Classic suburban house

Owning a home is one of the best ways for someone to build wealth. But what if you took homeownership a step further and started house hacking? By doing this you could reduce your housing expenses and drastically speed-up the path to financial independence.

You might be wondering what house hacking actually is. It’s the concept of purchasing either a single family or multi-family home and renting out a portion to cover the mortgage. So, let’s start by walking you through a couple of popular examples of house hacking.

House Hacking Examples

One of the most common ways for someone to get started in real estate investing is to house hack a multi-family home. The idea is to purchase a duplex, live in one side of the house and rent out the other.

We’ll talk more about finding the perfect property later, but the goal is to have the rental income cover a majority of the mortgage payment, leaving you with a smaller house payment and considerably reducing what is probably your biggest expense each month.

The other way someone can house hack is through a single-family home. Let’s assume you make the decision to purchase your first home. You’re single and you want your friends to move in with you. Each of them would rent a room, effectively contributing to paying your mortgage each month. In a perfect scenario, the combined rent payments would be equal to, or more than, your monthly mortgage payment, once again eliminating your housing expense.

Start Investing in Real Estate with a Lower Down Payment

Recently I had a friend who was about to purchase his first investment property. He was going through the pre-approval process with the lender and found out he would need to bring more money to closing than he thought.

One of the biggest misconceptions about investing in real estate is that people assume down payment requirements are similar to that of an owner-occupied home purchase. When you purchase a home for yourself, many have the ability to use an FHA or VA loan. This allows you to close with 3.5% down and in some cases 0% down. However, when you purchase an investment property, that you don’t plan to occupy, most lenders require at least a 20% – 25% down payment. By purchasing a primary residence and renting out a room/other units, it will give you access to lending options that may otherwise be unattainable.This gives you access to lending options not available to most investors.

The Math Behind House Hacking

Before you invest in any property, it’s extremely important to do the math behind the deal. It can be the difference between making money and ending up in the red every month. Before investing in any property there are three calculations that must be done and analyzed to make sure the deal is going to work.

1% Rule

When looking into investment properties, one of the first things many people will calculate is the 1% rule. No, this isn’t some super complicated formula used to determine an investment’s profitability. Instead, you simply look at the purchase price and the expected rent on the property. You’ll want rent to be 1% of the purchase price. When you’re planning to occupy a portion on the rental property, whether it’s a unit in a multi-family property or a single bedroom, you’ll want to calculate the 1% rule based on the entire rental potential. Eventually you’ll move out and this will become a 100% rental property.

To put this into perspective consider the following examples:

  • A $100,000 home should have rental income of at least $1,000 per month
  • A $200,000 home should have rental income of at least $2,000 per month

When you perform the 1% calculation on a house hacking investment, evaluate the home assuming you’re collecting rent on all units in a multi-family or all bedrooms of a single-family home. Eventually, you will probably move out and keep the entire home as an investment.

Capitalization Rate (Cap Rate)

Once you’ve found a home that passes the 1% rule, you can start determining the profitability of the property in relation to the purchase price. This is called the cap rate, and is done by dividing the purchase price by the net operating income. Let’s walk through how you would calculate the cap rate on a property you might be considering.

Let’s assume you’re looking into a duplex that costs $150,000. The plan is to live in one side and rent the other for $800 per month. This would have passed the 1% rule since you would perform your analysis on the potential rental income for both units. In this case $800 for the unit you’ll rent and another $800 in potential future income for your unit once you decide to move out.

Rental income (12 months): $9,600

  • Insurance: $900
  • Maintenance: $700
  • Taxes: $750
  • Vacancy: $800

$6,450 (net income) divided by $150,000 (purchase price) = 4.3% cap rate

For this property, the cap rate would be 4.3%. Most investors would like to see their cap rate above 4%, but for many, it depends on the specific market you’re investing in. Some investors want to see cap rates as high as 10% in certain parts of the country. Determine what the ideal cap rate is for your city and then you’ll be able to better assess a prospective property.

Let’s also calculate what the cap rate would be if you decided to move out and rent both units.

Rental Income (12 months): $19,200

  • Insurance: $900
  • Maintenance: $700
  • Taxes: $750
  • Vacancy: $1,600
  • Property Management: $1,600

$14,280 (net income) divided by $150,000 (purchase price) = 9.5% cap rate

Cash Flow

Once the property has passed the 1% rule and you’ve determined that it has a positive cap rate, it’s time to start looking to potential cash flow. This is the real reason why you’re looking into an investment property. You want to make money.

To start, let’s calculate the cash flow based on you living in one side of the duplex. Don’t be surprised if this number is negative. It just means you will be paying money toward your housing expenses each month.

Net income from the cap rate calculation ($6,450) divided by 12 = $537.50

  • Monthly mortgage payment ($120,000 financed at 4.125%) = $916

Net monthly cash flow = -378.50

This means you would be paying $378.50 each month to live in the home, which is considerably less than the market value of $800 per month that your tenant would be paying to live in the other side of the duplex.

Now let’s figure out what your monthly cash flow would be if you rented out both sides of the duplex.

Net income from cap rate calculation ($14,280) divided by 12 = $1,190

  • Monthly mortgage payment ($120,000 financed at 4.125%) = $916

Net monthly cash flow = +$274

There are a lot of advantages to getting your real estate investing career started by house hacking. It gives you the opportunity to get your feet wet and understand the ins and outs of being a homeowner and a landlord. It also gives you a place to live at a much lower price, which allows you to save up much faster for the next property.

While this is just an example of what is possible, we recommend discussing your options and prospects with a financial advisor, so you can do what’s best for your specific situation.

Have you considered investing in real estate? Let us know in the comments below!

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