Real estate can be a powerful investment tool if leveraged correctly, but it also carries some of the highest startup costs among asset classes. With the rise of $0 stock commissions and REIT’s it can be tough to stomach dropping $50,000 into an investment property instead of drip feeding $1,000 into your brokerage each month.
While someone well established in their careers might not blink at that down payment, it may seem insurmountable to someone fresh out of school right? Well it doesn’t have to. Now we could look at seller financing or other innovative solutions, but what if cut through conventional financing via house hacking.
Breakdown
House hacking is simply taking advantage of owner-occupied financing benefits and using them to possess a single-family home up to 4 unit multifamily property. As it’s an owner-occupied mortgage you not only get a lower interest rate, but also qualify for most low down payment loans as low as 0% (VA loan) or 3.5% (FHA loan.) So that previous $50,000 is now only $8,750; seems more manageable right?
If multifamily sounds a bit too scary though you have some other options available to you. With a large enough single family house you can rent by room or set up the spare rooms for AirBNB; depending on your location. The concept is generally the same, but let’s focus on multifamily as that’s where my first foray into real estate was and where I saw great success.
While limiting the equity locked into the home is great, let’s get into the real meat of how powerful house hacking is; cheap or even free housing. If you are currently renting how often do you look at your rent bill at the end of the month and think what else you could be doing with that money. Rents on average are 30% of the average person’s take home pay, ouch! If done right house hacking could almost or entirely eliminate that expense.
Let’s say that you are currently pay $1,200 in monthly rent. You have decided to make the plunge and start looking at some properties you could house hack. You find a 4 unit multifamily priced at $300,000 and get the seller to cover your closing costs so you only pay $10,500 out of pocket. With a 4.5% interest rate, taxes and insurance your monthly PITI comes out to $1,625. You are a working professional and don’t want to deal with tenet hassles so you contract out a property management company for 10% of each month’s rent and an initial placement fee.
The property management company fills your 3 vacant units over the next month with a rent of $800/month/unit after their management fees. So over an average month your expenses might look something like this:
- PITI – $1,625
- OPEX/Maintenance Fund – $300
- Vacancy Assumption – $300
- Net Rents – $1,950
- Monthly Cashflow = $2,400-$1,625-$300-300 = $175/Month
So what you might be thinking, $125 isn’t life changing money? That might be true, but
- You aren’t paying $14,400 in rent this year
- You have an asset worth $300,000 that’s also appreciating on average ~3% every year (hint, that’s $9,000 in year one)
- Your mortgage is being paid off every month by your tenets
- After a year you can put your unit up for rent (another $9,600/year) and do it all over again.
- Real estate is an unbelievably tax advantaged asset class. Depreciation, interest deductions and misc. operating expenses dramatically reduce your on paper tax burden.
That is why house hacking is such a powerful tool. If utilized correctly and with a bit of forethought, you can live rent free and set yourself up with a relatively passive income generating property. Before you immediately go out and start throwing down offers, there are some important metrics that you need to understand first. Even though house hacking is a good jump start into real estate, it is still an investment after all and needs to be evaluated as one.
Housing Math
1% Rule – The estimated gross monthly rent for a property should be at least 1% of the purchase price. More of a back of the hand calculation then gospel. The 1% rule allows you to quickly rule out properties that probably won’t pass the later rules. The necessity of this changes if investing for appreciation over cashflow, but someone just getting started should be exclusively looking for a cashflow positive property to begin.
Cap Rate – So the property passed the 1% rule awesome! Onto the next metric the capitalization rate (cap rate). The cap rate for a property is the net operating income divided by the purchase price of that property.
Net Operating Income = Rents – Vacancy Rate – Insurance – Taxes – OPEX fund
You can then take the above number and divide it by the purchase price. So if the net income is $6,000 and the purchase price is $100,000 then the cap rate would be 6% (6,000/100,000.) A cap rate above 5% is ok, but the more aggressively inclined should be targeting 7-9% cap rates. Alright so the property passed the 1% rule and has a solid Cap Rate what next?
Cash Flow – Cash flow is king for investment properties, if this doesn’t work the property won’t work. The cash flow on a property is simply a money in minus money out calculation. To calculate it you will take the above net operating income and subtract your mortgage principal and interest off as well. This will give you the total money remaining at the end of the month.
The cash flow should always be positive, particularly when just getting started and without a full portfolio to fall back on. While there is an investment strategy for targeting appreciation it is much more speculative. Where people get into trouble with real estate investing is maintaining cash flow negative properties or very thin positive margins. If the worst occurs (job loss, housing recession, etc.) you are in a precarious position that may be difficult to weather.
There are more specific guidelines and rules in some of our other articles, but the above should give you a general idea of what you should be looking for.
Final Thoughts
House hacking creates a more accessible investing solution to those just getting started and interested in real estate. You don’t need to have $200,000 sitting around to start reaping the benefits of real estate. If you don’t mind living a bit unconventionally then house hacking is a strong option available to you to jump start your journey to financial independence.
