In today’s market, should I house-hack and (combine primary residence and investment all in one) or should I buy a real estate investment property first? This is an important question. Let’s dive in!
The presumption I make with this article is that you will follow my advice and do a house-hack, which means that you will necessarily find yourself in the same position that I was in before I placed my bet. I was studying, internalizing, rationalizing the market to figure out what I should do, where, when, and how. And relative to this, what’s most important to me is that you are able to see the big picture in everything I write.
I am not interested in wetting your appetite with platitudes, hurrays, and cheap theatrics. I am not interested in selling you on how easy stuff is, or how quickly it can be done. There are gurus for that of which I am not one.
While I certainly do want to entertain you, more important to me is that you actually learn something on every post you read. What I want, and what gives me most pleasure is teaching. The best way I know to do this is by retracing my own steps out-loud for you. I want to share with you my thinking and how it eventually materialized into my actions.
Restarting my real estate investments
And with this in mind, when we first moved to Arizona in August of 2016, and I started looking around and evaluating my options, the very first question I asked myself was – Should I buy an investment property first, and use the cash flow to bridge the debt service on a primary residence, or should I house-hack, and essentially combine primary residence and investment all in one transaction?
I don’t think this was an unreasonable question. I am a real estate investor, and these are the terms in which I think. Real estate cash flow, in one way or another, is simply there to subsidize my lifestyle. How this happens is beside the point. I’ll take what the market gives me. But, the point is – I am open to being in sync with the marketplace, as should you!
Both of these approaches, buying a dedicated investment property to pay for the primary, and/or house-hacking, could work under the right set of circumstance to accomplish the stated objective of underwriting my living expenses. So the choice was valid and reasonable. And, since at some point you might find yourself at the same crossroads, it might be helpful to you to know that in the end I settled on a house-hack as the a much more elegant solution for my family.
Below are some of the considerations.
Conforming Residential Loans and House-Hacking
In America, there are mortgage loan products which are designated for owner-occupants, and those that are strictly for dedicated investment property. I don’t want to make this a lesson on the secondary market, Fannie Mae, or Freddie Mac, but in terms of down-payment requirement, interest rate, origination and other points, and potentially also the amortization, owner-occupied loans win out very considerably.
Now, before you email me to inform me that Fannie-Mae allows up to 10 mortgages (or whatever it is at the time of your reading) of the owner-occupied variety loans for investment property, understand that the terms on those mortgages as well as the qualifying guidelines are quite a bit more stringent than on a loan for a house that you actually move into.
In the end, it is always advantageous to buy as a homeowner who intends to move into the property. This will simply and unequivocally land you the best possible terms on a loan. Once you’ve played this card, then it’s a good idea to utilize Fannie/Freddie notes for as many investment properties as you can. And only once you’ve maxed those lines do you want to move into the commercial space.
Let’s get back on point and discuss some of the particulars of how all of this knowledge shaped my eventual decision to house-hack right out of the gate.
Amortization for Real Estate Investments
This may not necessarily impact you in the same way as it impacts me, so have an open mind. Now, in 2016 if I were to pursue a dedicated investment property, which is to say a piece of real estate that I intend to use for commercial purposes only without intention of moving into it, then a 30-year amortized mortgage is not achievable for me. As I alluded to above, the secondary market places restrictions on how many conforming notes of the residential variety an individual is allowed to have on his/her credit history to use as financing of investment property. And let’s just say – I’m out. I have not been able to get one of those notes for an investment property in many years, which necessarily means that whenever buying anything other than a primary residence I have to utilize commercial or portfolio financing.
Here’s the thing, while 25 and 30-year amortizations are not unheard of in the commercial space, most prevalent is either 15 or 20 years. Indeed, all such loans currently in my portfolio are on 20-year amortization.
