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Tenants make it harder for you to get rich

Posted by John T. Reed on

The dominant way of thinking about real estate investing on the Reddit real estate investing subgroup is collecting duplexes and triplexes. The purpose is increasing your net worth. Some want to live solely off property cash flow, but that takes millions of equity, so it’s really just another way to say you are trying to increase your net worth.

I used to think that.

I was wrong. The correct way to achieve that goal is to buy your principal residence that you occupy as your home. When you can afford to buy a 20% or more valuable home, sell the first one and buy the second. Just keep repeating that throughout your adult life. Own one increasingly more expensive house at a time.

“But,” you protest, “Without help from tenants’ rents, you can’t buy as much property.”

I used to think that.

I was wrong. Tenants do not help. They hurt. They slow you down. They are a drag on your progress.

I just researched this extensively.

The price you can afford when you buy a principal residence is the sum of two amounts:

  • the amount you can put down
  • the mortgageyou can qualify for

Tenants not only give you no money to put down, having them is a money-losing proposition. The money you are losing subsidizing your tenants in dozens of ways reduces your savings, a.k.a., down payment money for the next purchase.

Furthermore, as an owner-occupant, you get the cheapest mortgages with the highest loan-to-value ratios. If you are a vet, 0% down; FHA, 3.5%; PMI, 5% or 10%, conventional, 20%.

Last Friday, I asked my banker if they did rental-property mortgages. Yes.

Are the terms not as good as owner-occupied, single-family? Correct.

  • Higher interest
  • Higher front-end
  • Much lower loan-to-value ratio—60% which means 40% down. Often a 30-year amortization schedule but a balloon payment in five or seven or ten years.
  • personal liabilityon the mortgage (For technical reasons I have explained in other posts, home owner often are not personally liable for the mortgage. Landlords generally are.)

Those are all handicaps the lender dumps on your quest to be a millionaire because your building is occupied by tenants.

But wait, there’s more.

landlord insurance policy costs about 25% more per year than a homeowners insurance policy because of more and higher claims when you have tenants. And each property damage claim you make forces you to pay another deductible. Homeowner-occupants rarely have any claims. Those higher premiums and deductibles would have gone into savings for your next down payment if you did not have tenants.

Then there are all the utilities including trash and sewer. A childless couple who occupies a home they own, has utility bills. Call the total amount $X. If, instead, they live in a duplex with the same total value, their total utility bills will be $2X if the other unit is rented to a childless couple.

What if they have separate meters?

  1. That probably only covers gas & electric.
  2. Water, sewer, trash are generally not on separate meters
  3. If the tenant pays their own gas & electric, the rent will be lower than the rent would be if the landlord paid the gas & electric approximately by the amount for the gas & electric. It’s a wash.

Will property taxes be higher on the duplex than on a single-family house of the same value? They are not supposed to be, but assessors have been known to overassess landlords compared to owner-occupants—because homeowners are voters and are numerous and landlords often do not live in the town and cannot vote against the assessor.

Having tenants is a part-time job—about 3.6 hours per unit per month. When you get to about 50 units, it is a full-time job. That is time you could have spent earning more money and saving it for your next down payment. You can Google how much that rental property work pays if you did it for someone else: around $16 to $22 an hour.

Tenants trigger expense for replacements like roofs and appliances like AC condensers, furnaces, garbage disposers, dishwashers, refrigerators, clothes washers and dryers.

If you only own one owner-occupied home at a time, you always have just one of each of those. But if you own, say, ten duplexes worth the same amount of money total as your owner-occupied home, you will have ten roofs and you will be replacing one on average every three years. You will also have a set of those appliances for each tenant and be replacing them constantly.

Mainly, if you have a mortgage on your rental property, with the higher interest rate caused by it not being owner-occupied (even higher if you have an LLC), you will have negative cash flow.

Yes, real estate land is full of people who claim to have positive cash flow. If they have a loan-to-value ratio above about 50%, they do not have positive cash flow in spite of what they tell you and what they tell themselves. The operating expense ratio is about 45% nationwide on all sorts of buildings. Critics will say it varies for each building.

I used to think that.

I was wrong. Look it up. Look at your own Schedule E of your income tax return.

Operating expenses take 45%. The mortgage payment takes 60% or more. 60% + 45% = 105% of the rents, a.k.a., negative cash flow.

I remember when I was buying duplexes and triplexes that a VA mortgage originator said when calculating how much of a duplex you can afford, the VA only counts half the rent as your net income. There’s that 45% operating expense rating again. Lender are quite correct to only give you credit for the net rent, called net operating income in the apartment business, that you get to keep when it comes to qualifying for the mortgage. Net operating income is the cash flow the building would have if it had no mortgage.

For all of the above reasons, having tenants reduces the amount property you can buy compared to a what you have the down payment and income to qualify for as an owner occupant of a single-family home.

Instead of trying to get more and more tenants, your focus should be on saving for down payments and taking steps to increase your income where you and your spouse work full-time. For example, my youngest son took an exam in recent years that certified him as a higher level expert in SalesForce enterprise software. And he was able to qualify for a single-family, owner-occupied house that cost more than twice what his previous home cost. Q.E.D.

In the long run, those sources of down payment money and income to qualify for a bigger mortgage at your greater-than-$16-to-$22-an-hour full-time real job, and the greater all-around efficiency of principal residence investing, will get you to your target net worth faster and more surely.

There is also litigation. The more tenants you have, the more litigation you have. That is like another job when it happens, and while it lasts, you get to lie in bed every night worrying about whether the opposing attorney is actually going to get the millions of dollars from you that he or she is demanding.


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