I was talking to a friend of mine the other day and he brought up something interesting. He was interested in buying a rental property but he was worried that if he did he would have a hard time buying a home for himself in a couple years (he currently lives in an apartment and wants to stay there - for now).
Its an interesting predicament because he recognizes the incredible opportunity there is right now for investors to own rental properties, however, he doesn't want the banks to hold it against him and not lend to him when he wants to buy a home himself. As I told him - if its a good deal don't worry about not being able to qualify in the future since, if there is a positive cash flow, the effect will be minimal.
Banks typically lend based on a debt to income ratio. This debt to income ratio is calculated one of two ways - either by taking your gross earnings for the month - yes, gross earnings before taxes, insurance, 401k, etc and comparing it to your mortgage payment (including principal, insurance and property taxes). This is a simple and fairly aggressive method of determining how much a person can afford to pay on a mortgage since it uses gross income and it ignores other expenses such as credit card or car payments.
The second method takes into account the mortgage but also adds in the other expenses that a typical family would have, such as credit card payments, car payments, student loan expenses, etc. That is then divided over gross income to come up with a ratio.
The two debt to income ratios are known as the front end ratio and the back end ratio (respectively) and in general a rule of thumb is that when applying for a mortgage it is assumed that a homeowner could afford a front end ratio of up to .28, or 28% of gross income going to the mortgage and a back end ratio of .36 or 36% of gross income goes to total revolving debt.
So, how is our debt to income ratio affected by the addition of a rental property? Lets look at some numbers:
Lets say for example our potential rental property investor makes $100,000 per year, which equals $8,333 gross per month, lets also assume that investor were to purchase a house and take out a $200,000 mortgage at 5% interest and amortizes the loan over 30 years (a payback period of 30 years). The Principal and interest payments would be $1,074 and assuming another $300 in insurance and taxes that would mean that the PITI (Principal, Interest, Taxes & Insurance) would equal $1,374. Taking the PITI over the gross income of $8,333 equals a very manageable front end ratio of 16.5%. Adding an assumed $800 in other monthly debt gets us to a back end ratio of 26.1%
All in all, assuming that this investor has a decent credit score - at least above 680 and a down payment of 25% then there shouldn't be any problem getting a loan for the first house. Now we see the effect of renting out this house and buying a new house.
We will use the same assumptions as above but assume that this house is rented out for $1,500 per month - just barely producing a positive cash flow. We need to assume some maintenance and will subtract $100 per month for maintenance on the house, leaving this investor with rental income of $1,400. Next we'll perform a simple calculation to see what is the maximum that this investor could take out on another property and still fall under the .28 and .36 thresholds for front and back end ratios.
As it turns out this investor can take out another $250,000 before hitting the .28 and .36 thresholds. Assuming that this investor was happy living in a house with a mortgage of $250,000 then there shouldn't be any problem. Naturally, the investor would have to have the extra down payment and still have a qualifying credit score - at least a 680 in this lending environment.
This is just one scenario and in actuality the investor could certainly, if purchasing wisely, do much better than cash flow $50 per month. However, for purposes of this example I wanted to show a conservative guess and to show that you can indeed take advantage of the incredible buying opportunities out there and still be able to finance a personal residence.
If interested, I would be happy to send out the spreadsheet that I used to analyze the debt to income ratio for our investor friend. Leave a comment or follow my blog, make sure to include an email address and I'll send you my custom built spreadsheet free of charge.
Tuesday, February 15, 2011
Friday, February 11, 2011
New High End Mall for Goodyear, AZ
Good news for Goodyear residents!
Macerich company announced that they are going to start construction this year on a high end regional mall in Goodyear, AZ. The mall is scheduled for completion by 2014.
Interestingly, they didn't mention in this article the exact location but I'd be willing to bet we're going to see this go up on the north side of the I-10 between Bullard and Estrella Parkway. How could I possibly know that you might ask? Very simple - I checked out the city of Goodyear website. Looks suspiciously like the same project that was delayed in 2008 and 2009.
This is great news and further illustration that the market is turning a corner. This should mean more people traveling to Goodyear, more money spent in Goodyear, more jobs and an increased demand for housing. Just another in a series of indications to me that we are rapidly turning the corner and will soon start working down the excess inventory in this market - when that happens we may actually start to see price increases.
Macerich company announced that they are going to start construction this year on a high end regional mall in Goodyear, AZ. The mall is scheduled for completion by 2014.
Interestingly, they didn't mention in this article the exact location but I'd be willing to bet we're going to see this go up on the north side of the I-10 between Bullard and Estrella Parkway. How could I possibly know that you might ask? Very simple - I checked out the city of Goodyear website. Looks suspiciously like the same project that was delayed in 2008 and 2009.
This is great news and further illustration that the market is turning a corner. This should mean more people traveling to Goodyear, more money spent in Goodyear, more jobs and an increased demand for housing. Just another in a series of indications to me that we are rapidly turning the corner and will soon start working down the excess inventory in this market - when that happens we may actually start to see price increases.
