Should I convert my primary residence to a rental?

There is a lot to consider when determining whether you should rent out your primary residence. I have been getting this question more frequently of late, so let’s look at some things I discuss with my clients. First on the list is to determine the market rental rate for your property. Use Realtor.com, Zillow, contact a property management company or a licensed real estate broker to establish a price per square foot of going rents in your neighborhood. If rents are $1/sq ft on average and you have a 4,000 sq ft house, then figure your rental rate at $4,000/month. Remember real estate is local. That rental rate MUST cover your PITI (principle, interest, taxes, and insurance) at a minimum, otherwise you’re creating another liability instead of an asset.

  1. If you need the equity from your current primary residence to purchase the next home to live in, then you may want to consider a cash-out refinance while you occupy then home as your primary residence to obtain a more favorable interest rate. Will the rent still cover all costs after a cash-out refi?
  2. Capital gains tax: has an exclusion under current federal tax law as of 2022 that states if you have had ownership and possession of your primary residence 2 out of the past 5 years, then you can take $250K capital gains tax free as a single person and up to $500K as a married couple (I am not a licensed CPA – check with yours). Simple Ex. Purchased primary home in 2020 for $1M. You possessed and occupied for 24 consecutive months to meet IRS rules. Sold 24 months later in 2022 for $1.5M. Thus, you basically have a $500K capital gain with NO TAXES DUE. However, if you move out, convert it to a rental for 3 years and one day (nullifying the IRS exclusion rules), then sell for any amount over your basis of $1M, you will pay capital gains on all profits above your basis. If you have very little capital gains in your primary, then converting it to a rental may just be the best thing that will do for your future self.
  3. Where are you on your journey? If you are just starting out, then do everything you can to turn that first house into a rental and begin to build your portfolio. One rental income at retirement age could make all the difference in the world to the future you. Listen to my interview (episode #33) on the M.O.R.E. podcast with Kimmie P. and Bull Guting to hear about that. If you are an accredited investor, and you do not need the cash out to purchase the next home, then consider selling and becoming a LP in a syndication if you do not want to be a landlord.

Much more could be said about the pros and cons of converting your primary residence into a rental property, but I have listed the 3 most common conversations that I have with folks. Feel free to reach out with any questions. In closing, always run the numbers and own your financial future.

Breaking the 5 for 2 for life thinking

What is the rat race, the matrix, the trap, the deception? Simply exchanging 5 for 2 for life. Work for 5 days to get 2 days if you’re lucky. We are trained from school age to exchange 5 days for 2 days. T.G.I.F. But, how does this happen?

Most people are enticed into school debt under the guise that it will mean a
good paying job i.e., money: however, now you must pay for the debt incurred. Your
money is now someone else’s money. In addition to all the school debt, you need
a house, car, groceries, significant other (and possibly little significant
others as a result), boat, dog, bigger car, bigger house, lawnmowers or
gardeners, clothes, lots of shoes, new gadgets, bigger tv’s… heck one for
every room in the big house, etc., etc., etc. In other words, you need a good
job to create an income to pay for all those EXPENSES and LIABILITIES. As a
result, most will never be able to get off the hamster wheel they are on for 40
years or so without a massive shift in thinking and action. So, let’s begin to
shift our thinking so that maybe we can hop off the hamster wheel.

Let’s try to renew our minds and shift our mindsets with a little exercise.

You are going to acquire a new vehicle liability. This liability will cost
you $500/month. However, as an astute investor, and anti-hamster wheel spinner,
you begin to calculate 1) how much you need to invest and 2) what rate of
return you will need to get, so that your investment will pay for the
expense created by this new vehicle liability. (Did you catch the
shift from hamster wheel thinking?)

For example: Idea 1) Purchase a $150K single family home with $30K (20%
down). Maybe it’s a short-term rental or maybe a long-term rental, if after all
expenses are paid, it generates $500/month or $6K/year, then it will pay for
the liability that you want that costs $6K/year. Furthermore, once the new
liability is paid for, your income will continue. (Read my post on cash-on-cash
returns and how to calculate if you need a little direction.) The point is to
buy cash flowing assets to pay for your expenses.

Consider another example: Idea 2) as an accredited investor, you could invest $100K at 6% in a multi-family apartment syndication to yield the $6K a year to pay for the new $500/month expense because of the liability you want to acquire. Contrast this to wasting $500/month or $6K/year for 5 years on a vehicle and you will quickly realize that your $30K will never come back to you. It will never produce an income for you. Reach out for more information on cash flow investing.

