically has to be lower than 43%. So, to get a 150k loan with your current mortgage you'd need to be at around $7,500/month gross income not counting your 60k debt, if for example your monthly payment due on the 60k was $500/month you'd need gross monthly income of ~$8,600. They will not count your potential rental income, they typically only count ~70% of rental income after ~2 years.

If you don't have a substantial emergency fund you could get into trouble quickly, you need to be prepared to cover periods of vacancy/tenant non-payment and surprise repairs. A market downturn could leave you underwater on your rental while also driving down rents, leaving you with even more gap between rent and mortgage to cover monthly.

As far as renting goes, a management company is typically a lot of overhead for not much value, other than finding a tenant, they just make the calls you would make to local companies for things to get fixed and you foot the bill. Without decent cash-flow it's much harder to justify the management company cost, but paying for management is also harder to avoid when you're not living close to your rental. I personally wouldn't recommend starting off with long-distance rentals, but that doesn't mean it can't work.

Austin is likely to be a high-growth area for a while longer, but there are no guarantees. If you have considerable savings and income then it may be worth taking a chance on keeping the house as a rental, but with 60k in student loan/car/credit card debt, it seems likely that you're not in a good position to take on the risk.

Answer 2

The simple rule is to add up all your costs, add up all your income, and subtract the costs from the income to get net income. Then divide net income by amount invested to get the rate of return.

Simple in principle. A small catch is that there are often many numbers and it can be difficult to keep track of them all. When talking about a planned future investment, you may not think of all the relevant numbers that might come up. An even bigger catch is that many of the numbers are not known in advance and can only be estimated.

For example, you say the market in your area is going up and so in a few years you could sell the house for a significant profit. But what if this doesn't happen? What if there's a bust and the market value of your property plummets? Etc for all your costs and income.

You acknowledge that there will be negative cash flow, so the only way this can possibly work is if at some point in the future the cash flow turns positive. I think what you have in mind is that market values will go up so you can sell the house for a significant profit. Or you may pay off the mortgage, reducing your expenses. Or rents may go up. Etc.

I fear you may be grossly underestimating the extent of the negative cash flow. Have you considered that you may have extended periods with no tenant, so you will still be paying the mortgage, you will have to pay at least some minimal utilities to keep the lights on and the pipes from freezing in winter, have to pay somebody to mow the lawn and do other minor upkeep, while you have no income.

Maintenance is a significant cost on a rental property. There will likely be a constant stream of minor (and major) maintenance issues, from a clogged drain to the furnace or AC failing, that you will be responsible to repair.

You may get a tenant who trashes the place. I had a tenant who did $10,000 in damage. Sure, you can sue them. Good luck getting any money.

Answer 3

It's a big tangle because you have to consider tax conseqences as well.

Right now you get a tax deduction for the interest and taxes you are paying on the note. This is much of the mortgage payment right now. This tax deduction replaces your standard deduction of, if I recall, $12,000 in the new tax code, so the first $12,000 of total deductions don't help you. But you will fly by that quite quickly with a mortgage of that size.

This peels right off the top of your taxes, so it "refunds" at your incremental tax bracket (28%) as well as the state tax in your future state, which can be 11.2% in California. That's 39.2% for a Californian, so say 40% of your mortgage payment ($1000) bounces back to you as cash back at the end of the year when you get your tax refund. (you can make this go faster by adjusting your exemptions). You already get this deduction, though you may not realize it.

You cannot deduct most ordinary expenses of your home. Now, when it becomes rental property, you can. That means you can also deduct:

• Depreciation (of the fraction of the house's value which is not bare land). You amortize this across 27.5 years, so every year you take 1/27.5 of it. This is on the basis that most assets have a finite life, and happens to overlook the fact that houses last indefinitely if maintained. So on a house, it's kind of a "gimme".
• Actual maintenance expenses, because they are business expenses of your landlord business. Yes, really, this and depreciation too. Some of these may also need to be depreciated, though on a much shorter timetable.
• Insurance costs on the house and mortgage, as expenses of the business.
• Property management fees, again, expenses of the business.

You are effectively getting a 30-40% rebate on these amounts when you are a landlord. So it changes the economics significantly, and makes many properties profitable when they would not be otherwise.

Answer 4

Assuming you've already calculated your income minus your expenses (which must be true since you know you have negative cash flow), then the formula is actually simple:

Add the equity you earn to your income.

Equity consists of two parts:

1. Payments towards principle.
2. Appreciation (or depreciation).

Calculating # 1 is easy: if you have a fixed rate term mortgage, look at the amortization table to see your principle payments and add that to the rental income. For #2, appreciation is tougher to nail down but it sounds like you've already researched it and are comfortable with 5%. Take the current value of your home, multiply it by 5% and add that to the yearly income.