“Leverage” vs “buy a modest house”

Question

I am in what I suspect is not a particularly unique situation, but still doesn't fit into the standard model (I think).

I work and live in an area that has not seen negative rel-estate price changes in my lifetime and is (in my opinion) likely to grow over the next 10-30 years (prices grow that is).

I am 30 and have ~$450,000 in assets about half in real-estate, about ~$150,000 in 401k and other retirement, and about ~$100,000 in non-retirement stocks. I am considering retaining my current real estate investment (the condo I live in) but transitioning it to a rental property (my models make me %6 when I am extremely conservative, and %15 when I am the least conservative), and buying a bigger place for myself.

With the real estate income I would be paying ~%60 of my income to my two properties. Looking at the cash flow I would still be able to maintain company match on my 401k and live my current lifestyle (I live cheaply).

I believe that this is a reasonable investment, as I can leverage my money in a situation where I believe we are due for an increase in both inflation and interest rate increases, but it goes against the "buy a modest house" rule that seems so popular. Am I missing something? When if ever are there exceptions to the "rules"?

Answer 1

It's really a matter of your tolerance for risk.

It sounds like your local market is very strong, but I'm twice as old as you, and I've seen decades long strong markets fall apart and leave friends and family underwater. Eventually the markets recovered, but as the saying goes "The market can remain irrational longer than you can remain solvent." The hazard being that the economy hits a rough patch, you (briefly) can't meet your mortgage payments, the bank forces a sale at a depressed price, and you loose most, or all of your equity. Of course a 401k invested in index funds has its hazards too. The other issue is that being a landlord has it's own trials and tribulations. Are you prepared to take those on?

Answer 2

I can´t make the decision for you but here are some considerations:

If I understand correctly, you want to rent out your own smaller place and buy a new bigger place to live in.

I see 2 problems with this model.

1. The largest part of your real-estate investment does not generate you any cash-returns, since you live in it. If you where to leverage your condo to buy a bigger place, and rent that out, it should essentially pay for itself.

2. You are not very well diversified. If you rent out a single space, you are in high risk of getting no returns for a certain time. If your tenant fails to pay rent and after you got to kick him out, you have to redecorate because he left the place in a mess - can you cope without the rent for half a year + having to pay the repairs?

So, while I consider real estate as a great investment for generating passive income, the entry barrier is quite high, as you should have at least 4-6 parties to be well diversified and even better have property in different areas so you are not that much affected by trending areas. Also, don´t underestimate maintenance and administration work - its not quite as passive as it sounds to be a landlord.

So in your situation I would consider staying in the condo and buying a House whit multiple units instead, at least from a financial perspective.