If you plan and delay some gratification and acquire income producing assets that pay for your liabilities, then once the expensive liabilities are paid for, your assets will continue to spin off all that wonderful cashflow as long as you hold the cash flowing assets. Whereas, if you blow through your income on liabilities and expenses, then you will never see your cash again and must continue to go back to work, exchanging 5 for 2 for life.

In this thought exercise, we have only considered one liability you want or
have… think of how many liabilities you really want or have. Now think of how
much money you are throwing away on liabilities that will never pay you and
never work for you to produce perpetual income. You need lots of cash flowing
investments to get off the hamster wheel of 5 for 2. You must start today to
change tomorrow.

What investments are on your horizon to pay for your liabilities? How much
will you need to invest and what will be the rate of return needed to
accommodate for your expenses from liabilities?

1) Leave a reply to solve the problem (*you might help others shift from income to expenses thinking vs income to investments to pay for expenses thinking*)

Is real estate really passive investing?

In short, “No.” Similar to driving, you have to steer, accelerate, brake when necessary and so on, but do you really need to lay the asphalt or paint the lane markers? Both are involved and interacting with the road, but from very different roles.

Ultimately you have to decide how much work you are going to put in to find markets and properties that make financial sense based on your investment criteria (you have a criteria right?) and decide what type of assets to invest in. You decide to lay the asphalt or simply drive the road others have paved. You will have to consider all the options and educate yourself, be it short-term or long-term rentals, single family or multifamily properties, storage units, notes, billboards, etc. Then you must determine your level of participation. Will you actively manage and take all the calls, screen tenants, run background checks, draft lease agreements, fix toilets yourself, etc. or will you manage a property management company that will do all of that for you or will you do a mix of the two by hiring out specific services while performing some on your own?

Some asset classes require less “active” roles for beginning or strategically more passive investors than others. Consider the activities needed to run a single family as a short-term rental vs a long-term rental. Consider the activities required to lease a billboard or a storage unit facility vs a single-family home. How about managing your own rental portfolio vs managing your property manager? Or fixing your own properties vs subbing out the work? What about choosing a keen operator of multi-family syndications where you are simply a limited partner investor? (More on this in a future post.) What if you owned a commercial building with a triple-net lease and a corporate tenant? You decide the level of passivity in your investments, by choosing the asset class you invest in. But, you still have to determine your destination and then calculate your best route to arrive at that destination. How many pot holes and pit stops you are willing to endure and so on.

I have spoken to many that have just stumbled into being an investor rather than planning for it and now they need to educate, focus and maybe shift directions because they were unprepared for the road they have been on. Every road leads to a different location. If your road is dirty, bumpy, long, and or slow surface streets and you want to be on an interstate or smooth freeway, then you can exit the road you are on and take a different road to achieve your financial freedom goals. You are not a victim. You are the master of your destiny.

Don’t give up on investing because you bought a rent house without calculating market rates, job growth and vacancy rates, failed to properly screen tenants, or simply misunderstood thinking that money was supposed to simply flood into your bank account after failing to do your due diligence. Educate yourself, level up, free your mind from the 5 for 2 exchange and change your stars.

Find your trusted real estate resource and develop a plan for prosperity and perpetually “passive” income.

How inflation affects real interest rates and investment returns

Let’s discuss an interest rate of 3.4% and an inflation rate of 6.8% (according to BLS.gov/cpi for December of 2021) and look at the outcome. Inflation eats away at the future purchasing power of a dollar. In other words, it buys less because it has been devalued. The same $1M today, will not buy $1M of goods next year, but only say $932K worth of goods. Because of the 6.8% inflation rate you will need $1.068M to purchase the same assets or goods next year.

Regarding debt/mortgage payments: you are paying back your fixed rate loan in the future with cheaper and cheaper money. Because you locked in your debt payments today with today’s purchasing power, the longer you hold the note and the more the dollar is devalued the greater the hedge or delta against inflation. Meaning that you will have more to spend in the future as you locked in debt at x value today, allowing rents to keep pace with inflation while your payments are anchored at a previous years buying power.

