Even just this morning, a close friend of mine texted me asking if they should turn their home into a rental property. It’s also a frequent question I see being raised in groups and forums. So I think it makes sense to address it.
In reality, the question usually comes up in two forms:
- I own a home and need to move. Should I turn the home into a rental property?
- I am going to buy a home. But eventually I will move. Should I buy this home because I will eventually turn it into a rental property?
The idea seems so solid and almost too good to be true. Use your house to make money. Who wouldn’t want to do that?
But doesn’t always work out that way. So how can we answer this question?
But how could it go wrong?
First, let’s discuss why the answer to this question is not straightforward. It’s really due to one important reason:
We don’t buy our home the same way we buy a rental property.
Simple as that.
We buy our primary residence with emotion. We overpay for things that we really like and want. Because we will be living there. We don’t care if we overpay. And as long as the home fits within your financial plan and you buy intentionally, you really shouldn’t care if you overpay.
That’s why I recommend setting criteria for yourself before buying your primary home. But that’s another story.
Anyway, the point is that we don’t buy our primary home with cash flow in mind. And cash flow is what matters when buying a rental property. That’s why most homes don’t actually cash flow. And why in general, your home makes a poor rental property.
For instance, my home would have negative cash flow as a rental. It makes a terrible rental property but a great primary residence!
How can you successfully turn your home into a rental property?
I’m guessing you can surmise the answer from the above discussion.
The way to successfully make this transition between primary residence and rental properties to buy your home like a rental property.
That means that you need to really thread a needle when buying it. You want a home that fits you and what you are looking for but also one that cash flows well.
Usually this means making some compromises on your end when it comes to the property as a primary home. Maybe you found another home that is bigger or when better amenities. But it doesn’t cash flow. So you go with the smaller home or the less fancy one that does cash flow.
Or it means swallowing a tough pill and just selling your current home when you are moving if it doesn’t cash flow.
And this brings us to an important point…
Do not keep your home or buy a home (either renting out our or not) because you expect big market appreciation.
This is pure speculation. And you need to minimize the role of luck in your investing as much as possible
But even more, primary homes are valued based on what people will pay for them. And that is fickle. Much more fickle than the valuation of rental properties based on net operating income and ROI.
If you are paying a big mortgage on your former home even though it doesn’t cash flow and a market crash occurs, you are in trouble.
But if your property cash flows, you don’t care if the market value goes down. Your tenants are paying the mortgage and you are putting extra cash in your pocket every month.
This is exactly the same reason why I don’t buy rental properties based solely on market appreciation.
So, how can you tell if you can turn your (prospective or current) home into a rental property?
Well, you need to evaluate the cash flow potential of your home, whether you are already living there or looking a prospective home to buy.
The way that I figure this out is using the cash-on-cash return metric.
Cash-on-cash return (CoC) is the percentage of annual cash flow that a property puts in your pocket divided by the amount that you paid out-of-pocket for that property.
I pursue properties that reach an expected CoC return of 10% or greater. If it meets that mark, I am going to make an offer. If not, I’ll pass.
An example of how to analyze:
Let’s say you want to buy a $150,000 property using a mortgage with 25% down.(Although if you plan to live there first, you can often get this for much less money down.) You also pay $5000 in closing costs and put another $5000 into renovating the property.
So, you put $47,500 out of your pocket into the property ($37,500 for down payment + $5000 closing costs + $5000 renovation = $47,500).
Now, let’s say you calculate that after you move, you could make $400/month from the property after paying the principal and interest on the mortgage, maintenance, taxes, insurance, and all other expenses. That equals $4800 annually.
Therefore, your CoC would be 10.1% ($4800/$47,500).
Boom…this property makes sense as a home and to-be rental property!
What about if you already own the home?
Just run the same calculation using the money out of your pocket when you first bought your home and your expected cash flow after expenses when you move and rent it out.
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How to figure out the cash-on-cash return of a property?
