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To Rent Or Buy?

12 May 2011 18 Comments

The following post is submitted by Arthur Garcia – a regular 20smoney contributor – He is the founder of thebusinessofu.com, a website that focuses on personal finance, business and self-development.  Arthur interviews everyone from real estate investors to precious metals experts to everyday people with extraordinary stories.

I was in a coffee shop talking with some friends recently when one of the couples posed a challenging dilemma – should they continue to rent or should they buy a house.

After asking them a few questions, I realized that the couple’s problem wasn’t that they couldn’t afford to buy a house; their problem was that they couldn’t afford to buy a house in the neighborhood they were living in.  Here is how the numbers broke down:

* 2-bedroom apartment (West LA): $1900 per month

* 3-bedroom house (West LA): $600K or $3,220 per month (excludes down payment of $60K/$120K at 20/10 percent down respectively)

My suggestion was to buy a cash-flowing rental property in a different housing market and continue to rent where they were living.  Everyone in the group quickly dismissed the idea; some even rolled their eyes and thought I was joking.  What about the American dream and pride of ownership?  The couple responded that they couldn’t see themselves “throwing money away” on rent.

I pulled out a piece of paper and showed them the following:

* Rental property: $110K – cash flowing $400 a month with a $22K down payment

* 2-bedroom apartment (current appt): $1,900 – $400 (rental $) = $1,500 a month for rent

* Plus they retain $38K/$98K of their $60K/$120K down payment respectively *

In spite of the very sobering figures, the couple decided to buy a primary residence anyway.  They borrowed money from family members to make up the rest of the down payment and are now the proud owners of one bloated mortgage.

Based on their current income, they are left with only $250-300 a month after their monthly mortgage payment and cost-of-living expenses.

This is unfortunate because they are going to have to work extremely hard to raise a family – they will have little discretionary cash left at the end of each month to invest in theirs and their children’s futures.  This means that they’ll probably go into debt or possibly lose the house if either of them is faced with a medical illness or unemployment.

I’d like to take a look at another real life situation in which a couple did the exact opposite.  The couple wanted to move out of the suburbs and into an upscale location near a booming downtown metropolitan area.  Here is how those numbers broke down:

* 2-bedroom apartment (in downtown neighborhood): $1,500 per month

* 3-bedroom house (in downtown neighborhood): $400-500K or $2,500 per month (excludes down payment of $40K/$80K at 20/10 percent down respectively)

Rental Property – A single family home (within a 2-hour radius from where they resided) cost 80-110K and cash flows $400 per month with a ~$20K down payment.

Cost of Rent – the total cost of rent is now $1,100 (after subtracting their new stream of passive income) and they still retain $20K/$60K of their initial liquid cash reserves had they bought a primary residence at 20/10 percent down).

My friends in the second example plan to continue investing in rental property to grow their passive income.  Because they are renters, they are not restricted to live where they can afford to buy – instead, they choose to live in an upscale neighborhood with one of the best school districts in the area.  This is going to save them further from having to pay private school tuitions as well as saving them in gas and wear-and-tear on their vehicles – they’ve afforded themselves the convenience of living near their places of work.

Takeaway – If we take a step back to look at our country’s current state of economy, this is a great time to acquire distressed assets.   Here are two revenue-generating ideas:

  1. Multi-family: Buy a multi-family property (2-4 units) – Live in one of the units and have your tenants pay down your mortgage.  I know of one investor who lives in a triplex for free implementing this exact strategy.  If you occupy the property, the financing can be extremely favorable and can be as little as 3-10% down.  Not to mention that if you live in the property for two years, you don’t have to pay taxes on any capital gain on a future sale (limited to $250K for single, $500K for married).
  2. Rent and buy: Purchase a cash-flowing rental property within a lucrative housing market that makes sense.  Continue to rent while building equity and letting someone else pay down your mortgage on the rental property.  I know of an investor who pays $3,000 a month and lives one block from the pacific coast beach (a comparable mortgage in that same neighborhood would be $4-7K per month).

I felt this post was necessary, especially after listening to my friends’ conundrum on whether to rent or to buy.  Too many people blindly accept the allure of pride of ownership without ever looking at the hard numbers to make their decision.

