Purchasing new home....rent or sell my existing?

Question

I'm in Calgary, Canada. I currently own my own home (no outstanding debt) - typical single family starter close to schools, etc. I'm purchasing a new home that has a basement suite (although a bit of work needed if I want to register it (doesn't have separate entrances off of common stair entrance) where we would live upstairs.  I'm debating whether to

1) sell my current home, use the proceeds towards the new home, thus minimizing the interest on the new home HELOC, then keep looking for another investment property (maybe attached up / down or detached with main / basement suite) closer to my new property (less rental income until a second property found)

or

2) keep my current home, and rent it out....and when I have enough equity again, look for another investment property...

For both options, I would need to complete some upgrades to my existing home (minor repairs, bathroom reno at a minimum)

I'm familiar with doing the analysis on purchasing a property for revenue (the four boxes) and also the 1 percent rule (almost impossible to find in my city but with effort, possible) but I'm not quite sure how to analyze the above.

Any suggestions? similar experiences?

Thank you!

Clayton Mobley · Answer

Ok, I don't know about Ca tax laws or financing so please consult someone who does before you pull any triggers. That being said, I'm guessing that, like here, you can get lower interest rates for primary residences than for investment properties, the risk is lower to the lender. If that's the case, then I would say you should sell your old property to benefit from all that appreciation (like you said, it's not as likely to keep increasing as the new place is). I would not use it to pay down your new prop, because if you then turn around and take a HELOC you've just got additional fees to pay and the same amount of debt (more or less ). I'd leverage the new prop just as you laid out ($260k @4.45%) and use the proceeds from the sale of the older, highly appreciated prop, to build a portfolio of leveraged cash flow props. You need to consider how much debt you're willing to take on. But if you have that much cash to work with, you could potentially have a tidy little portfolio of properties that produce better income than the one you currently have.

**Again, please please speak to someone who knows your market, your tax laws, your financing options. General REI strategy is one thing, but those details could render all of my advice totally irrelevant, so make sure you know where you stand before making any moves. **

That being said, if this were me, in the US, I would sell the old prop and use it to build a portfolio of rentals. More diversification, more income, more flexibility long-term. I'm a conservative investor (cash flow over appreciation any day), but I also don't like having capital sitting unused, so at this point in my career (mid-30s) I'm not looking for fully paid properties, I want to leverage my capital to have as many doors as possible and let tenants pay them off, because time is on my side. Like any investing strategy, I will become more conservative as I near retirement. So, consider your risk tolerance seriously before making a decision. You may want to just buy 1-2 props in cash if you're risk averse (again, not sure the prices in Ca for solid B-class rental props) and would rather have more monthly income with no loan risk; or spread that capital across several down payments if you don't need the income now and want to snowball a portfolio over time (my personal strategy).

Either way, you need to make sure you've done the homework necessary to know where you can get solid returns, stable tenant base, etc.

Hope some of that was helpful, good luck!

Clayton

Clayton Mobley · Answer

The New Property

The new property is a house hack - where you live in a property and rent part of it out. You'd need to prorate the amount of your mortgage that would be funding the rental space in order to know what your rent to value ratio is (how big is this space versus the entire prop?). If you're financing, apply that prorate to your down payment to see how much cash would be invested just in the rental space, then add your rehab budget. You'll need to do the same for all your other prop-level expenses, like taxes and insurance, so the math will be trickier. Since you're buying this prop one way or the other (correct?), the return rate on this basement rental isn't really that important, you're going to be paying that mortgage anyway so anything is better than nothing in terms of rental income. If you only have to put ~$20k or so ($10k plus some pro rata portion of the dp, just guessing) and can get $900 a month, keeping expenses low (you'll obviously manage and keep the place maintained since it is also your house) then your return on that unit will be quite good.

A rough math breakdown:

With the loan amount and interest rate you mentioned, assuming similar tax and insurance rates as the current prop, your monthly payment is going to be about $1600. Let's say 20% of that is attributable to the rental unit, that's $320. Add in some maintenance (5%) and vacancy expenses (10%) and let's assume you get to keep a conservative $450 per month. For the year that's net income of $5400, which doesn't include the fact that your tenants are helping to pay YOUR mortgage, which is a major plus. If you put $20k into it, you're sitting pretty at about 27% CoC. Again, I would include the loan paydown since that's free equity in an appreciable property, but we started with CoC so let's stick with it.

