We recently made an offer on a house in San Jose. It was a small 3-2 fixer-upper in a decent part of the city. After the offer due date, my wife and I heard back from our real estate agent, they received 15 offers on the house, and the chosen offer was all cash, 8% over asking price. My wife was pissed. So was I.
Generally, when everyone and their aunt thinks an investment is a good idea, it probably isn't. In a seller's market as strong as this one, we’re going to lose.
Our old plan: use every dime we’ve ever earned on a down payment on a home in the Bay Area.
My new plan: use our $150,000 in cash to buy rental properties with financing. Continue working at our 8-6 jobs for another 5 years to help make the mortgage payments, then retire with 600k in assets**. How are we going to get there? To be decided.
Step 1: Get the wife on board. After all, it’s her money too.
Step 2: Devise a sound plan based on our financial position.
Current Financial position:
- Combined income: $15,375/month pre-tax
- Cash reserves: $143,000
- Less liquid assets (gold, silver, notes): $10,000
- Credit scores: ~750
- Food, rent, random irresponsible spending: $3,000/month
- Tax: $5,500/month
- Acquire between $200,000 and $500,000 in real estate assets with a minimal cap rate of 5%.
- Finance the properties using 10 year mortgages with 25% down.
- Use the income from the properties to subsidize the mortgages. Use our income to pay the difference.
- Refinance the loans to 30 year fixed after five years. Optionally use equity to purchase more properties.
- Leave the Bay Area.
- Repairs on the properties will cost 1% of the property value per year
- Property values will stay the same over the next 5 years.
- We’ll keep our jobs over the next 5 years
The graphs are based on calculations I used to help me compare two investment options; buying a home versus buying a rental. If you have other means that you might have used in comparing the options, please let me know.
Rent vs. Buy: Predicted Net Worth After 5 Years
Stategy #1: First up, house only. This one feels a lot like treading water. Because we have to use all of our cash for the down payment, we’re left in a scary spot with our jobs. Strategy #1, my friends, is how we land ourselves squarely in the rat race. With this one, we NEED that paycheck.
Figure 1. Financial position over 5 years if we purchase a home for $800,000. Five year retirement goal at 54% completion after 60 months ($322k finishing assets). The grey line represents my P2P lending investment****.
Strategy #2: Invest in a $200,000 rental property. With 25% down, this leaves us with $92k in cash after the investment is made, and we achieve 80% of our financial goal after 5 years. As a starting point for a real estate noob, this feels good. If things work out, great, I can double down. If they don’t, I can float this strategy along for a few years or more, even in the worst case scenario.
Added benefit: Extra cash leaves us open to newer, juicier opportunities.
Figure 2. Financial position over 5 years with a $200,00 rental property with a 5% capitalization rate. Asset earns $833/month in rent, our income subsidizes the remaining $982/month. Grey line represents grand total of my P2P lending income and the $200,000 rental property. 80% goal completion after 5 years with no reinvestment.
Strategy #3: Go ham on rentals. Buy $500,000 in rentals, use a significant portion of our after-tax earnings to subsidize rental mortgages and expenses. The net result of the risk over the term? Just 2% closer to our goal.
I realize this strategy will pay off over a longer term, but after 5 years I begin to doubt even my very conservative assumptions.
Figure 3. Financing position over 5 years with $500,000 rental property with 5% capitalization rate. The properties earn $2,096/month and we subsidize the remaining $2,443 in mortgage, interest and property tax. 82% goal completion after 5 years.
Based on running the initial numbers, we're planning on renting in the Bay Area and preserving our job-sourced income for the next five years. We'll rent an apartment for about $1,800 per month and make a single $200,000 real estate investment in the coming months. I have a lot to learn about buying rental property before then.
Here's my plan before I buy:
- Try to find a mentor online and collect feedback about my plan. Do people think it's too conservative? Unrealistic? Adjust plan accordingly.
- Leverage existing connections who've achieved success in real estate.
- Connect with friends in less expensive cities in California who would be willing to manage my rental property. Deciding which city to purchase in will depend on steps 1 and 2.
If anyone reading this has experience with buying rental properties with bank financing, please get in touch. I'd love to pick your brain.
**$600,000 in assets invested safely at 5% interest earns $30k/year. More than enough of a financial base to live in an inexpensive part of the country and pursue part-time work. Anything on top of the expenses is gravy.
***Pros can chime in on this, but I believe these are conservative assumptions underpinning a conservative plan.
****I invest $600/month in P2P lending as my “new car fund”. It’s earned just under 10% interest since I’ve begun about 6 months ago. Loans are unsecured, so this money could vanish if the economy tanks. Once this fund hits $60k, I get a new BMW. Before that? I drive my 15-year-old first car.
*****Other considerations for buying a rental include the very strong tax benefits.