House Hacking

A Will to Invest reader asked me a question last week. “You said your goal is to ‘house hack’ your first property in Portland or elsewhere. But what is a house hack?” This is a fantastic question and one that certainly deserves both a short answer and a long answer. In short, house hacking means buying a property with multiple units or bedrooms, living in one unit, and renting out the others. At its core, it’s that simple. For a real estate investor, the rental income from the units in which you don’t live can cover a portion or even all of your mortgage payments on the property. This means that an investor can live in one unit for cheap or free while building equity in an appreciating asset along the way. It is a beginner-friendly way to start investing in real estate that requires less cash in hand and provides housing for both yourself and others.

House Hacking in Greater Detail (Case Study)

Let’s look at this concept in a bit more detail. As a case study, I will look at a potential house hack on a home in Portland, Oregon. I’ll pick this home in southeast Portland (12025 SE Market St). Why? It’s on the market, it has been on the market for a while, it’s a triplex, and it’s in my budget. Does that mean that it’s a good investment? Let’s find out.

Credit to Redfin and listing agent. Not my image of 12025 SE Market St

This property is a six-bed, three-bath triplex in decent condition. A quick Google Street View tour around the neighborhood shows us that it’s not in the cleanest or prettiest of locations but there are some promising developments nearby and an elementary school right down the street. It is close by to shops and recreation but isn’t very accessible by public transit. Putting all of that aside, let’s talk simple numbers.

Initial Investment

The asking price on the MLS (Multiple Listing Service) is $599,900 which (doing some of the math that we will do in a second) puts this property in a shaky spot for cash flow. It has been on the MLS for over 100 days, though, and just had its asking price lowered by $29,000. Even with the price decrease, it’s still sitting unsold during a very hot market so I’ll be generous to myself here and say that I could buy it for another $10,000 under the asking price. That puts my final purchase price at $589,900. I’ll assume that I purchase the home with a 5% down conventional mortgage with a 3.2% interest rate (both of which are realistic assumptions of my financing strategy) which puts me at $29,495 down and $2429 monthly debt service. Add in an estimated 2% closing cost which comes to $11,798 and I am looking at a $41,293 initial investment. Right now, that is a little bit above my budget considering that after purchase I would want at least $3000 liquid for repairs and stabilizing the property but it is certainly not out of my range for this summer. Great. So I can afford to buy the property. Let’s look at what I stand to pay each month after the purchase.

Payments

I will keep this part quick and simple (simpler than it really is and should be). $2429 monthly debt service + $403 property taxes + $100 homeowners insurance + $369 PMI (Private Mortgage Insurance) = $3,300 PITI. Private Mortgage Insurance is required if the down payment is less than 20% (more on that later or read the linked article) and typically ranges from 0.5% to 1% of the purchase price per year. Here I have assumed 0.75%. PITI stands for principal, interest, taxes, and insurance and is a figure for the monthly cost of owning the property before any management and maintenance costs. You can also read more about the implications of PITI here. In short, my estimated PITI of $3,300 means that I should at a minimum be expecting to make that much by renting the units if I want this to be a profitable investment.

Income

This property has 3 units, all of which are currently rented out. Redfin.com gives me some super helpful information by showing the current rental rates for each unit. The units, which have the same number of bathrooms, bedrooms, and square footage respectively rent out for $950, $950, and $1200. Why, then, is one unit generating so much more rent with the same features and space? That’s a great question. It looks like this is the case because the most expensive unit has its own washer and dryer while the other two only have a washer and dryer hookup available. I will take this fact in account shortly as I try to make the numbers work for this investment.

Running some super simple numbers, the current rents give me $3100 a month in rental income. Assuming a 5% vacancy loss, that puts me at an estimated $2945 GOI (Gross Operating Income). Clearly, this is not a good cash flow. I am already at a loss each month even before accounting for additional expenses so at face value, this property would not be a good investment. As such, I might look for some kind of value add (the listing mentions that there is space to build a fourth unit), offer a lower purchase price, or conclude that this is not the property for me. However, for the sake of this demonstration, I will do the simplest possible value add and install a washer and dryer in both of the other two units such that all three units can be rented for the price of $1200. Based on current prices, this would cost me roughly $2,600 which means I will need to budget for that extra expense upon purchasing the property.

As far as I can tell right now, these three units are otherwise entirely equivalent so I’ll assume that with the added washers and dryers, I can boost all rents to $1200 a month. This is obviously not a realistic assumption given that these units are currently under lease and I can’t expect to raise rents by $300 and keep the same tenants. Nonetheless, I’ll proceed with this assumption for now. These new rents give me an estimated $3,420 GOI after accounting for vacancy loss which puts me at positive monthly cash flow prior to expenses.