To show the advantage of locking in today’s purchasing power via a fixed rate mortgage or debt mathematically, use the following formula to calculate

Real Interest Rate = [(1 + Nominal Interest Rate) / (1 + Inflation Rate)] – 1 or

[(1+3.4)/(1+6.8)-1] = -3.18%

Now consider: If the inflation rate from December of 2020 of 1.4% is used and same note rate of 3.4%, then the real interest rate would be 1.97% vs the -3.18% for December of 2021. Hopefully you can see how inflation works in your favor as an investor with fixed debt on an income producing asset. In addition, you can begin to understand why governments attempt to create inflation as a way to “inflate their way out of debt.” That topic however, would take a whole series of blogs just to scratch the surface, not to mention topics like stagflation and deflation.

For more information on finance and the economy: The Creature from Jekyll Island: A Second Look at the Federal Reserve

What is Cash on Cash and how I calculate it?

Cash-on-cash (CoC) is a way to measure the cash flow percentage derived from an investment that you made. Generally, cash flow investors will look at cash on cash returns, as a starting point when considering an investment or comparing multiple investments. Cap rates, IRR and ROI do not always rule the day, they are just more metrics to be discussed at another time. You can not go broke if every deal you make has positive cash flow from day one.

Let me help you remember how to calculate cash on cash. Think… How much Cash will I put IN my pocket every year? Divided by how much cash I pulled OUT of my wallet one time? You could remember it: divide $In/$Out. That is $$ IN your pocket / $$ paid OUT to get it.

For example (Deal 1), you bought a single-family home for $385K with 25% down (so you get a break on the interest rate). That’s $96,250 out of your pocket. But wait, there’s more. You had closing costs +/- 2% and apx. $30K in updates… that’s OUT of your wallet $134,750.

Now, start adding up all your expenses (and I include everything) … Mortgage payment (principal and interest), insurance, taxes, utilities for cleaning and showing, property management, termite/pest contracts, POA dues, vacancy factor for the area, etc. Cost of ownership = $2,060/month. You did your homework by looking up rents in the area and know rental rates for this area at .90/sq. ft. and will bring in $3,100/month on this property. You take $3,100 rent and subtract all the expenses of $2,060 = $1,037/month or $12,444/year. Now you now know how much money will be IN your pocket.

$12,444 (IN) your pocket / $134,750 (OUT) of your wallet = .092 or 9.2% Cash-on-Cash return.

How is this helpful? Well, you found another property (DEAL 2) for $225K and it doesn’t need as much work, so less money out of pocket. Great, right? You built a spreadsheet in excel after the first go around and now you punch in the numbers on this one. This one will put $5,345 (IN) your pocket and it will require $67,500 (OUT) of your wallet. What will be your cash-on-cash return? Which one is better? Post an answer back.

Advanced: The home value goes up, it was a BRRRR, whatever… but you refinance either deal and pull all of your capital back out and continue to let the tenants cover the debt with a positive cash flow. Now you have ZERO money in the deal and your still getting paid!! Are you with me?  

Calculate your cash-on-cash return of any amount IN your pocket yearly divided by NOTHING out of your pocket. Ie. $5,000 yearly income / Zero OUT of your wallet. Can you say INFINITE? How many of those can you do?

These same principles apply to multi-family, storage, commercial, etc.

Fireplaces done right.

Fireplaces can be a wonderful focal point, or in some areas, a needed source of warmth. If you are remodeling a home or considering a custom build. Think about getting your stove up off the floor by raising it up 12 to 18” for a better view from your sofa or bear skin rug. In production housing we typically see tile or a slab on the floor with the fireplace at the same level. But what if you simply framed the stove in a little higher than floor level and then built a raised hearth? I prefer the better line of site when in use and it creates a nice sitting spot when not in use.

Depending on your heating circumstances or intent for a wood or even gas burner, consider ducting the convection heat to the rest of the house with proper ducting and inline booster fans connected to a switch with a snap disc. Modern wood burners are extremely efficient, and most can be purchased with a blower already installed in the unit. They efficiently pull cold air from the vents below the firebox and as the air is heated, it creates a convection and forces the warm air out from the vents above the firebox and warms the whole room. A booster fan simply helps that process with the flip of a switch. A snap disc is sometimes installed at the blower unit and is a bi-metal product. When it heats up, it closes the circuit and kicks the fan on. As the bi-metal cools (as fire burns down) and separates the connection, the fan shuts off, so you are not blowing cool air. If you take this to the next level, then consider a wood burning unit ready for ducting that can deliver warm air to other areas of your home through ducting. If you install inline boosters in any ducts, then consider wiring them to your snap disc installed under the fire box and already connected to your main blower.

