Before buying any property, always ask yourself, Why am I buying this? This seems obvious, yet many buyers later regret not asking this simple question.
The best reason to invest in real estate today is for cash flow. There has never been such a perfect combination of low home prices, low interest rates and high rents. It makes a lot of sense today to buy a home if it’s cheaper to own it than to rent it. There are many areas in the country where this is possible, and both homeowners and investors should take advantage of this rare opportunity to increase cash flow.
However, in high priced markets along the coasts, the opposite is true. It’s still cheaper to rent than to buy, which means there may be more price adjustments on the way. Low interest rates have made it possible for people to afford more expensive homes, but what will happen when rates creep up?
They have been held artificially low since the Fed started buying mortgage backed securities, but that program is now over. Even a half percent increase in rate can price buyers out of the market.
Buying vs Renting Property By the Numbers
Let’s take a look at a typical property for sale, located right at the center of the nation in Kansas City, Missouri. It’s a 3 bedroom, 2 bathroom home in the upscale suburb on NE Howard Street in Lees Summit. It is fully renovated with a new kitchen, new bathrooms, updated plumbing, electrical and HVAC.
This home would cost $1100 per month to rent. It would cost only $780 per month to own with a 30 year fixed rate mortgage at 5%, including taxes and insurance.
Why is it Cheaper to Own Than to Rent?
The market has overcorrected in some areas. This house is now $80,000 when it sold for $120,000 at the peak in 2006. The low price combined with historically low interest rates make the monthly mortgage payment more affordable than ever.
The down payment is not a stretch either. An FHA loan would require 3.5% down, which would be $2800 on this house. The renter’s deposit would be $1100.
From the extra $320 the home owner gets by not renting, he should put aside $100 for future repairs.
That leaves an extra $220 cash flow that could be used to pay off the mortgage in 15 years instead of 30.
Who's Better off in 15 Years u2013 the Owner or the Renter?
Most rents increase 4% each year, so the renter would likely be paying over $1800/mo for this house in 15 years.
The homeowner, on the other hand, would have no house payment if he did indeed choose to pay off the mortgage in that 15 year span.
He would still be responsible for taxes and insurance, which would be around $500 per month. He also would own the property free & clear, increasing his net-worth by $80,000 or more if home values in the area increase.
What About 30 Years From Now?
The renter would be paying approximately $3000/mo for rent for that same house in 30 years, due to an estimated 4% annual inflation! Don’t believe me? Look up rents from 30 years ago.
The homeowner would still only be paying for taxes and insurance, which may have increased to approximately $1000/mo.
The home will most likely have doubled in value in that time frame and would be worth around $160,000. Again, if you don’t believe me, look up home prices 30 years ago.
And since the homeowner has set aside $100/mo for repairs, he has had over $36,000 to keep the home updated.
What if You Move?
While this all makes sense on paper, the truth is that families rarely stay in the same house for 30 years. A job may take you to another location, or you may find a home more suited for your changing lifestyle. If you sell your home, you will be facing 8-10% in closing costs.
Instead, consider keeping the home. You will avoid paying the closing costs, and the chances of renting it out for more than your mortgage are good given the increase in rents. Tax advantages will increase your cash flow as well.
Keep up your plan to pay off the home in 15 years with the extra cash flow, and you’ll truly land among the wealthy. That home will be paying you every month for the rest of your life.
Unfortunately, the homeowners who lost their lifesavings today probably paid too much for their property. They have surely learned their lesson to never buy a home that costs more than 2-3 times the average salary of the area.
Others who bought at the right price but then refinanced to cash out the equity may also regret their purchase. They have hopefully learned not to treat their home like a piggy bank.
But I think you’ll be hard-pressed to find a homeowner today who bought 20-30 years ago, paid off their mortgage, now owns the home outright, and regrets that decision. They are the ones looking for tax shelters and solid asset protection as others try to come after their wealth.
Take a look at Walnut Creek, California. In 2006, the median home price was $729,000. Today, it’s $526,000. The federal tax credit boosted the values up a bit from a low of $510,000 last year at this time, so some buyers think the upward trend will continue. But they may not be considering that the average income in Walnut Creek is $82,000. An affordable mortgage should be only 3 times the annual income, not 6.5. For Walnut Creek to become affordable, the median home price would need to be $246,000.
When interest rates rise, but incomes don’t, the result is a downward pressure on prices.
Compare these numbers to Dallas, Texas, where some neighborhoods have a $90,000 median income, $135,000 median home price and $1450 median rent.
If you were to rent in Walnut Creek, a $526,000 home would lease for about $2000 per month. That’s $1000 less than the mortgage, taxes, insurance and basic home maintenance would have been. Even with tax deductions, you’d still pay less to rent and would not be subjected to the risk of potentially further declines in prices.
However, even if it is more expensive to buy than rent in places like Walnut Creek, it still might make more sense for some people. These buyers may be seeking stability, tax relief, or a chance to renovate to their liking. As long as they plan to stay put for a minimum of 10 years, they could find themselves ahead of the game.
The government is attempting to create inflation to combat deflation. This is done by expanding the money supply. Even if the median home prices dropped another 20% to $420,000 during this deflationary period, it could experience huge gains once inflation kicks in. With just 5% inflation, that home could be worth over $700,000 10 years later.
Leveraged real estate has always been the best hedge against inflation because you can pay your loan back in less valuable dollars. You don’t have any more spending power, but at least you’ve kept up with times. This means you’ve got to be able to hold on to the property for an extended period of time to reap the rewards.
If you’re buying investment property, once again, you must ask yourself, “why?” Income that far exceeds expenses is a great reason. Selling the home for profit after making improvements also works. But buying on speculation, simply hoping that prices will rise again can be a huge mistake – especially if the property has negative cash flow at the get-go.
If you bought the $526,000 home in Walnut Creek as an investment, you’d put $125,000 down and then pay $12,000 in negative cash-flow. In the long run, the prices very well could go up, but then you’d have to add up the cost of lost funds along the way.
Whereas, had you bought in a cash-flow market like Dallas, you could have bought 4 properties with $125,000 down. The cash flow would be $300 per property per month, or $14,400 annually positive cash flow.
One strategy would be to take all that cash flow to pay off the 1st home in 8 years, and the 2nd home 4 years after that. That means in 12 years you’d have $31,200 in annual cash-flow, 2 houses paid off (valued at $300,000 not including inflation) and 2 more houses that could be paid off in 4 more years. (For a total equity position of $600,000 and $48,000 annual income, not including inflation.)
Compare these numbers to the Walnut Creek home that may or may not have inflated to $700,000 in 12 years. Subtract the $140,000 paid to negative cash flow so the real value to you is $560,000, but the loan would still be over $400,000. That’s a $160,000 equity position and still a negative cash flow position.
The difference between the high priced markets and the cash flow markets is significant. And all this, just because you asked, “Why?”