Expenses

Finally, I must account for additional expenses. For utilities (water, gas, electricity), I will mark down $50. How do I justify that? Well, first of all, I can see that water is an included utility for the current tenants (it is included with their rent) which means that the property must have a shared water meter. That is not always the case. With many duplex and triplexes, water, electricity, and/or gas have separate meters for each unit which means that renters can pay those utilities themselves. With this property, since water is shared, I will either have to charge an additional fee for water usage or take on that cost myself. The shared meter is definitely an unfortunate downside to this property. I will have tenants continue to pay their own gas and electricity as they don’t appear to be included right now and then introduce a flat fee for water usage upon taking over the property. I will assume some loss on top of that fee and allocate $50 to cover it.

I will tentatively mark down $50 for lawn service and $30 for trash service. I’ll allocate $100 for repairs per month and, in the event that a given month is incident-free, pay that into an account for larger repairs down the road. That puts me at $230 additional monthly expenses after PITI. The biggest additional expense, though, and one that heavily influences my ability to move out and eventually rent all three units, is property management. Assuming that an external property management company will cost me 10% of GOI, that adds $342 in management expenses for a total of $572 additional monthly expenses.

Cash Flow

All told, my estimates of PITI, rent, vacancy, and expenses put this property in a bad spot. I have $3,470 coming in each month and $3872 going out for a $452 monthly deficit and a -9.24% cash-on-cash return. Long term, I’m building equity and expecting appreciation of the property but negative cash flow is still a bad investment. To remedy this situation, and as a demonstration of how a property that might not work can be made to work if the right steps are taken, I’ll make a few more baseless assumptions and assume that I could spruce up the property a bit with minimal repairs, renovations, and cleaning and then rent each unit for $1300. Then I’ll assume I can self-manage the property as well. Suddenly, I’m looking at a $175 positive cash flow each month and a 3.59% cash-on-cash return. This is a tiny and very fragile positive cash flow which just goes to show how razor-thin the margins on a property can be and how important it is to perform due diligence and get the numbers right. I would still consider this a bad investment given that any significant repair or any expense that goes beyond my estimates will put me in the red. It also isn’t profitable enough for me to eventually install outside management when I move out. A 3.59% cash-on-cash return is not a steal by any stretch of the imagination. But that’s ok! Not all properties are good investments and, baring some significant value add on my part, this one probably wouldn’t be.

Adding in the 'House Hack' Part

Finally, let’s get back to house hacking this property. A house hack would mean that I move into one of the units instead of renting it out. Suddenly, I’m back to a $1060 monthly loss because I’m losing a third of my rental income. But on the flip side, I’m paying $1060 a month in living expenses while building equity in an asset that will appreciate with the market and which could generate positive cash flow when I move out. That sure sounds a lot better than paying $1060 (or much more) in rent to someone else for no gain! This is the beauty of a house hack at its core. One can pay as much as they would pay to rent their housing (and often much less) while most of that money comes back to them in the form of equity in a property. This is an extremely powerful wealth-building tool!

Financing

While I’ve already outlined the central benefits of a house hack, one of its biggest benefits is the financing options that it unlocks. As compared to investing in a property exclusively to rent to others, a house hack allows an investor like me to use owner-occupied financing which entails much lower requirements for down payments. I could be asked to pay a 20% down payment for a typical investment property. However, if I will live in a property for at least one year, I can utilize much lower down payment loans that range anywhere from 5% conventional loans to 2.5% down FHA Loans. This means that a $30,000 down payment would go from purchasing a property worth $150,000 with 20% down to $600,000 with 5% down. Of course, this also comes with Private Mortgage Insurance but so long as that is accounted for when running the cash flow numbers, it is well worth it.

Then, after a year of residing in the house, I can move out, turn it into a full rental property with positive (hopefully) cash flow, and buy another. If the cash flow is strong enough, I can even put the property in the care of a property management company and free up some of my time commitment in exchange for less profit. This step is crucial for eventually building scale which is, once again, why a strong cash flow is important. This process is a foot in the door for many beginner investors and a very appealing situation for me to get my start, whether that be this summer or after I graduate from college.

Final Notes

House hacking, as with all real estate investments, is not a perfect situation nor is it guaranteed money. Even with the generous assumptions that I gave myself while analyzing this property, I only reached a theoretical positive cash flow. With thin margins—or even with properties that cash flow to the tune of $1000 or $2000 a month—a long vacancy, an expensive turnover from one tenant to another, or an unexpected repair like a burst pipe can set you back thousands and wipe out all of your profit. That’s the game you play with all investing. It’s a risk, but with scale, you can mitigate your risk and achieve a much more secure financial position. As a beginner investor, a property that breaks even or loses a bit of money can be an anchor that can pull you down as you try to attain more properties. However, in the long run, if you operate in the right markets with the right strategy and buy with rent increases and appreciation in mind, you stand to make significant long-term gains with the power of leveraged appreciation. The question is not if you should invest or even when you should invest but how you should invest.

If you are trying to figure out the how, let’s talk. Thanks for reading.

-Will Hammond