Clayton Mobley · Answer

@Cindy Heselton Ok I'm going to take this piece by piece since you're asking a lot of questions and I don't want it to get all muddled.

Your Current Prop

Firstly, Congrats on all the appreciation!! That's fantastic! One question I would have is: what are the capital gains taxes like in CA? If it's anything like the states you could be in a pretty good position if you sold.

Let's assume you hold it, though, just for the sake of this thought experiment. With $1800 a month in gross income, your rent to value ratio is not amazing (about 0.5%), so that's a tick in the Sell column. Since you'll need to put in another $30k to make it rent ready AND have already assumed you'll have some large capex items coming up fairly soon, your investment in this prop is substantial.

As for your question about CoC, first let me say that it's not my favorite metric for analyzing rentals because it's going to change every year depending on expenses, rent increases, etc and it doesn't include one of the most powerful types of return - equity built up by tenants paying off your mortgage (although in this case that doesn't apply). Typically CoC is used to determine return on the sale of a property, not for annual returns on an ongoing investment. That being said, the CoC calculation includes all of the cash you have invested in the property vs the cash you get out of it.

So, if you had purchased this as a rental and made a down payment and then let tenants pay off the loan, the CoC would be calculated using that down payment (plus any rehab work you put in, maintenance expenses, closing costs, etc), but not the full loan amount since someone else is paying that. In your case, this was your primary and you paid the loan. The time you rented it was after you paid off the loan, so everything you paid, including interest - and plus the $30k you'll put into it now - is all your cash in the prop for the sake of CoC (this is why the CoC on rentals purchased with all cash is so much lower, more cash in the deal, lower CoC; leveraged purchase, higher CoC).

I would consider also running that number assuming you replaced those capex items now (esp the ones you think only have 5 good years left). My guess is that you won't really like the number you get. Even without that, and assuming you lived in a world where mortgage interest doesn't exist, you're $200k ($170k purchase + $30k rehab) into the prop with only $1100 * 12 = $13,200 in net annual cash flow. That's just 6.6% CoC. Given that the real number will be lower once you take interest and closing costs into account, I think you can do better.

Clayton Mobley · Answer

@Cindy Heselton Can you give us a bit more data on your current property? It;s hard to weigh the options without knowing how viable and investment that prop would be. If you could give us the following, I'm sure the BP community will have some opinions for you ;)

• Value of the current prop
• Estimated Rent Rate
• Estimated Rehab cost
• Would you manage it yourself or hire out?
• What are the taxes on the prop? Insurance?

My gut is that option 1 is more complicated and expensive than it needs to be if the current prop could be a good investment. Since you own it outright, you could always pull equity from it if you really wanted to expand your portfolio asap, but that's a decision you'd need to make based on your finances and ability/desire to carry additional debt.

Feel free to @ me in your response and I'll take another look when you have some data to crunch ;)

Cindy H. · Answer

Hey all - thought I should update you! I sold my original home, bought another one to live in, paid it off completely (mistake), renovated basement suite to make it legal (thinking short term rental so I can schedule visits from family and friends as our main floor space is limited).  We just bought a rental property with 3 suites, positive cashflow, needs a bit of work but because it's fully occupied (we assumed the leases) we'll just take care of some of the immediate repair needs (I will probably start a different thread on prioritizing repairs. That one's under a mortgage amortized over 30 years :).

Cindy H. · Answer

Hi Brianne,

I really appreciate your input!

My current property is in Macewan, typical family starter 4 lvl split, close to schools. My new property (and the one we want to live in) is in Lynnwood/Ogden.

1) I agree...rental is less...I was getting $1800 in 2017 but could afford to drop it easily as I was paying for a property mgr before and now I don't need one

2) From what I've researched, I can only deduct the interest (against rental income) if the interest is incurred to pay for the property being rented.  So the old house which I was considering renting is already paid off...no more interest left on it.  The new property has a basement suite, so I could deduct some of the interest on the financing for the new one against rental income.

3) completely agree...as Clayton indicated as well above

4) I know it's a waiting game...but I really don't think prices are going to increase again for a long time.  Plus, if I can reduce the debt on the new house, then we would have full equity plus cash to consider if another investment opportunity came along...and then those renters would pay our equity (or at least part of it) and if prices drop further (which they likely will..) we'll be in a better position.  Plus I would prefer an investment property closer to my main residence to reduce transportation costs...

