The following is a guest post courtesy of Woodstock and Dr. Linus from dadsmakingcents.com
There’s no shortage of time, energy, and effort spent when buying a home, especially your first home. For most people, this represents the single largest purchase of their financial lives and, for obvious reasons, they want to make sure it’s absolutely perfect. The problem is your first-time home is rarely your last home. Meaning, your first home is not just a roof over your head but it’s a financial opportunity and should be considered as such during the process.
This is the story of Woodstock’s first home.
REAL ESTATE WEEK:
Recipe for Success Using Your First Home Purchase
My first blog was inspired by my first home purchase, which was a tiny, new construction: 2 bed, 1 bath condo in a high rise building. I was single and living alone, but excited to get a place I could call my own. I spent money on upgrades that I considered valuable, like bamboo flooring, fancy fixtures, and custom window treatments.
Like many, I thought because I could afford my payments I was fine and that eventually, the condo would appreciate after 5-6 years and provide equity for my next purchase. Coming out of law school, I wanted to establish myself as a professional and what better way to do it than with a bachelor pad in a high-rise.
I left the condo after 6 years and it wasn’t until recently that I truly recognized the error of my ways and appreciated the money lost with this investment.
Dr. Linus and I contracted the real estate itch with an investment opportunity that forced us to put on our nerd glasses and educate ourselves on the financials of what we hoped was a good purchase. This first purchase led to another, and eventually, some level of clarity on the differences between a good and bad deal.
Through our purchases, Linus and I have come up with an approach to real estate investing that I think could be applied to any real estate purchase, whether it be investment property or a personal residence. Had I assessed my first home purchase knowing what I know now, I may have made different choices.
Here’s our approach applied (retroactively) to my first home purchase:
Dads Making Cents’ Assessment
Lesson #1 – For starter homes, consider the rental market
If we’re viewing the first time home purchase through the lens of an investment then the analysis starts with rentability and the return on investment (ROI). For this analysis, we will use the 1% Rule and the 50% Rule which were discussed by Dr. Linus on our site previously.
(Quickie: House price x 1% = rental of house. $100k house = $1,000/month rental.)
The expected rent should be at least 1% of the purchase price. This is a quick and dirty way to assess the income potential for a rental property. If it’s greater than 1%, then you have a good chance at being cash flow positive. Not all purchases will net you a full 1%, and the further you are from that number, the more you’re relying on appreciation of the property value to close the gap.
This estimates the expenses of a property (not including mortgage) to be 50% of the gross rent. This will account for property taxes, Homeowner Association (HOA) dues, insurance, repairs, unoccupied months, and other misc. expenses. This also helps budget for one-time expenses like a new HVAC unit or new roof which will not happen every year but should be budgeted for in advance.
So Let’s Do the Numbers
Below, we look at the scenario with the 1% rule (ideal) and with market rates (actual) at the time of purchase. As you can see the “actual scenario” is not an investor’s dream, but luckily Woodstock was not renting the place from day 1.
|At the time of purchase|
|Expenses||$1,375||$1,375||Based on 50% rule|
|Mortgage||$1,100||$1,100||20% Down ($55,000) @ 4.5%|
|NOI (Annual)||$3,300||($11,100)||Net Operating Income|
|Cap Rate||6%||Ouch!||NOI / Purchase Price|
Let’s fast forward 10 years and look at the most recent data. The unit has been rented for 3 years with the same tenant and other than a special assessment for some building repairs it’s been smooth sailing. As you can see the market rents have improved but still not up to the optimal level.
|Expenses||$1,000||$1,000||Based on real expenses|
|Mortgage||$1,100||$1,100||20% Down ($55,000) @ 4.5%|
*Cap Rates are not the best rate to use 10 years after purchase. Instead I will use Return on Equity (ROE)
Lesson #2 – Overspending on Amenities or Upgrades
The ROI of any investment is based on maximizing revenue while minimizing cost and expenses, but first time home buyers are rarely looking at ROI. The excitement is the ambition and desire that everything be the absolute best. Home buyers (first-time or repeat) will always try to justify upgrades at the time of purchase by thinking it will improve resale value. Sure that might be true but it won’t increase resale value in proportion to the increase in purchase price. The developers and real estate agents are incentivized to push up the sale price via upgrades because it results in higher profits and commissions.
From a rental perspective, hardwood or laminate is negligible, ¼” v ½” granite is irrelevant, and fixtures are functional not decorative. When buying your first home, keep an eye on the big picture. Leave the custom cabinetry, fancy built-in’s, and designer fixtures for when you are in your forever home because the value of those upgrades are in their usage, not the resale. In this case, if Woodstock had gone with the base features offered and passed on the upgrades then he would have had a lower purchase price and helped close the gap to the 1% rule.
Lesson #3 – When to Cut your Losses
Our inclination is to tough it out with investments that are not ideal and wait for the tide to turn rather than cutting our losses. We all make mistakes or misjudgements in our financial lives, but when those mistakes have been identified, how do we pivot?
This property does not just represent a loss of $100 a month ($1,200 annually), it’s also the opportunity cost on what the equity could have earned.
We illustrated how to get 10-12% in a Crowdfunded REIT. At $100,000 in equity, that $1,200 loss could easily be a $1,200 gain making it an actual loss of $2,400 annually when accounting for opportunity cost.
The reality is, your first home, unlike your “forever” home, is in fact an investment. It can be held onto to create cash flow, it can be sold to make a downpayment, it can be used as collateral on another deal. This first home purchase can be the first domino to fall in your quest for financial independence but only when analyzed correctly.
Woodstock and Dr. Linus
A special thanks to Michael Dinich. Blogger, expert, advisor, whatever you want to call him, guys like him push this community forward. We were able to accelerate our path to financial independence through their lessons and have made wiser decisions accordingly. Thank you for inviting us to post on your great site. We look forward to collaborating in the future.