There seems to be no shortage of various “rent vs. buy” calculators. We googled for that very phrase and it gave us more than 10 million results. Still, these calculators are a very handy tool for those who are currently renting and thinking about owning real estate instead of living in someone else’s property. These handy little financial tools ask things such as where you intend to live, what is your current monthly rent in the home you’re living in now, how long you intend to live in your next home, current market rates and other questions. We have our very own rent vs. buy calculator that we think is a tad better than the rest and you can access it here.
Most often, the result is it’s better to own than rent in today’s interest rate environment. Granted, there can be pockets where rental rates are extra low and mortgage rates are high but overall the advantages of owning outweigh renting. For those who file their income taxes for the first time after owning a home for a year are somewhat surprised at the impact owning has on taxes due- or refund received. Interest and property taxes are eligible as a tax deduction and both reduce overall taxable income. But another area which needs some serious consideration is owning a multi-unit property and living in one of the units.
Types of Multi-Unit Property Financing
A multi-unit property can be a duplex, which is two separately metered residences sharing a common wall. The property owner can live in one side and rent out the other. A triplex is a similar structure yet there are three such attached units and a fourplex has four. Lenders sometimes refer to these types of properties as “2-4” unit homes. For multi-family properties have more than four units, such as an apartment building, then conventional and government-backed loans won’t be an option.
When a buyer purchases a 2-4 unit property strictly as an investment property and does not intend to occupy one of the units, it is considered a rental and subject to rates and terms reserved for non-owner occupied homes. Because government-backed loans such as VA, FHA and USDA are only available for a primary residence, these won’t be an option. Conventional loans underwritten to Fannie Mae and Freddie Mac guidelines will ask for a down payment of at least 20% for a duplex and for a 3-4 unit property the down payment is at least 25-30% of the sales price of the property. Interest rates for non-owner properties will be approximately 0.25-0.375% higher than those reserved for a primary residence. And as rental properties are typically purchased for long term equity gains as well as monthly cash flow, a fixed rate term is favored over a variable rate loan.
The FHA and VA Advantage
However, if you intend to occupy the property, then a government backed VA or FHA loan might be your best option if coming to the settlement table with as little cash as possible is one of your requirements. VA loans do not require any down payment while FHA loans ask for a down payment of only 3.5% of the sales price of the property. Conventional loans will also require less down if you live in one of the units. On a side note, should you ever decide to leave the property and occupy another residence, making the entire 2-4 unit property for renters, the terms of the original note will not change as long you’ve occupied the property for at least one year.
The primary benefit using VA or FHA loans to finance a multi-unit property is the same when buying a single family home- there is much less cash to close required using either program and if coming to the closing table with as little cash as possible using the leverage of today’s rates then this route is suggested.
Let’s look at an everyday example using an FHA mortgage with a sales price of $850,000 on a four unit property and you will live in one of the units. The down payment is $29,750 and the loan balance is $820,250. After adding in the upfront mortgage insurance policy and taking into account the monthly mortgage insurance premium the payment is around $4,800 per month.
Your real estate agent has provided you with market rents for the area of similar properties and determined you can rent out three of those units at $1,750 each. Each month, that brings in $5,250 and is more than enough to cover the mortgage payment. Your tenants are in effect paying your mortgage for you.
Now say that you also decide to move out after a couple of years and rent out all four units. Now the income is $7,000 per month. You can use this income any way you want including paying down the mortgage balance over time. The math works the very same with a VA loan only you come to the settlement table with even less of your own cash due to the lack of a down payment.
We’ll address some of the more generally known income tax advantages but you should also consult your financial planner and accountant for professional advice. First, consider personal deductions you list on your federal returns. Let’s say you’ve purchased a duplex and live in one of the units. For income tax purposes, you would be able to deduct half the mortgage interest and half the property taxes as there are two units, not one. Remember, this is for your personal deductions that appear on Schedule A.
With regards to the rented unit, these deductions will appear on Schedule E, not Schedule A. Any costs associated with the rental unit may be eligible for a deduction. Management fees or fees you pay to a real estate agent to find tenants can be listed on Schedule E. So too are costs for maintenance and repairs. Remember, these fees are for the rented unit, not the unit you occupy as your primary residence. You can also depreciate the rented half over time, again reducing your federal income taxes each year.
Okay, now that we have the basics, what exactly are the advantages of owning a multi-unit property? The first consideration is the cash flow each month. Before deciding to buy any rental property, multi-unit or otherwise, you first need to run the numbers to see if the property will positively cash flow. That means the rental income from the units should be more than enough to cover the financing costs, property taxes, insurance, management fees and maintenance. If the math works, then you’ve just invested in an asset that will increase in value over time while providing you with income each and every month.
If you live in one of the units the monthly income means you essentially have a free place to live as the tenants are paying your mortgage and associated costs for you. Consider a duplex that has a mortgage on it in the amount of $200,000 on a 30 year mortgage at 4.0%. That leaves a principal and interest payment of $954. If property taxes are $160 per month and insurance $80, the total financing cost is $1,194. If the other unit generates $1,750 in rent each month, you’re cash flowing $550 each month. The more cash flowing units you own the more profit you will make each month.
If you’re thinking about buying a multi-unit property and you’re not sure if the math will work, contact us and we’ll run some numbers for you based upon current market interest rates. If you don’t already have a real estate agent, you’ll want to get one. A good agent can help determine whether or not a property will cash flow, help find tenants and manage the units for you. If you’d like a referral for an agent in your area we’d be glad to help.