ARMs and Real Estate Investing
Aside for the obvious reality that shorter amortization period results in monthly higher debt service, which is not the greatest thing when you’re trying to create as much cash flow as possible in the short term, there are other “inconvenient” elements to commercial paper as well. For instance, more often than not, commercial financing incorporates ARMs, and/or balloons. For those of you who don’t know this yet, ARM stands for Adjustable Rate Mortgage, and basically what this means is that the interest rate you pay on outstanding balance of the Note adjusts at specified times throughout the life of said Note, and it is generally tied to some bond rate metric.
So, payment on a loan like this might start out at 5%/annum rate and 20-year amortization. But, but after say, 5 years, the interest rate adjusts to whatever the going rate is at that time. The new monthly debt service is calculated based on this new interest, the outstanding balance on the note, and the amortization period still remaining.
And the reason this is kind of a big deal, of course, is the interest rate risk. In August 2016 my thinking was that chances are better than not that rates will be going up. Thus, if at all possible to avoid this exposure, that would be my preference, And this was a strike in my mind against going with a plan which involved commercial financing…
Balloon Loans and Commercial Financing
Now – the balloon is a stipulation in the Note that after a certain period of time (but before the amortization fully amortized to zero) the loan has to be repaid in full. In order to accomplish this one can either sell the property to pay off the remaining balance organically, or refinance.
So, you might start out with a 20-year loan, and your interest rate might reset in year 5, at which time your monthly debt service will adjust. This would be the ARM component of your loan. Further, instead of repeating the same process at year 10, there might be a balloon stipulation instead requiring to pay off whatever balance is left on the note completely. This, as you can imagine, represents some risk. Why – because the decision to sell is not a choice, but a mandate. What if the markets do not cooperate? Obviously, this creates a potentially dangerous situation.
What I just described is very common and characteristic of commercial portfolio loans. In other words, lots of moving parts, and while you certainly have to get used to these complexities if you want to grow as a real estate investor, if you have other options it’s probably best to max them out before considering a balloon.
Here’s the thing – I’ve got too much property to qualify for anything other than commercial financing on anything other than the primary residence, and this has been the case for many years. So, buying a property strictly as a rental necessarily pushes me into commercial financing, which means dealing with all of the ARMs, balloons, and all the rest of it. And frankly, none of it bothers me. To grow large enough as an investor you will at some point have to do this, because that’s the only way.
However, the only reason I was considering this route is to bridge the cash flow from a rental into covering debt service on my primary. And the exposure to interest rate risk, the ARM risk, and the Balloon risk was not welcome under the circumstances. And finally, while there aren’t many times in life when we are afforded clear options, this time I actually had options, so I was determined to pick the best one.
As an owner-occupant performing a house-hack, for instance, I had the option of obtaining a conforming, 30-year amortized Note, with no ARMs, balloons, or any other junk. This, all things being equal, made the option of a house-hack (any type of a house-hack) much more interesting to me than buying an investment property to bridge the debt service on a primary. The fact that I could achieve my equity and cash flow objectives while not having to deal with commercial financing made a house-hack a much more attractive avenue to pursue.
Does this sound complicated or are you following along? I hope so, because there were more considerations that came into play. Stay with me.
Down-payment – House-Hack vs Investment Property
Similar advantages of owner-occupied notes can be observed relative to the down-payment requirements. In August of 2016 it was possible for me to qualify for a residential loan with down-payment requirement as low as 5%. By contrast, as it relates to investment property financing, a down-payment of 25% would be requisite for me.
Those of you who know me well are aware that my preference is always for low or no money down. Putting money down equates to buying value, and I don’t get excited about that. There are times when larger down-payments are appropriate. Specifically, when you’ve succeeded at accumulating wealth and the game becomes more about preserving the money you’ve already made. But while we are in the process of building wealth as opposed to preserving wealth, we never want to buy value – we want to create it out of thin air.
That said, putting down 5% instead of 25% is appealing to me because I am building wealth. It’s my presumption that you are reading this book for the same reason, so let’s think this through.
