Seriously, it is possible to never pay for housing again, and there are plenty of people doing it right now. This article will be a real estate case study, and I will lay out specific action items that can help you take advantage of house hacking.
Finally, this article will be a little more technical with regards to entity formation, tax treatment on income, rates of return, and more.
What is House Hacking?
So, what is house hacking? According to Auction.com, “House hacking is when you live in one of the multiple units of your investment property as your primary residence, and have renters from the other units pay your mortgage and expenses.
House hacking can also occur in single-family homes when the investor lives in the property, make improvements, and looks to resell within a couple of years.
Renting out a bedroom, basement, or additional portion of your home can also be considered house hacking.
This is a solid strategy for investors looking to do a quick fix-and-flip, or for investors looking to buy an owner-occupied multi-family property, such as a duplex, triplex or quadplex.”
Multi-Family Focus
For the scope of this article, I will be focusing specifically on investing in multi-family homes (duplexes, triplexes, and quadplexes), and I will not talk at all about investing in single family homes.
Now, some readers might also be thinking “Alex, didn’t you write an article in the past called “Don’t Buy a Home in Your 20’s?”
Yes, I did write an article talking about how buying a home too early in your life can destroy your ability to create wealth.
I would encourage anyone who has not already read that article to check it out. House hacking is entirely different than buying an ordinary home because the real estate is viewed as an investment property, not simply a place to live.
Investment Property vs. House
1. Cash Flow
This will be the biggest differentiating factor between investment properties and a house. According to the definition of investing I provided within “Buying Bitcoin is not Investing” and Warren Buffett’s definition of investing, an investment asset creates income.
Meaning, if you buy a piece of real estate (say a triplex), you can rent out three units and collect monthly payments from the tenants.
This results in value creation and income. Contrarily, if you buy a single-family house (like the majority of Americans do) you will never receive any income/value creation, unless you sell your home in the future for an amount larger than the purchasing price.
According to Realty Mogul, “You can think of cash flow investing the same way you think about dividends with stocks.
At some interval, whether it is monthly, quarterly, semi-annually or annually, you will receive regular cash distributions from your investment.
You are buying a portion, or all, of an asset that can be leased or otherwise used to generate income.
With real estate investing, cash flow is the result of proceeds from rent payments. Let’s take a multi-family apartment building as an example.
Say the property has 50 units and each unit rents for $1,000 per month. If we assume an expense ratio of 40%, the net income per month on that property is $30,000.
While it is always a good idea to keep some portion of that net income in reserves, the remainder of the income is available for distribution, in this example, $28,500.”
2. Tax Treatment
As I mentioned in “9 Legitimate Ways to Earn Passive Income”, there are more millionaires in the real estate industry than any other industry in the world.
This is almost certainly due to the preferential tax treatment that landlords and investors receive.
According to Mad Fientist, a popular finance, investing, and real estate website, “Real estate is an I.D.E.A.L. investment:
- Income: Regular cash flow from rents or interest payments. I consistently see unleveraged returns of 5-10% from this one method of making money. With reasonable leverage, it’s possible to see these returns jump to the 10-15% range or better.
- Depreciation: A required accounting method that spreads the cost of an asset over multiple years (27.5 years for residential real estate). This paper expense can “shelter” or protect other income from taxes and reduce your tax bill.
- Equity: If you borrow money to buy a rental property, your tenant essentially pays off the property for you. You use the rent to pay the mortgage, and each month the principal paydown (aka equity) gets bigger and bigger like a forced savings account.
- Appreciation: Over the long-run real estate has gone up in value about the same rate as inflation (3-4%). This passive style of inflation helps, but active appreciation is even more profitable. Active appreciation happens when you force the value higher over a shorter period of time, like with a house remodel.
- Leverage: Many investors use debt leverage to buy real estate. This means, for example, $100,000 can buy four properties at $25,000 down instead of just one property for $100,000. Leverage magnifies the profits mentioned above (and potentially the losses). Plus, interest on debt is deductible as a business expense
Single Family Isn’t I.D.E.A.L
Using this same investment philosophy, single-family homes are certainly not I.D.E.A.L (more like E.A.L).
In fact, income/cash flow from rent payments, depreciation of the purchased asset and capitalizable expenses, and the deductibility of property taxes, insurance, and maintenance are what provide investment properties real value.
If you buy a home for $300,000 and in 20 years it is worth $400,000, you have to sell your home to realize any of the gain, and it is emotionally difficult to part from your home and move.
