Talk to a lender and learn the rules of qualifying for a mortgage
You need to learn the rules that underwriters follow to be able to qualify for a mortgage. Once you learn the rules you can develop a plan to fit the lender's qualification requirements. Terms to learn and what lenders will need from you: Debt to Income Ratio (DTI), W-2, Pay Stubs, Bank Statements, Tax Returns, and PITI (this is your total mortgage payment including Principal Interest Taxes & Insurance).
Buy a primary residence to live in
Primary Residence loans have the best rate and terms, they also require a relatively small down payment (5% or less) making this the most affordable way to get started. You will be required to move into the property within 60 days and live in it for at least 12 months. You should buy in the best neighborhood that you can afford.
Buy a new primary residence to live in
After you fulfill the requirements of living in the previous home for a year, you are ready to turn it into a rental and move into a different house. Qualifying for the next house is the same as the 1st with one difference, you are going to have two mortgages. Good news, the lender will be able to offset the mortgage on the 1st house with 75% of the market rent since it is going to become a rental.
Example: your PITI (including HOA) is $1500 and market rent is $2000, this will cancel out the 1st house on your DTI and all you have to do is qualify for house #2. If market rent is only $1600, then that will hurt your DTI by $300 (75% of $1600=$1200), you can still keep it as a rental, you just won't qualify for as much on house #2.
Calculating your Return on Equity (ROE)
Say you paid $250k for a property and the PITI (including HOA) is $1500, current value is $330k and you owe $230k, so you have $100k in equity. Market rent is $2000 (expenses of: 4% CapEx, 4% Maintenance & Repairs, 4% Vacancy, 8% Property Management) these expenses equal 20% of rent (these vary a lot depending on the property, but this is a good starting point), so Net Rent after expenses is $1600.
This means you are getting $100 of cash flow; $1200 annually
Plus let's say your monthly principal portion of your PITI is $500; $6000 annually
Plus let’s say your property appreciates 3% on $330k value that's $825 monthly; $9900 annually
Total that’s a $17,100 return on your $100k (17% ROE)
Lets change this example so the property only rents for $1600, so $1280 after expenses:
Cash Flow -$220; -$2640 annually
Principal Paydown $500; $6000 annually
Appreciation $825; $9900 annually
Total that’s a $13,260 return on $100k (13% ROE)
Cash Out Refinance Example
Home is worth $400k and you owe $160k (Rate of 4%). PITI is $1300, Principal Paydown is $400 and Rent is $2000 ($1600 after expenses)
Cash Flow $300; $3600 annually
Principal Paydown $400; $4800 annually
Appreciation $1000; $12,000 annually
Total that's a $20,400 return on $240k (8.4% ROE)
In this example I would consider a cash out refinance, you could borrow up to 75% of the Value, so you'd take out a new loan for $300k (Rate of 5.5%), pay off the $160k loan, pay some closing costs and cash about $130k tax free that you could use to buy another property and add to your reserves. Your new numbers on this property would be worth $400k, owe $300k, PITI $1900, Principal Paydown is $300 and Rent is $2000 ($1600 after expenses)
Cash Flow -$300; -$3600 annually
Principal Paydown $300; $3600 annually
Appreciation $1000; $12,000 annually
Total that’s a $12,000 return on $100k (12% ROE)
This example might look like you went negative on cash flow, but remember you took $130k cash out of the deal, you were making $3600 per year in cash flow, so that’s over 36 years of cash flow that you took all at once and if rents increase by 3% annually you will be back to positive on your cash flow within 5 years.
Why you don’t want to pay a property off
Let's use the same example as above, but say its paid off, so $400k value, PITI is $200 (because you will always have Taxes & Insurance), Rent is $2000 ($1600 after expenses)
Cash Flow $1400; $16,800 annually
Principal Paydown $0
Appreciation $1000, $12,000 annually
Total thats a $28,800 return on $400k (7.2% ROE)
Other Key Considerations
This strategy can build equity and create wealth but managing the cash flow and reserves is essential. As you can see in the examples, the cash flow usually makes up the smallest portion of the overall return, but the cash flow is what you need to survive. Make sure you always have 6+ months of PITI payments as reserves. Appreciation and rent increases can really accelerate this strategy. The key to both of these things is buying in an area that has an increasing population and high paying job growth, tech jobs for example. Here in Arizona, Gilbert and Queen Creek are both great examples of this. Over time, rents increase, values appreciate and the principal portion of the PITI increases. As the amount of equity in a property increases the ROE decreases, when the ROE gets below 10% it's time to consider doing a cash out refinance or second position loan or sell the property. There are also tax considerations, such as depreciation and IRS Section 121 Exclusion.
