AskDong

I’m sure there are better guides to real estate investing out there, but this is my personal two cents in my series about earning money.   What follows are lessons I’ve learned from my own personal experience. I own a 2 Bedroom Condo in the Boston Area which I purchased in 2002 for about 300k. A t the time I put 10% down, and had to piggy back 2nd mortgage for another 10%. I lived in this condo between 2002 and 2006 and had a roommate the entire time. I also ended up refinancing twice.  Below is the cost structure through each refinance as to give some background on the property.

First mistake I made was refinancing for the first time. I shouldn’t have done that. The rate drop wasn’t significant enough for me enough to actually incur the closing costs of refinancing given the possibility that rates would drop further. Most no-closing cost refinances are not actually free. I did it within 7 months, so at least I didn’t reset my length by any significant amount.

I’ve said this before and I’ll say this again if you’re buying a place for yourself when you’re young, it’s best to get a roommate(s).  Especially in locations like New York, Boston and San Francisco where property is so incredibly expensive.  I like living with people so having a roommate never seemed like inconvenience.

Besides the most obvious benefit of having a roommate, rent payments, having roommate can be a great tax benefit as well. Since I rented out 1 bedroom in my 2 bedroom apartment, I was able to treat 50% of the expenses related to the condo as deductible tax expenses. For this reason it was more cost effective for me to charge my roommate a fixed rent that included all utilities instead then splitting utilities. By paying the entire utility bill, I could then deduct 50% as a rental expense.  Additionally I was able to deduct 50% of the condo fee as well. The deduction from the mortgage interest is a wash since one can’t take the same interest deduction for both the personal mortgage deduction and as a rental expense deduction. In net the deductions I was able to take on the condo fee, utilities, and other misc items, resulted in nearly a $5000 paper losss. Of course had I not chosen to rent out a room, I would’ve been able to deduct more personally on mortgage interest and property taxes, but I wouldn’t have been getting rent either.

Rental expenses are first used to offset rental income, in my case the rent from my roommate. Then if you’re an “Active Participant” you are allowed to deduct additional rental losses against up to 25,000 of income from other sources as long as you make 100,000 or less (which gradually phases out at a Modified Adjusted Gross income of 150,000). An “Active Participant” is anyone who owns at least 10% of a rental property and makes active management decisions such deciding tenants. Since I was choosing my roommate, I qualified and was able to use the rental losses against the income from day job while I was playing slum lord to my roommate.

I moved out of that condo near the end of last year, and this is the first year I’m treating my condo purely as a rental property. While I was living in the condo, it was my home first and then investment second. Now that I don’t live in anymore, it’s an investment first and only. Seeing the property purely as investment is very different.

Many real estate investors will tell you that the most important thing a rental property can do is be cash flow positive. Rental incomes should be able to support all rental and expenses and then some. However a property can be cash flow positive and still be a poor investment if the Return on Equity (ROE) is low. This is the case if there is great deal of equity in the property.  I believe most real estate “gurus” advise against ever having substantial personal equity in a property. Not being a real estate guru, I’m agnostic towards having equity in a property or not.  However, it’s important to earn a good rate of return on the equity that is there.  For example if you’re earning only 3% on equity, why invest in real estate when a savings account will pay 5 percent?

Below is an estimate of what the numbers for my condo look like. I’ve extrapolated for a full year.

So since converting my condo, I’m earning ROE of a little over 6% if that. The return is based almost purely on the principal payments being applied to my mortgage. On a cash flow basis my condo is a poor investment given that I pay almost 3,000 more annually than I actually take in. My cash flow is particularly poor because of the high condo fee, and  taxes I pay.  On the taxes end it’s critical to minimize the assessed value.  It’s not uncommon for assessed values to diverge from actual values. City and towns do not individually assess the value of houses or condos but instead depend on mathematical formulas to determine the value of a home based on square footage, number of bathrooms, parking spaces, neighborhood, and other quantifiable characteristics.

One note about my principal payments is that my mortgage is almost 4 years into the life of the loan as a result the portion of my mortgage payment going to principal vs. interest is slightly higher than it was when I first took out the mortgage. Had I been making this calculation based on when I first took out the loan, the amount applied to principal would’ve been about $3,250 rather $3,850.  As a result even though the denominator (equity) is increasing, the numerator (principal payments + pos cash flow) increases at a much greater rate therefore improving my ROE which is simply (principal payments + pos cash flow)/equity.

Also this is the first year I will be taking depreciation. Depreciation is simply the decrease in value of any property due to age. For a residential property the IRS allows you depreciate the value of a property over 27.5 years therefore generating a paper loss of (1/27.5) of the value of the property every year. So even though technically I’m earning paper profits (principal payments) with depreciation I end up having paper losses which can then be used to offset other income (assuming income qualification).  Given that my property is not cash flow positive, that paper loss is not quite as interesting.  If I were actually cash flow positive, I would be able to generate income effectively without paying taxes.  Of course, in the end the IRS always catches up as whatever depreciation that’s taken is then used to lower the cost basis when a property is sold.  Even though you have to pay taxes in the end, depreciation allows you to both defer taxes and translate what would be taxable income into potentially lower capital gains. The capital gains rates for depreciated property is not overly generous at 25% but still has the potential to be lower than one’s marginal income tax rate.

The question remains do I think rental real estate is good investment? My own experiences have been OK. Despite, generating paper profits, I’m also generating negative cash flow. Negative cash flow is never good, especially in a housing market that looks to be in decline where I cannot count property appreciation.   If I were all of sudden to become cash constrained that negative cash flow is a liability around my neck.  The other issue is vacancy. I’ve been lucky so far not to have any vacancy, but it’s not uncommon for an apartment to sit vacant for at least a month or two. I think it’s best to budget at least one month of vacancy into the annual budget/estimate for any given property.  Ideally a rental property needs it’s own “emergency” savings ofa few months to pay for repairs and tide it over vacant periods.

Of course the biggest issue with any rental real estate is the actual hands on work on required. I’ve been lucky to have a good tenant who pays on time and is pretty low maintenance. Not all tenants are of this ilk. I think if and when you decide to invest in rental property you need to ask yourself how much work you’re willing to actually put into it. Even if it’s not fixing things yourself, are you willing to stop by when needed to deal with contractors? Are you willing to find tenants? The less work you’re willing to do yourself the less likely you’ll make money. A property manager will typically take anywhere between 5-10% off the top. Hire a real estate broker to find tenants, they can potentially take a months rent. In Boston, who pays the broker can vary. In a strong rental market the tenants will pay, and in a weaker market the landlord will pay or split the cost with the tenant.   If I were doing it again, I would’ve purchased a multifamily. Live in one unit, and rent out the other units. It’s much easier to maintain a property that you yourself live in. Get a taste for what being a landlord is like without making the full plunge.

Disclaimer: I’m not a real estate expert. This post is more a reflection of my own experiences with rental real estate and should not be construed as professional advise. A professional I am not, and apologize for any potential misuse of terms in this post.