Tuesday, February 8, 2011
Phoenix Area Real Estate Market
I've been noticing a trend in Phoenix area real estate - prices keep going down!
I'll admit I'm not shocked but I am a little surprised that the market hasn't started to turn the corner yet. I was looking in the Palm Valley area today at houses and looked at a few properties which are listed on the MLS that would make fantastic rental properties. One property was a 4/2 and the others were 3/2's. The most expensive was listed at $105,000 - this in an area with a fantastic school district, great shopping and dining nearby, close to the freeway system and right near Luke Air Force Base.
The last property I rented out in that area of town had renters calling me the day I put up the sign in the yard - I ended up renting it out within 2 weeks to a great family that is taking great care of the house - and paying on time! (which is always a large plus in my book). The cash flow on the house is nicely positive even on a 15 year amort loan and that area of town also tends to draw quality family renters who are looking to get into the school district for their kids and settle down.
So going back to the properties I looked at today - and the couple I will investigate further later this week. If we were to pay market price for a property in this neighborhood (which, of course, we wouldn't) then we are looking at prices of a little over $100k for a 4/2 and $89k for a 3/2 & about 1,600 square. Using the 3/2 as an example I would legitimately expect to receive $1,200/month in rent on a property like that if it were fixed up nicely to where a family would want to move into it - less fixed up you could rent it out for $1,000 in your sleep. The 3/2's should be at least $1,100 - at minimum.
So, for this area of town (paying market prices), assuming you pay cash, then your annual yield would be ($1,200*12)/$89,000 = ~16.2% annually. Are your CD's or bank interest paying you that? The stock market has been up but do you realistically expect to make 16.2% on your money? If you finance this purchase and take advantage of the sub 5% interest rates that are out there now then after your down payment you end up with this cash flow:
Down payment = 25% * 89,000 = $22,250
Assumed fix up cost (Just a guess - I haven't actually seen inside yet) = $10,000
Total cost up front - $32,250
Monthly mortgage payment on the remaining $66,750 balance, assuming a 30 year amortized loan at 5% interest, compounded monthly = $358.33
Average taxes + insurance = $150
So, monthly cash flow = $1,200 - (358.33+150) = $691.67 monthly cash flow
Yield = ($691.67*12)/$32,250 = 25.7%
Oh, and by the way if financed that doesn't include the fact that the renter is paying off your mortgage. It also doesn't take into account any appreciation - which its anyone's guess as to when the market will start posting increases but given Phoenix's history of boom and bust I wouldn't at all be surprised to see another strong market back in the valley of the sun - if not within 5 years, at least within 10.
I'll admit I'm not shocked but I am a little surprised that the market hasn't started to turn the corner yet. I was looking in the Palm Valley area today at houses and looked at a few properties which are listed on the MLS that would make fantastic rental properties. One property was a 4/2 and the others were 3/2's. The most expensive was listed at $105,000 - this in an area with a fantastic school district, great shopping and dining nearby, close to the freeway system and right near Luke Air Force Base.
The last property I rented out in that area of town had renters calling me the day I put up the sign in the yard - I ended up renting it out within 2 weeks to a great family that is taking great care of the house - and paying on time! (which is always a large plus in my book). The cash flow on the house is nicely positive even on a 15 year amort loan and that area of town also tends to draw quality family renters who are looking to get into the school district for their kids and settle down.
So going back to the properties I looked at today - and the couple I will investigate further later this week. If we were to pay market price for a property in this neighborhood (which, of course, we wouldn't) then we are looking at prices of a little over $100k for a 4/2 and $89k for a 3/2 & about 1,600 square. Using the 3/2 as an example I would legitimately expect to receive $1,200/month in rent on a property like that if it were fixed up nicely to where a family would want to move into it - less fixed up you could rent it out for $1,000 in your sleep. The 3/2's should be at least $1,100 - at minimum.
So, for this area of town (paying market prices), assuming you pay cash, then your annual yield would be ($1,200*12)/$89,000 = ~16.2% annually. Are your CD's or bank interest paying you that? The stock market has been up but do you realistically expect to make 16.2% on your money? If you finance this purchase and take advantage of the sub 5% interest rates that are out there now then after your down payment you end up with this cash flow:
Down payment = 25% * 89,000 = $22,250
Assumed fix up cost (Just a guess - I haven't actually seen inside yet) = $10,000
Total cost up front - $32,250
Monthly mortgage payment on the remaining $66,750 balance, assuming a 30 year amortized loan at 5% interest, compounded monthly = $358.33
Average taxes + insurance = $150
So, monthly cash flow = $1,200 - (358.33+150) = $691.67 monthly cash flow
Yield = ($691.67*12)/$32,250 = 25.7%
Oh, and by the way if financed that doesn't include the fact that the renter is paying off your mortgage. It also doesn't take into account any appreciation - which its anyone's guess as to when the market will start posting increases but given Phoenix's history of boom and bust I wouldn't at all be surprised to see another strong market back in the valley of the sun - if not within 5 years, at least within 10.
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