Obviously, the above example is a bit artificially straight forward. A lot of numbers go into figuring out the CoC return of a property.
The CoC Denominator
The easy part is figuring out how much money you are paying out of pocket for the property. That is a simple equation:
Money out of pocket = Down payment + Closing costs + Repairs/Renovation
The down payment and closing costs are easy to estimate by asking your lender. The repairs/renovations estimates can be a bit more tricky. I recommend walking around the property with your contractor to get a sense. You can even bring them to your showing or open house. You can also ask your real estate investor agent if they have a lot of experience but tread carefully (they want to sell to you and some agents may be inclined to underestimate).
Whatever that value is will be your denominator in the CoC equation.
The numerator is a bit more tricky
The first step to figuring out your numerator (AKA the annual money that the property puts in your pocket), is to get an accurate estimate of how much rent you can get.
I already mentioned Rentometer as a good option to get a general sense. But there are 3 other ways that you should confirm that your rent estimate is accurate:
- Compare to similar listings on rental websites like Zillow or Apartments.com
- Ask your investor real estate agent (make sure that they are actually an investor real estate agent first)
- Ask your property manager (or if you are self-managing, just call property management company and ask, they are happy to help. We did this)
Once you have monthly rent, you need to figure out all of the other estimated monthly expenses.
- Mortgage principal and interest
- Estimated vacancy and turnover (usually use 5-10%)
- Property management fee (if using a property manager – most property managers charge 10% of monthly rent)
- Unit turnover fees (if using a property manager for this – most PMs will charge one month’s rent for this service)
- Estimated maintenance costs (usually use 5-10%)
How do you find estimates for all of these variables?
It can seem overwhelming to figure out all of the estimated expenses, but it’s actually not too hard.
For your mortgage principal and interest, just ask your lender. For utilities, just call the utility companies. They will give you averages for that property over the past few months. For insurance, ask your insurance agent. For property management and turnover fees, ask your property manager or put $0 if you plan to self manage. And your estimate maintenance and vacancy can usually be safely assumed at 5-10%.
Err on the side of OVERestimating your expenses always. You want to bake some room for error into your calculation.
Putting it all together
Once you have the monthly expenses, simply add them up and subtract from your monthly estimated rent amount. Next, multiply by 12 to get the annual net income. The resulting number will be the numerator for your CoC equation.
Now, all you have to do is divide this number by your denominator, the out-of-pocket amount, and you have your cash-on-cash return.
You can figure this calculation out via pen and paper, online calculators, or using a simple spreadsheet, which is what I use.
If this CoC is 10% or greater, you should consider this a home that could successfully become a rental property.
If it doesn’t meet your CoC criteria, you can always play with the variables. Maybe if you bill back utilities, the numbers work out. If you are buying the home, maybe if the seller decreases the purchase price by $10,000, the CoC goes to 11%.
But you need to remember to negotiate based on your criteria
That’s the beautiful thing about investment real estate. You fall in love with the numbers. If a property doesn’t meet your numbers, don’t get emotionally attached, just move on to the next one that does. This is easy because you already have a primary home. So emotions are (pretty much) out of the picture.
But when you are buying or have a combined home/investment property, it’s a different story. Emotions are more involved. So remember what your purpose is: to turn this home into a rental property. So stick to your criteria and move on if they don’t work!
The way you perform thesis analyses will set you up for success!
What should you do if the numbers don’t work?
It’s easy in theory but hard in practice. But you need to do the right thing or you could really hurt yourself financially and create an actual real estate investing headache.
If the numbers don’t work:
- Walk away if you are buying a property
- If you already own the home and are moving, just sell it and move on
If you are considering this process, you also need to make sure you can find the right real estate agents to help you, figure out your property management plan, and have an asset protection strategy with the right LLC formation and insurance in place!
What do you think? Should people turn their homes into rental properties? Have you done thing or thought of doing it? How did it go? Let me know in the comments below!