We are living in arguably the best time to purchase cash flowing rental property.  Areas that didn’t pencil out 3-5 years ago are providing a steady monthly cash flow of $300-500 a month for savvy investors.  Another factor to consider is that inflation is beginning to rear its ugly head in our everyday lives (just visit your nearest grocery store), and a 30-year fixed rate mortgage is a great way to hedge against the declining value of the dollar.

I hope this was an insightful post – please let me know your thoughts…

 

 

18 Comments »

  • Pete D said:

    Good post. I rent now and live 2 blocks from ocean in Newport Beach. Am surrounded by multi-million homes and I pay $1400 a month( I got a good deal!) for a 2 bedroom duplex unit.

    I am looking to buy investment property in inland OC and the IE.

    I would like to buy multi family but cap rates still seem to be high (Granted I have been only looking at the MLS). Mostly 6-7 caps in OC and 7-8 caps in IE. Have you found this the case to be in LA?

  • Arthur Garcia said:

    Pete,

    Congrats on the sweet deal – I love Newport! I would say your best bet is the IE. I own a few units out there. There are some really good deals out there. I have a few multi families, but I actually prefer single family homes. I find that I can usually get a better quality tenant (in my market) and have less time-consuming problems. I don't mind taking a little less cash flow if the renters take care of the property.

    I don't buy in LA and I don't encourage you to either. The locations where the numbers make sense aren't areas I want to visit (warzones). Hit me up via email – artieag81 (a) gmail.com and I'll be happy to share more info about the IE and the market I buy in.

  • Click here said:

    This is a good post with nice comment. I think it is good to rent and better to buy, if there is means.

  • Omaha classifieds said:

    I live in Newport Beach too! We live in the same area but there`s a difference. You pay 1400$ per month, you really got a good deal. I pay 1900$ per month. Why is the difference so big?

  • Arthur Garcia said:

    Thanks Dinheiro – I appreciate the feedback.

  • updawazoo said:

    Buy only if u:
    – Want a stable home for you and your family
    – Increase your net worth
    – Not have to worry about your mortgage going up every couple of years unless u other than old school fixed rate mortgage
    – Once paid off, u never have to worried about being homeless, unless u stop paying your property tax. other than that, your fine.

  • Arthur Garcia said:

    updawazoo,

    Thanks for the comment. I like your points above, but I would argue that you can enjoy all the benifits you listed and more without having to live in the properties you purchase. Like I mentioned in the post, there are some areas where I don't it makes sense to buy. I am not saying people should purchase in those areas, but I would reccomend making that move after other income-producing assets have been acquired, just my 2 cents.

    Thanks again for the comment!

    AG

  • coppy said:

    Well said bud. Hopefully the fam and I can follow your instructions one day!

  • Arthur Garcia said:

    Hey Coppy!

    Thanks for taking time to comment. When that time comes, I'll be happy to help in any way I can.

    Best,

    AG

  • Andy said:

    Arthur-
    Great article. I am 24 now, renting an apartment and reading as much as I can on personal finance, investing, and personal improvement. I have been thinking about real estate as an option for additional income streams, and your site is very helpful. Good luck and keep writing!

    -Andy

  • Latoyia Honig said:

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  • WPC Decking said:

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  • Dave said:

    Just don't forget to account for the personal preference factor. You can show numbers all day, but if someone is emotionally attached to an option, it might be the better deal nevertheless.

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  • Michael said:

    the 400 dollars you receive from an investment property would surely have to be used to pay the mortgage on the rental property along with possibly extra income to cover the mortgage. you also need to add in local authority rates, maintenance, insurance, mortgage protection therefore your current rental of 1900 would more than likely increase with these costs. Just thought this is worth bearing in mind also.

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  • dissertation service said:

    I have been renting a house for years. But it's time to stop it. Helpful article!

  • Mariane Desil said:

    Thank you for providing this interesting article.I've recently got married and my husband suggested me to buy a house where to spend our vacations.A friend of us who works at a boston vacation rental company told us that it is better to rent than to buy as we will save a lot of money.