2 Choices with $50,000 Investment
Let’s just say you have $50,000 to play with. The way I see it, you have 2 choices:
You could make a 25% down-payment, in which case you can afford to buy a $250,000 house at 75% LTV (loan to value):
House Value = Down-payment $$$ / Down-payment % = $50,000 / 25% = $250,000
If you chose this option, the entire $50,000 you have will be committed toward the down-payment.
You could make a 5% down-payment, in which case you can buy a much more expensive house. Let’s just say you find a house for $355,000 and make an $18,000 down-payment:
There are a few points to discuss here:
One – if you were to go with the second option, you would obviously have money left over. If you have available $50,000 but the down-payment requirement is only $18,000, this leaves you with a surplus of $32,000 in your pocket. For one thing, cash is king and having it is always better than not having it.
But more importantly, could you use that $32,000 to make repairs to the house which in turn would improve the value of the house from $355,000 that you paid, to say $425,000? If you buy the right house, this answer is – yes.
And finally, if you buy a house in an appreciating market, then the same % level of appreciation will result in more dollars the more value you are starting out with. For example, 10% appreciation on a $250,000 would give you an additional $25,000 of value. However, the same 10% of appreciation on a $355,000 would result in $35,500 of value. Which is better…?
All things considered, the fact that I could get more house for less cash out of pocket by going with a residential note weighed heavily in my decision-making. On all of my investment acquisitions, even those that are financed with commercial notes and require large down-payment, I’ve always subsidized the down-payment to be either low or no money out of pocket for me. But this always requires complex blended financing packaging, investors, and all the rest of the tricks I discuss in CFFU. The House-hack strategy makes low money down as simple as possible which makes the house-hacking very attractive, indeed.
And thus it was becoming clearer to me that from a financing point of view I’d be able to maximize my investment dramatically if I were willing to enter into it as an owner-occupant, and not an investor. With the amortization advantage, which would help the cash flow, and the down-payment advantages, which would not only help my reserves but maximize the rate of return, the house-hack was starting to gain some sense of inevitability in my mind.
Interest Rates are Lower for House-Hacks
Seven days per week (and twice on Sunday) I can get lower interest rate on an owner-occupied note than a commercial note. Interest rate makes a serious dent on buying power. So, the better interest rate I can get, the happier I am. Done – nothing much more to add here.
House-Hack Property Management
Any way you slice it, whether this was to be a pure investment purchase or a house-hack of any sort, I was going to have to manage it. I was going to have to create systems, form relationships, and in short, build infrastructure.
All things being equal, the question was – “How do I get the intended result with the least possible time into it?” Having thought about it at length, and having discussed it with Patrisha, we arrived at the conclusion that a well-executed, blended house-hack was the best way to do it. Being in the same physical location as the project is simply irreplaceable. Granted, it is not scalable, but we weren’t looking for scale just yet; only a house-hack to get us planted in the new location.
Easy – right? Well, not so much. Because as very experienced landlords who have seen people behave as people behave, we knew that a poorly done cash flow house-hack could end up doing just the opposite of what we came to Arizona for. We were here to simplify and up-scale our family’s life, and we were both cognizant that a poorly chosen house-hack could instead compress our living arrangements and created more headaches than it was worth.
But, at the end of the day, the upside of a well-executed hack seemed to outweigh the risk. We simply needed to be extra careful about the location and the asset itself, so as to hopefully benefit from the market trending up. The location we chose would also help us to attract tenants to our project who would be easy to manage.
All said, given the right location and asset, a blended house-hack looked good from the management stand-point.
When we speak nonchalantly about house-hacking it might seem as though this is easy as pie. Similarly to anything else having to do with real estate, house-hacking is tricky and requires a lot of thought. And, just as with everything else, it’s easy to misstep…
More on the subject coming soon.
Be sure to check out my other posts on house hacking: