Having sold one house (condo), and bought two in the past three years, I feel like I have a tiny shred of wisdom to add to this much debated topic. These are the four rules that Rob and I went over when we bought our most recent house.
- Pretend you are investing in a rental property.
- Understand if your repairs will pay off.
- Only buy houses if you can follow conservative rules of thumb for personal homes.
- Only buy in locations you love.
Pretend its a rental property
You should, generally speaking, only buy a house where you would prefer, from a financial perspective, to be the landlord than the renter. To make this judgement call, you need to understand two numbers: monthly cash flow and cash on cash ROI.
Monthly cash flow is the expected rent less known expenses. Expect ed rent is how much is a house like the one you're considering buying could be rented for in a similar neighborhood (check Zillow, Postlets, and Craigslist). Depending on the general rental/ownership landscape of the particular neighborhood you are considering, it might be tough to find decent numbers, but do your best to come up with a reasonable number.
Known expenses are mortgages, taxes, insurance, association dues, maintenance (estimate at about 5%-10% of rent), capital expenditures (estimate at about 5%-10% of rent) and vacancy (about 1/12 of rent).
After taking rent and subtracting your known expenses, are you still coming up with a positive number? If you're not, you probably want to pass on that house.
Cash on Cash ROI is your Annual Cash flow (multiply your monthly cash flow by 12) divided by how much cash you had to put down.
To better illustrate this, I'm going to show my current single family home, and our numbers:
Expected Rent: $950/month (this is what our house was rented for when we bought it)
Capital Investment: $100
Monthly Cashflow: $515
Down Payment $65,000 (no mortgage)
Cash on Cash ROI= (595*12)/65000= 9.5%
As a landlord, I would feel pretty happy with a 9.5% cash on cash return based on fairly conservative numbers, and I would be happy with a $515 cash flow. To be honest, since you're considering a primary house and not an actual rental property, I would be content with a positive cash flow (above zero dollars) even if the ROI is low.
Understand if your repairs will pay off
In order to figure out if your repairs are likely to pay off, its important to learn two numbers. The first is an estimate of the cost of the repairs, and the second is the market cap for your house.
Generally speaking, if you're buying with the intent to do extensive repairs (more than paint and flooring), you are likely to be taking your house from one of the nastiest houses on the block to one of the nicest. Do you have a good idea of how much those repairs are going to cost? If you're not an expert in that field (and even if you are) it's worth it to consider calling a contractor for an estimate. We plan to put in $15000 in maintenance and improvements over the next year or two (if we do our bathrooms), after putting in $10K already.
We like our house a lot more, but with the prices I've mentioned, we don't expect to see a huge financial payoff. We've seen "nicer" houses in our neighborhood sell for around $100K, so if our house is "nice" we can really only expect $90-$100K if we sell in the next two years.
Honestly, that's a pretty bad ROI (maybe even negative), which is why we are constantly back and forth about the bathrooms. Everything else will have a great ROI, but in our case, the bathrooms are bound to be a lot of work, so the juice might not be worth the squeeze. On the other hand, if we were going to stick around for 15 more years, we would have them done without hesitation.
Follow conservative rules of thumb
It takes a while to get used to home ownership, and there are usually several thousand dollars worth of expenses when you first move in, that's just how it goes. The first year of home ownership sees a lot of people sinking into debt as they try to suddenly get used to the American dream. If you follow all the conservative rules, even if you've completely ignored my advice you probably end up just fine in the long run.
Only buy in locations you love
Ideally, you would be able to design a reasonable life without venturing too far from your humble abode. I can't say that your location will be perfect through all stages of your life, but if your house is nearby most of your favorite haunts, then you have a very good thing going.