Am I Borrowing Too Much?

Question

Hey Bigger Pockets!I’m looking at my first property and it will be a buy and hold. It’s a 4-plex in a diserable area, and it will cash flow now and after upgrades (more on that later). This is assuming I go with a conventional loan. Going with an FHA will put me at a cash flow disadvantage because of the PMI. List price is $310K (considered high for the area) and I am targeting a price of $285K (not interested in it too much above this) but the mortgage + PMI and PITI will leave me at about 0 cash flow each month (will break even after saving for expenses, which I estimate are about half of the rent). Rent would bring in $2,750/mo. Also, if I went with FHA and had PMI I know I could refinance if I got my LTV below 78% but this might not be to my advantage since interest rates are increasing and multi family rates will be relatively high. I’m guessing 6-7% in a couple of years. I’ve calculated that id pay more with the refinance than just continuing to pay PMI. Just to keep my options open, I’ve reached out to a friend who is an investor and we’ve worked out a deal where he could lend the 25% downpayment and I would pay him back over the span of 2.5 years at 10%. This would allow me to avoid PMI and the place would cash flow very well after the investor was paid off. This gets to the other part of my dilemma and the reason for this post, which is to ask the community if they think I’d be borrowing too much.Again, this will be my first property. I make a good wage as an engineer and work is stable and don’t really see that changing over this time frame. It’s a newer gig for me and just finished paying off student loans so don’t have anything to contribute to the down payment. I’d use the amount I’ve been paying off my debt with (~$1,500/Mo) to pay off the investor, along with the cash flow from the property so that the agreement above was satisfied. I’ve lived on my current budget for several years (essentially living like a grad student) and know my living situation is comfortable enough and paying this amount is sustainable for me. So, is it considered too risky to borrow the downpayment of $~75,000 + interest and hustle paying it off in 2.5 years? The house has a brand new roof and is structurally in great shape. New wood floors and tile have been put in recently. It has stable tentants (retired/older folks) in a great area. If the current tenants move out I would rehab the place lightly (cabinets, some new hardware, paint, etc) and increase the rent. Rent is waaaaaaay under based on comparable rates this area. I live about 3 blocks away and am charged $1.10/sqft. I’ve done my due diligence and know this is a fair rate for the area. We’re at the base of the mountains in ABQ on the hiking and biking trails (again, highly desirable area and virtually no crime). The current units are rented at under $0.8/sqft and my realtor agrees this is very low and can easily be increased. Just seems like it’s a good opportunity but I could also be missing something important. Thanks in advance!Zach

John Ferrughelli · Answer

@Chris SeveneyI’m also new here in the investing game - my question is why is $2,750 a month in rent for 285K not a good play? Not disagreeing or challenging - just simply asking because I might be missing a key part of this. I ran the numbers and even with no money down, Zachary would still come out on top. Just wondering why you think it’s a bad investment.

Andrew Johnson · Answer

Zachary Stoll For what it’s worth it doesn’t sound like you have adequate (or any) reserves. It’s always a dicey proposition if you’re going into a *projected* zero cash-flow scenario with no reserves. My limited experience is that there is always some “stabilization” hiccup that happens during Year 1. That could really put you behind the proverbial 8-ball. Or things could be fine, it’s just an outsized risk. The kind of deal you’re describing (in my underinformed opinion) are best taken on by those can that can play with “house money”. They can put 25% down, they can wait 12 months to raise rents, they can handle any hiccups along the way, etc. And those people generally have reserves and sometimes have other cash-flowing properties that could prop up a deal that takes a short-term hit. That profile is much, much tougher for a first-deal investor.

David Zheng · Answer

Explain this to me....are you living in one unit and renting out the other 3?because 1. you cannot get an FHA loan (or any conventional loan under 80% LTV) if you are not living in the unit for at least 1 year. 2. you can only get "gift funds" from your friend as a downpayment if its a primary. So if you aren't planning to live in the apartment and want to get a 25% down investment loan, your friend wont be able to give you the downpaymet. Unless you two create an LLC together and purchase it that way. 3. if you are getting 2750/m from 3 units while living in the 4th, its not a horrible deal as long as its a good area.

