In order to build wealth, we need to have a deep understanding of how to build wealth. One of those areas that we’ll need to understand is to how to develop a foundational housing strategy that builds wealth.
Incorporating your life, similar to how a business is incorporated, certainly does have its privileges. In the past few posts I’ve discussed the tax advantages as well as the operating leverage that incorporating your life has on your wealth building goals.
After all the years of working with entrepreneurs and counseling business owners, it’s clear to me that approaching your life like a business has many distinct advantages over the alternative of not doing so.
An additional activity that is highly advantageous to approach like a business is your housing choice. What now has become synonymous with ‘house hacking’ is the choice to purchase a multi-unit dwelling instead of a single-family dwelling as your first housing purchase.
Single-family houses don’t generate income
As to what now has become folklore in the wealth building community, Robert Kiyosaki in his seminal book on wealth building, “Rich Dad, Poor Dad”, aptly summarized that the purchase of a single-family dwelling is a non-income generating asset and not a wealth building action. I agree with that assessment.
So with this as the mindset to approach your housing option, we are talking about a strategy focused around the purchase of a multi-unit dwelling as a first real estate purchase.
And this is VERY important…most lenders will allow you to purchase a multi-unit dwelling first that has a positive cash flow and then purchase and move to a single-family dwelling.
However, very few lenders will allow you to purchase a single-family dwelling first and then purchase a multi-unit, EVEN if that multi-unit were to positively cash flow. The reason is that your personal income coverage is exhausted once you purchase a single-family dwelling but if you purchase a multi-unit first, you normally get a pass because the income being generated by the positively cash flowing rental property has its own income coverage built into that transaction equation.
Real estate brings leverage to the game
Let’s get down to brass tacks. Real estate is one of the very few assets where an average person of average wealth can obtain an asset in a significantly leveraged position (Please understand that I am NOT an advocate for highly leveraged positions as a general concept.
In fact, I’m against it. Let me explain. If you were to purchase a multi-unit dwelling and live in it, you would in many cases be able to qualify for a loan as low as 3.5%. The FHA currently extends a 3.5% loan to owner-occupied rental property owners that have a credit score of 580 or greater.
Of ALL the asset classes (paper, real estate and businesses) there is not another scenario where you can control 100% of the asset for just 3.5% invested!
Let’s do the numbers real quick. On a property that’s worth $100,000 in order to control 100% of this asset, all you’d have to do is come up with a $3,500 down payment.
Now here’s the kicker. If that property’s value were to increase over the next few months to say $110,000, you now are not only controlling the original valuation of $100,000 with your $3,500 but you have now ‘made’ $10,000 on that investment. That’s a 185% Return on Investment (ROI) and you didn’t even do anything!
You get to control all the asset for a portion of the cost
Benefit #1
Benefit #2
The second benefit, as indicated above, is the potential valuation increase over time although that is not what we’re necessarily interested in as part of our initial analysis in buying the property.
Benefit #3
The third benefit, and the primary reason for this choice, is the income being generated from owning this asset.
Obviously when we choose to buy a multi-unit dwelling we are interested in receiving the rental income being provided by tenants. If this wasn’t an interest then there probably would be very few logical reasons to do it in the first place.
And here’s the finer point to this…if you purchase a multi-unit property it MUST generate rental income…and in my humble opinion…enough to cover the mortgage and operating expenses of the ENTIRE property. In other words, the property has to positively cash flow. Period.
Some readers will object that as long as the rental income from the other units ‘contributes’ to the overall mortgage and operating expenses of the property it cuts your housing cost considerably, and that is true on the surface,
BUT if the purchase is meant to be an investment (and that’s what I consider it to be) than it MUST generate more income than total expenses.
The 1% Rule
One very, very good rule of thumb is called the “1% Rule”. The 1% Rule states that if all the gross rents being generated are equal to or greater than 1% of the cost of the property, then it stands a very likely chance that the property will positively cash flow. Let’s apply some numbers to this.
IMPORTANT: Before we do anything, we need to figure out whether the property will positively cash flow assuming we will NOT be living in one of the units. This is VERY important because while we are living in one of the units we will obviously not be generating income from that unit. What we MUST avoid is buying a property that doesn’t positively cash flow when we don’t live in it.
Let’s assume we purchased a $100,000 multi-unit property with two units, a duplex. Provided that each of the two units were to rent out at $500 each per month, for a total of $1,000 a month, we stand a good chance of that property positively cash flowing.
Here’s the reason. On a $100,000 property financed over 30 years at 3.5% down (leaving $96,500 to be financed) and 3.5% interest rate, the monthly mortgage (less principal mortgage insurance (PMI)) would be $433 dollars a month.
Working backwards from our gross rents of $1,000 per month, we could incur a monthly operating expense plus owner paid utilities of $567 per month ($1,000 – $433= $567), or 56% of gross revenue, and still break even. Now don’t fret, a 56% operating expense is a very, very high percentage.
Although the industry uses 20% excluding paid utilities, a more realistic all in loaded percentage might be in the range of 30% to 40%. Using the larger percentage of 40%, which is still considerably larger than most consider normal, we’d have a total monthly expense of $833 ($433 to $400 = $833) and a positive cash flow of $167 per month ($1,000 – $833 = $167).
Benefit #4
The fourth and last benefit of purchasing a multi-unit property is the potential tax deductions. If operated under a Limited Liability Corporation (LLC) entity, you would have the same benefits of any corporation as it relates to being able to deduct ‘reasonable’ business expenses required to operate that business and generate business income.
The obvious expenses that come to mind would be a vehicle used in plowing snow, riding lawn mower, cell phone, internet and possibly the proration of a portion of a home office if dedicated to the operation of the ‘business’. The point here is that there are some lucrative benefits of being able to ‘offset’ living costs, very similar to that of a business, that you would other have to incur strictly out of your personal next income if you didn’t have a business entity created.
Conclusion
In summary, the following are the four primary advantages of purchasing a multi-unit rental property as your first real estate purchase:
- The ability to control 100% of the asset’s value for very little investment
- The potential valuation increase over time
- The income being generated from owning this asset
- The potential tax deductions
As you all well know, wealth building is a comprehensive strategy and it needs to include ALL parts of our lives. With housing having traditionally been roughly 30% of a family’s annual living expenses, and now approaching an unbelievable (and unimaginable in my opinion!) 50%, it is more important than ever that the right housing strategy be followed.
That RIGHT housing strategy is to incorporate a portfolio of multi-unit rental properties into your life.