The last item to consider is fresh air for combustion. Some fireplace units will draft air from inside your home. However, some units can be ducted to pull outside air in from a duct. This is much easier than you are probably thinking as most fireplaces are located on an exterior wall anyway. I prefer to pull combustion air from outside.

Now, if all of this ducting and snap discing is overkill for your area and you simply want some ambiance in a room, then consider an electric model. With a little bit of framing and electrical work, you can have a very sleek and appealing fireplace for a $200-$900 depending on how wide of a unit you would like. For example: Mystflame 72 inch Electric Fireplace – Ultra Slim Frame – in Wall Recessed & Wall Mounted – Multicolor Flame – Log & Crystal Hearth – 1500/750 Watt Heater – Remote Control & Touch Screen- Timer

There you have it. Give your fire a nice line of site by getting it off the floor, create a sitting spot for when it is not in use with a built-up hearth, install a snap disc if you have a blower or booster fans installed, duct it to the rest of your home and use an external air source for combustion.

Bathroom renovation or custom build considerations.

When building a custom home or simply renovating to update or add desirable creature comforts to a master bathroom, consider splurging on some items and pulling back on others.

For example, ask a person if they would rather have a deep soaking tub or a jetted whirlpool tub (don’t forget to ask about cleaning those little jets). Most never use the jetted whirlpool feature, despise cleaning those little jets and really just soak in a mostly hot bath. Which leads us to the water heater. By the time most whirlpool tubs are getting full, the water heater tank is emptying out and pumping cold water into your hot bath. Opt for a tankless water heater and endless hot water! If you simply must have a whirlpool tub, then spend even more and get one that also heats the water. I have found that the best solution is to install a deep soaking tub and a tankless water heater and ditch the jetted whirlpool tub. Tankless water heaters are a great idea if you have the ability to upgrade. For an idea on equipment prices: SteamSpa Raven Series Wifi and Bluetooth 9kW QuickStart Steam Generator Package in Brushed Nickel | Touch Screen Wifi App Control Steam Shower Kit with Drain Pans Speaker and filter kit | RVB900BN-A-F.

HEATED FLOORS!!! Ask anyone on a slab foundation! “Would you have installed heated floors looking back?” You will get almost unanimously, “YES!” Most big box home improvement stores now carry DIY options that are simple. Measure your floor area and lay out your copper coils (some even come on a uniform mesh or grid), some use a liquid leveler or mud to cover, then lay your selected tiles. Don’t forget to connect your thermostat for your specific heating flooring system so you can enjoy waking up to nice warm floors underfoot in the mornings or program as desired. You can find heated flooring kits online around $80-$600 depending on your square footage. For the DIYers try: SunTouch TapeMat Electric Radiant Floor Heating Mat Kit and SunStat Command Thermostat, 30 Sq. Ft, (120V), Plain.

Heated towel rack! Must I say more? You will need an outlet if remodeling, so you’ll need an electrician and much easier to accomplish on a new build. A wall mounted unit like I installed in my own home when I built can be acquired online around $150-$225. Thinking about a wall mount option: HEATGENE Towel Warmer Wall Mount Electric Plug-in/Hardwired Heated Towel Rack Mirror Polish.

If you really plan well, you might even install a steam generator and create your own wet sauna/shower. A steam generator will run you about $2K online. You will need 220V, so you may need an electrician and a plumber to install the unit and plumb it correctly. I would also suggest that you use Kerdi fabric on the interior of your sauna/shower area to create a vapor barrier if you’re installing a steam generator as steam is very different than water from a shower. If you really want to upgrade to a wet sauna as a DIY remodel project or considering a custom build, you could start shopping here SteamSpa Raven Series Wifi and Bluetooth 9kW QuickStart Steam Generator Package in Brushed Nickel | Touch Screen Wifi App Control Steam Shower Kit with Drain Pans Speaker and filter kit | RVB900BN-A-F.

All things considered and depending on your skill and comfort level or sweat equity, for around an extra $3K-$6K in equipment, you could wake every day to your spa-like heated floors, step into your wet sauna, or catch a good book in your extra deep soaking tub and hop out to your warmed towel. Every single day! Would it be worth it? Would it add re-sale value? My wife says, “Yes” and “Yes”. You decide for yourself.