Thomas S. · Answer

Buying cash flow is never a good investment. Your DP will not increase true cash flow on the property. The only way this would be a worthwhile investment would be to bring rents to market rate as soon after you purchase as possible. If you are not prepared to charge market rents your may want to reconsider your goals in regards to investing in income real estate.

Jeffrey Holst · Answer

@Zachary Stoll @Chris Seveney is correct this isnt a great play. You need to look for properties that at least meet the 1% rule which is to say the rents at the min need to be 2850 a month on this deal and even then its really tight. I'd pass. I know you say you want to get in and this deal is better than others (this may be true) but if you cant find good deals then getting into the market is a mistake. Keep looking and find a great deal. Also if you are confident you can pay off 75K in 2.5 years at 10% Thats paying like 2700 a month. Start banking that 2700 in a investing account now so while you look you are gaining cash for the down payment on the great deal you find. Sometime I buy 3 deals in a month and other times I dont buy for 6 months in a row. You cant chase these deals if the numbers arent right then walk. My best guess on your deal is you need to get it for less than 250K for it to make sense.

Chris Seveney · Answer

Zachary Stoll Paying $285k for $2,750 a month in rent is not great - only play is banking on appreciation which is speculating. Me personally I would see that as being over leveraged. Others may differ but I am more conservative and you are banking on a lot of things to go right to make this work.

Jim D. · Answer

Also, are you saying that it's currently rented for $2750, but market rent would be more like $3500/month? If that's the case, this could be a great first buy.

Jim D. · Answer

Call a lender and see if you will qualify for the conventional HomePossible loan. This is a little-used conventional loan which can be used for owner-occupants on up to 4 unit properties. It's better than FHA loans because it only charges one form of PMI instead of two (FHA loans charge both single premium and monthly PMI). Additionally, the PMI can eventually be dropped without refinancing once you get to 78% LTV (whereas with FHA it stays for the life of the loan). The reason this loan is rarely used is that you have to meet the following conditions:1. Must be first time homebuyer2. Must make under the median income for your area (you can look it up on the HomePossible site)Might be worth a look!

Zachary Stoll · Answer

Thanks @Jeffery Holst, @Thomas S., @David Zheng, and @Andrew Johnson for your feedback!Sounds like I need to save up some more $ before diving in. It seems I'm probably "chasing" deals and could put myself in a bad situation.I realize this is the top of the market, sooooo.... better deals will present themselves in a buyer's market?As an update, I did consider putting in an offer after adjusted my strategy to borrow only $20,000 for a 5% downpayment (plus closing costs) using an FHA loan. I considered living in lowest price unit and renting out the other 3 (total rent would be $2,065 for the 3 combined).My lender told me I could use funds from anywhere as long as they "season" in my account for 2 months, as this is how far back the banks check.I'd have no problem increasing rents to market value and believe the current rents are under priced. Lots of simple things could be done to increase value as well (hardwood/tile floors, new cabinets, counter tops, paint). I estimated ~ $3,200/mo from all 4 units after renovations. But this would be a few years away after I lived in one unit for a year (and fixed it up) then made my way around fixing up the others as tenants turned over.Still, many thanks for all the great advice here. As anxious as I am to get into the game, it sounds like saving up for a downpayment over the next year may yield a safer strategy. I just worry a bit about interest rate increases over the next 12 months. Seems like the FED will increase rates about 1.0 to 1.25%, which (from my simple calculations) would increase my mortgage payments by the same amount as ditching PMI (through a refi after an LTV of 78% was reached).

Zachary Stoll · Answer

@Chris SeveneyThanks for the response! Unfortunately most properties around here look much worse than that. I estimated a cash flow of $450-750 depending on if rents were raise for not. But it's great to here others feel a bit hesitant as well. My backup plan was to stack cash at the rate mentioned above and hopefully have enough for a downpayment (or part of a downpayment + outside investments) in a couple years.For comparison, what do good deals look like in your area?