Q&A: Should I Buy a Bigger House for Roommates?

Following last week's post on the ROI of rental properties, another interesting question is whether you should buy a small one-bedroom condo (for example) to keep expenses low, or a three- or four-bedroom house to gain some rental income. There are two main considerations: ROI and overall financial safety.

As far as ROI is concerned, I think it's very similar to last week's calculations. There are some differences in the details, though. Your principal and interest (P&I) payment will be higher, but when determining the ROI on the rental portion of your property, I think it should be specified as the difference between the large house's payment and the small home's P&I. You would have had the base P&I payment anyway, so it's not really a cost associated with the renters. Similarly for most of the expenses. Property taxes and insurance will be higher for a larger house, usually. Maintenance costs will be higher with the increased wear and tear, and you'll need a larger refrigerator, but maintenance costs haven't risen that much for me. Utilities will be higher, but probably not terribly so.

Your investment amount should be the increase in down payment, or the difference in overall home value. In this scenario, I am strongly inclined to use the overall home value in my calculations. This gets into the overall financial safety aspect. A pure rental property can be abandoned and sold off if you don't want to deal with renters anymore. If you get tired of having roommates, you can kick them out, but you still have to pay for the entire house. Lowering your expenses requires moving and the house-buying-and-selling process and headaches associated with it.

Consequently, I think it is very important to buy a house with many financial cushions included, even when you plan on having roommates. As I mentioned ages ago, I bought my home knowing I could afford the payments and other costs using just my base salary after all my preferred expenses had been taken out - 401(k) contributions, IRA contributions, miscellaneous spending money. Each of these expenses was a cushion, and any rental income was a nice bonus.

And there are other reasons why you may not have roommates anymore. I would guess that most people are single when they contemplate having roommates in a house they are buying. It's possible you meet that special someone that thinks you're a special someone, too. Roommates may get in the way then. It's possible that special someone comes with a second income that's much higher than that provided by roommates, but they might also be going (back) to school, or you might be having kids right away and one of you will be staying home. Either way, it'd be nice to be able to spend your first year together in wedded bliss, rather than struggling to downgrade your home.

For me, it seemed to make sense to buy a bit bigger. It's definitely worked out so far. On the other hand, I'd have a much lower debt than I have now, and might have purchased a standalone rental property already. It's hard to know exactly how things would have been different, but I can't say I've had any major regrets with my house and/or roommate situation.

Q&A: What's My ROI on My Rental Property

When evaluating the return on investment of a rental property, you have a few different options on which numbers to use. The numbers depend on what exactly you consider income, and/or what exactly you consider an expense, and what exactly you consider your initial investment.

On the income and expense side, you have the following:

• (+) Rent.
• (-) Principal and interest payment.
• (-) Property taxes.
• (-) Homeowner's insurance. The cost of homeowner's insurance will vary based on location, age of the house, construction type, environmental factors, etc. Mine costs 0.4% of my home value, so I've been using that as a starting point.
• (-) Maintenance costs. For my house, I estimate 1% of my home value in maintenance costs each year. For a rental property, I think I'd estimate 2%. A common rule of thumb is to use 3%, and you can't really go wrong planning conservatively.
• (-) Utilities. This depends on the setup you have for rent - utilities included, a fraction of utilities per room, or utilities in the name of the tenants. In other words, it might not be applicable, but it's not really optional.
• (+ optional) Principal portion of P&I, because it is adding equity to your net worth, but it doesn't help your cash flow.
• (+/- didn't forget about it) Taxes. The interest portion of your P&I isn't directly tax deductible like it is for your primary home, but it is a business expense that offsets your business income. (Your business in this case is being a slum lord.) This applies to all expenses above, plus depreciation of the house, if you go that route. Tax laws concerning business income and losses are somewhat complicated, so I'm not going to go into them.

The net income is fairly straightforward to calculate once you choose what exactly you're including. It's much harder to estimate before you buy the property, unfortunately. Other than the estimates I listed above for insurance and maintenance, many house listings include the previous year's tax amount. Some will also include a history of utility costs, but you usually have to talk to the listing agent and/or current owner. Estimating the rent you can charge requires looking at rooms and/or houses in the area. I use craigslist.org and Google Maps (with the "Real estate" overlay enabled under the "More" button/menu and the Listing type selected as "For rent"). Then, just to be safe, I assume I will rent to college students that move out every summer and leave me with a 25% vacancy rate.

After all that, you find yourself with a net monthly income. You then have to determine how you want to calculate your return on investment. It comes down to whether you consider your initial investment as the amount of cash you parted with - your down payment, or the amount that you're responsible for - the total property value. You can also reevaluate your return on investment at any time using your current equity as your investment amount.

Personally, I'm not a fan of using your current equity to reevaluate. The theory is that as your equity increases, you can increase your ROI by selling the house and using the increased equity to get a new house (or two) with higher income potential. To me, this seems like messing with a good thing. I also hate being in debt, so this might be an entirely emotional position on my part. I also don't view increased equity from home appreciation as an increase in your investment. It's more of an unrealized gain. The only equity I would count is principal reduction, but in that case I would definitely include the principal portion of the P&I as income. The amortization schedule, where the principal portion increases each month, will then take care of the principal reduction to some extent.

Naturally, I made a calculator for this. Utilities aren't included because of the complexity in options. "Maintenance Costs" is a good place to tack that on if you need to. It's fun to play with, if nothing else. I view my maintenance cost and vacancy rate assumptions as conservative. If I can have a positive ROI even with these estimates, I consider it a win. Any extra is a nice bonus. Plus, rent will increase with inflation while P&I should remain constant (until it goes away completely!).