My recommended reading list for real estate and personal growth.

These are in no particular order. Whether you are just getting started as a first time home buyer, investor or seasoned in the real estate space, I have found these to be great books to expand my knowledge and understanding of real estate, finance and personal growth.

Buy, Rehab, Rent, Refinance, Repeat: The BRRRR Rental Property Investment Strategy Made Simple

How to Invest in Real Estate: The Ultimate Beginner’s Guide to Getting Started

Rich Dad Poor Dad: What the Rich Teach Their Kids About Money That the Poor and Middle Class Do Not!

The 10X Rule: The Only Difference Between Success and Failure

The 80/20 Principle: The Secret to Success by Achieving More with Less

The Creature from Jekyll Island: A Second Look at the Federal Reserve

Good to Great: Why Some Companies Make the Leap and Others Don’t

The ABCs of Real Estate Investing: The Secrets of Finding Hidden Profits Most Investors Miss (Rich Dad’s Advisors (Paperback))

[By James Clear ] Atomic Habits (Paperback)【2018】by James Clear (Author) (Paperback)

The Millionaire Fastlane: Crack the Code to Wealth and Live Rich for a Lifetime

Think and Grow Rich (Your Coach in a Box)

Tax-Free Wealth: How to Build Massive Wealth by Permanently Lowering Your Taxes (Rich Dad Advisors)

The Effective Executive: The Definitive Guide to Getting the Right Things Done (Harperbusiness Essentials)

Principles for Dealing with the Changing World Order: Why Nations Succeed and Fail

Your home is NOT an asset.

Simply defined, assets put money into your pocket and liabilities take money out of your pocket. Your primary residence is not an ATM machine, does not put money into your pocket and requires large capital contributions to keep and maintain. It is a roof over your head for you and your loved ones, not a business or investment.

Real estate investments have seasons when they are assets and seasons when they are liabilities. That is why it is critical to understand the numbers before purchasing what you think is an investment. Whether single or multi-family, short-term or long-term rentals, learn to run the numbers.

Why invest in Real Estate

Investing in real estate is not a scary as you have been thinking, and with a little bit of understanding and planning it can become a path to wealth.

Over 20+ years ago my father-in-law, a real estate broker, gave me the basic vision for investing in real estate (or as I like to call them now – my 401k’s).

I was working for Pepsi-Cola at the time and my father-in-law asked me what life would be like after working for a large company for 40+ years and at the end of that time period the company declared bankruptcy or my 401k was dissolved or anything else beyond my control. Similar to the stories of many from companies that altered pensions like Enron, Delta, IBM, EMC2, etc., etc., etc. Well, I had never given it a thought until then, and the thought was that it could very well happen to almost anyone at any company. So I asked, “what could I do about it?”

Dad explained the basic concept or vision to me which I will repeat for you here.

Dad asked, “what if you bought 10 rent houses by age 35?”

HA! I lived in California at the time and could not (or so I thought) even buy myself a place to live.

Dad continued with the vision. “Let’s say each house costs $100K and you buy your last one at age 35 because with a 30 year mortgage it will be paid off (by someone else) at age 65 when you want to retire.” “So, what is your net worth at age 65 with 10 rent houses paid for after 30 years at $100k each (assuming NO appreciation)?”

Uh… $1 million!!!! I blurted. Wow! could that be right? Yes, I was correct.

Dad continued to ask questions. “If you had $1M and you put it in the stock market, would you sleep well at night?” “What type of income could you get from that without reducing the principal?” Then he continued to explain, “let’s say you invest in some preferred shares at 4-4.5%, now your semi-secure money is spinning off $40-$45,000 a year of tax disadvantaged income (meaning that after taxes maybe you’ll have $28-$32,000).” “Can you live on that?” “Ummmmm, probably not,” I replied.

Dad continued, “what if you kept your 10 rent house and each one generated $800 a month?” I added up quickly that was $8,000 a month, because you would own 10, and I quickly calculated that meant $96,000 a year!

So, Dad asked, “Which retirement plan sounds better to you? $28-$32,000 a year of tax disadvantaged income or $96,000 of tax advantaged income?” (more on tax advantages in another blog someday).

WOW! I caught the vision and I hope you have too. Granted this is simplified and real estate investing is not truly passive investing, but hopefully you can understand the power of cash flow and why you would want to work it into your retirement plans.