Invest in a house

In December of last year, a real estate agent who is a close friend brought our attention to a townhouse in short sale. The townhouse is in the fastest growing neighborhood inMaryland. It is within walking distance of the town center and a short drive away from an interstate highway.

The seller bought the townhouse for $350k five years ago, and he was now asking only $170k.

I did a quick search on Zillow and found out that similar townhouses in that area are renting for about $1,700 per month. I did another search on the county planning board and found that a new hospital is being planned nearby. Then, I went with my wife to check out the place, and it was in relatively good condition. We decided to buy it on the spot.

Three reasons for my quick decision:

1. At $1,700 per month, the gross rental income per year for this property could be over $20,000.
2. The townhouse sits in a convenient location that is close to restaurants, as well as arts and entertainment venues.
3. My wife loves real estate; she could spend hours on Zillow.com, Trulio.com, and Redfin.com. What better way to use her energy and interest than in real estate investment.

What we did not expect was the hassle dealing with the short seller and the seller’s bank – Bank of America – but that’s another story. After eleven month and multiple tripartite renegotiations, we finally bought the house for $185,000. That’s still a good deal. Let’s run the numbers.

Capitalization (cap) rate

The price of the house is $185,000. After closing costs and a few thousands dollars for repairs and refurnishing, the actual cost of the house is closer to $191,000.

Annual gross rental income is expected to be $20,400. Property tax amounts to about $2,000, home owners’ association fee is about $1,000, and insurance is about $500. Management and repair costs are estimated to be $1,500 – we will likely not incur this amount since my wife will do the management herself and she will make me do the repairs.  These add up to about $5,000 in annual operating expenses. The net operating income (NOI) of the property is:

NOI = $20,400 – 5,000 = $15,400.

The capitalization rate of this investment is:

Cap Rate = $15,400/$191,000 = 8.06%.

My rule of thumb for property investment is that the cap rate has to be larger than 8%. Otherwise, it’s not worth the trouble. The property barely makes it.

Notice I did not include the mortgage in my investment decision. With leverage, even a lousy investment can be made to look like a great one. In this property, I was able to get a super low 3.99% rate mortgage. With that, the actual cash outlay for this property (including closing and initial repairs) is less than $48,000, yet future net positive cashflow is about $8,000 per year.

In conclusion, it’s a good deal made sweeter by the low rate mortgage, but it’s a big investment in time and energy as well. It’s not for everyone. Is it for you?

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