Home Value ($):
Down Payment ($):
Interest Rate (%):
Property Taxes / Year ($):
Homeowner's Insurance / Year ($):
Rent Income / Month ($):
Vacancy Rate (%):
Maintenance Costs / Year ($):
Count Principal as Income?
Yearly ROI?

P&I	Monthly Costs	Monthly Income	Net Income	ROI down payment	ROI total value

Made an Offer

Last Sunday, I went to open houses, as usual. I found [1386311 - 20981 W 116th St - $310,000], which has an amazing backyard. It's got a two-story deck with a screened in sun room (which they filled with a hot tub that wouldn't stay). The yard continued on into a park with sand volleyball, community pool, and a basketball court and playground. The location is fairly ideal, and it's got a lot of cool things about it. My mom found the kitchen to be a bit small, and I found the basement to be a bit smaller than I'd like.

We also found [1376482 - 14557 S Greenwood St - $289,000], which was better than [1375753 - 14116 W 53rd Tr - $288,500] from last time, and in a better location. I still wasn't in love with it for any reason, but it had a decent yard, and was surrounded by nicer houses (which can help resale, apparently).

On Friday, JD and I went to 7 houses, including [1385690 - 15969 Clairborne St - $299,950]. It's a very open house, has a large basement (in two main sections), and large bedrooms. While walking through it, I kept asking, "Where are the negatives?" The only two we could find were the small backyard and the tandem garage. But, the backyard doesn't have a fence to the right, so it opens into the neighbor's yard, which is nice for now. A three-car garage would help while having roommates, but it's not necessary, really. If you go look at the listing for this house, don't worry about the two bedrooms in the basement - they're actually on the top floor with the rest.

Yesterday (Saturday), JD, Carrie, my brother Brian and his girlfriend Aimee, and my parents all joined me in visiting these top three houses. We saw them in reverse order. Everyone liked the Clairborne house and found the Greenwood house lacking. As much as we liked the 116th St house a week ago, it just didn't compare to the Clairborne house. It's considerably smaller, a bit more expensive, and more cut up into actual rooms, instead of areas. The greenspace was the main selling feature, we felt. But, you can't add openness to a house, or much size. For the price difference, I could add a pretty nice deck to the Clairborne house, if I really wanted to. The basement wasn't as nicely finished in the Clairborne house, but it was much bigger, should I ever want to upgrade it.

So, I went back to my parents' house and watched some tennis until JD showed up with some paperwork. He talked about how the comparable houses in the neighborhood have been selling for more, often, and how the subdivision is ending its new construction, which means houses in the area should start to appreciate more. Basically, that this appears to be a pretty good deal. So, we drafted up the paperwork and I signed an offer for $280,000. This includes a home warranty, but little else. Being vacant, there is no washer, dryer, or refrigerator to negotiate over. Once we agree on a price, we can add in closing costs so I can finance those as well. The owners bought the house for $265,000, though, so at $280,000, minus 6% in agent commissions, they'd only be taking in $263,000. The $299,950 asking price is after coming down from about $330,000, so I'm not sure how much lower they can go. We'll find out, though!

I'm pretty excited about the house. It's over 4200 finished square feet for under $300,000. It's located right around 159th and Ridgeview, so it's close to at least one friend from work. The basement has a little exercise room or den, which would be perfect for our LEGO room. At 151st and Ridgeview is Garmin, so it's possible my brother can keep me with a supply of roommates. So, my brother can come over and play ping pong or darts after work, and it's got fairly ready access to I-35.

So, probably a $290,000 house, $230,000 in debt, an extra little bit in monthly income, and lots of maintenance. But, I'll have a house of my own, and I'm pretty happy about that.

Financial Benefits to Homeownership

I've been compiling a list of benefits to owning my own home. The list is a bit longer than I expected, actually.

• Interest paid is tax deductible. Based on a $300,000 home value, this will be about a $13,500 deduction, which is about $3375 in saved taxes. Of course, this benefit diminishes over time.
• PMI premiums are deductible. This will not apply to my house purchase, as I plan on putting a full 20% down, but it's an added bonus, if you have to pay for PMI.
• Home appreciation. When I first buy my house, I will own 20% of it. However, any increase in value becomes my profit as though I owned the entire house.
  
• Immune to inflation. My mortgage payments will end up being rather large, given $240,000 in debt. But, this payment will not change. As time progresses and money becomes less valuable, my mortgage payment just gets easier.
  
• Rental income. Being single, I have the flexibility to rent out rooms in my house. While this probably isn't as financially secure as having a wife with a second income, it certainly doesn't hurt anything.
• Credit building. Due to my parents including me on their credit cars for the past 8 years or more, I have an excellent credit score of around 794. I can claim virtually no credit in this achievement, but it's kind of cool. The point, though, is that making regular payments on time helps your credit score.
• As opposed to paying rent. When you pay rent, your money goes to the landlord (which I will be!). When you make your mortgage payments, you build equity. You become a little more your own landlord every month.
• Tax deductible property taxes. Yep, property taxes are tax deductible, too. Of course, you still have to pay them.
• Points are tax deductible. If you improve your interest rate, points are tax deductible. Which is kind of like getting 25% off the cost of points. Not bad.

Did I forget anything? I feel like I did. Leave a comment and notify me!