5) mortgage vs heloc...yes...I need to perhaps do some math on this...because I'm getting paid a varying rate per month (I work from home on a daily paid employment contract)....the challenge with the mortgage is that if we decide, we can't simply pay it off at once or put money over a set amount against the principal.  I'm a bit leary of entering into a mortgage after realizing that I did it all wrong for my first home (5 yr, fixed rate, 35 yr amortization in 2002)....although I did change my payment to bi-weekly, increased the payment amount and managed to pay it off in 13 years..

Brianne H. · Answer

Hi @Cindy Heselton,

Out of curiosity, what areas are your properties in? A few things to note:

1) If your place was rented for $1800 starting in 2014, keep in mind rental prices have also gone way down since the good years 5-6 years ago. Keep in mind you may not be able to get $1800 for it again.

2) If I remember correctly, if you pay down your primary residence, and then borrow against it, the interest you pay can be deducted for tax purposes, so that's something you've definitely got going for you.

3) On the other hand, an ~$1800 rental on a ~$350k valued property isn't a fantastic return, especially if you're got financing on it.

4) If you sell, you'd be able to get that large amount of cash now, but as you know prices have dropped. If you were selling in a different year, you would likely be able to get a lot more for it. My own property just appraised for 480k, and in a better year would probably be closer to 550k-600k.

5) 4.45% for a variable rate? That would be for a HELOC, correct? Is there a reason you'd like to keep all of it as a HELOC, or would you maybe want to do a portion as a HELOC and the rest as a mortgage? Prime + 0.5% seems to be going rate for a HELOC, but if you wanted to keep a portion as a mortgage, you could knock off about 1%.

Clayton Mobley · Answer

@Cindy Heselton Yes I would agree, you would be better served to sell this property and use the cash to buy one or more leveraged properties that your tenants essentially pay for over time. This is how many many folks get started in REI, selling an appreciation primary home and using the capital to fund down payments.

As for the spreadsheet, I must admit I am not overly familiar with the one Brandon recommends, although he is definitely an amazing resource. I personally do not count income I can't guarantee (appreciation and rent increases) in my return calcs. Ideally, you will benefit from those things, but I always like to make a conservative estimate of my returns and then be pleasantly surprised when the real number is higher.

I also don't typically take into account tax benefits of rentals in my calcs. If a property produces decent income when you're just looking at the facts of the rental (current rent, maintenance, vacancy, taxes, insurance, P/I), then all those other benefits of REI are just icing on the cake. If the market doesn't go the right way every year, if you can't increase rent, if tax laws change, you still have a solid investment that cash flows (and you've accounted for potential vacancy in your calcs).

If you like I would be happy to shoot you over one of the interactive ROI calc sheets we use for our properties. You can input any data you like so it's pretty useful for analyzing other props. They also include amortization tables for 30yr and 15yr notes, so you can see what your returns will be incl that equity or without it (more of a CoC figure). Feel free to message me any time.

Cindy H. · Answer

Hi Clayton...wow! thank you for the detailed answers and you've definitely helped in putting it all in perspective.  For capital gains in Canada, basically we pay no capital gains on our principal residence....and then if the use of that home changes (i.e. converting to a rental), the capital gains is calculated from the value at the time of change in use, to the value when the house is sold.  While my house was valued last year at 365,000...prices in our market have dropped 5 to 10 percent since then....so the appreciation is not as great as it seems (plus the interest I paid on the mortgage).

Hopefully this isn't an oversimplification, not withstanding the caveats you mentioned, but because my current house was already paid for by me (only a few years of renters helping to pay the mortgage), it would make more sense to purchase a new property as an investment, where the tenants are essentially paying for the equity in the home....

I see what you mean now for CoC not being the best metric...do you know where i can find a spreadsheet (a starting point) that I can adapt for my market to help me with the analysis. I played around with the Bigger Pockets one...and it does consider rental increases / property appreciation....will it analyze the equity build up by tenants paying the mortgage?

Cindy H. · Answer

@Clayton Mobley how do I analyze a property that I currently live in where I would rent out the basement? Do I simply pro-rate the costs / expenses?

and I should have added above...that my current property area won't appreciate as much as the new area that I'm moving into :)

Purchasing new home....rent or sell my existing?

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