If you never sell your home, you never get to take advantage of the gain, so was it really ever an “investment” in the first place?
Case Study: Graham Stephan
Here is Graham’s background from The Oppenheim Group (brokerage on Netflix’s “Selling Sunset”):
Specializing in the sale and lease of high-end properties throughout Los Angeles, Graham Stephan brings an unparalleled one-on-one service to each of his clients.
Raised in Santa Monica, California, Graham Stephan obtained his Real Estate license shortly after his 18th birthday and dove headfirst into the world of Real Estate in 2008 with Coldwell Banker Previews International.
Since 2008, Graham has sold over $125,000,000 of Residential Real Estate and continues to increase his sales volume year-after-year.
The key to Graham’s success is simple: a genuine passion and infectious enthusiasm for the Real Estate industry.
His notable clients include Orlando Bloom, Chloe Moretz, Suki Waterhouse, LaVar Arrington, Wale, Casper Inc., among many others.
Outside of Real Estate sales, Graham owns five rental properties that he manages in his spare time throughout Los Angeles and San Bernardino County.
He is also an avid car enthusiast and can be often found at car meets or driving through the Malibu Canyons on weekend mornings.
Graham’s Real Estate Philosophies
- Only invest in multi-family properties that create passive income streams
- Buy properties in price appreciating markets
- Don’t be afraid of a little TLC
- Use leverage to maximize his returns
Graham is the perfect individual for a house hacking case study because he has ACTUALLY made it work and has worked in the real estate industry for almost a decade (with one of the word’s best brokerage firms).
It’s safe to say that he has the professional reputation and technical wherewithal.
The numbers behind this case study, while not exactly identical, are similar enough to yield accurate results.
For example, Graham may purchase a triplex for $300,000 ($25,000 down), live in one of the units, and rent the other two units out for $1,500 a month.
Additionally, Graham notes that he uses 30 year fixed-rate loans to leverage the debt. Right now, loans can be acquired at 4% interest rates, so that’s our assumption.
Realistic Assumptions
- 20% effective tax rate
- Property value and rent increases 2% each year based on inflation and historical averages
- Depreciation calculated using MACRS 27.5 schedule, placed in service in July. The property itself is worth $275,000 (excluding land of $25,000 because land is not depreciable)
- Property tax at 1% of market value
- Insurance starts at $2,000 a year and increases at 2% annually
- Maintenance expense of 10% of rental income
Based on a 4%, $275,000 mortgage for 30 years, the monthly payments are $1,312.89. This amount can be calculated using an excel spreadsheet or online amortization calculator.
Year 1 Amortization Table and Rental Income
Year 1 Explanation
As you can see, the rental income payments Graham is receiving from his tenants are more than enough to cover his monthly mortgage payment, property taxes, maintenance, and insurance.
Due to the tax treatment of real estate, Graham is able to depreciate his property, deduct interest expense, property taxes, insurance, maintenance, and other business expenses.
He is also building equity every month in the amount of the “Amortization” column.
This means that after year 1 (and only after 1 year!) Graham has already made a 57.10% effective gain on his investment! Also, since he lived in one of the triplex units, he did not have any housing payment.
Graham is a master in using this money he “saves” on housing to reinvest in more rental properties.
Year 2 Amortization Table and Rental Income
Year 3 Amortization Table and Rental Income
I will not continue past year 3, but it is easy to see that every year Graham continues to hold onto his investment properties, the equity continues to build, rent prices increase, and the market value of the property itself increases.
While there is absolutely no guarantee of return, there is plenty of margin for error. If he encounters vacancies, evictions, or bad tenants, he will be okay.
Keep in mind the most important part of this article! Graham is still making these ridiculous returns without paying for his housing!
These housing payment savings effectively increase his returns even more.
Additional Resources
- House Hacking: The Only Real Estate Investing Strategy You Need to Build Wealth, Live for Free (or almost free), and Make Money Through Homeownership.
- The House Hacking Strategy: How to Use Your Home to Achieve Financial Freedom
- The Book on Rental Property Investing: How to Create Wealth and Passive Income Through Intelligent Buy & Hold Real Estate Investing!
Here is a video from Graham’s YouTube channel about House Hacking! If you liked this article, be sure to subscribe, share the article, and check out my popular articles. Additionally, here are more articles about investing, money management, retirement planning, and early retirement!
