House Hacking: How to Invest in Real Estate And Live For Free
My first house hacking experience was the first time I bought a house. Although I technically became a landlord, I didn’t consider myself a real estate investor. I sold that property at my first opportunity. However, if I only understood real estate investing strategies, I would have never let that property go! In 2011, my wife shared that she wanted to own a condo downtown and rent it out. I quickly disagreed with her and told her, “I didn’t want to fix toilets.” Fast forward, and I now own multiple investment properties in my local real estate market. My journey reminds me of two things 1) I love real estate investing, and 2) my wife is always right!
What is House Hacking?
House hacking is when an owner lives in their property and rents out other parts of the property.
Ultimately, the tenants are the ones paying the monthly mortgage payment while the owner lives rent-free. For example, a person can buy multi-family property (e.g., triplex), live in one of the units, and rent out the other units. Another example is a person who owns a single-family home, lives in one of the rooms, and rents out the other rooms.
My simple house hacking strategy was owning a single-family house and having roommates pay rent. I didn’t do this to start building wealth. Instead, I invited my friends to live with me, primarily for social reasons. I technically became a landlord. I owned the property, but my roommates were helping pay the mortgage!
The Benefits of House Hacking
Looking for your first investment property but unsure of where to begin? House hacking provides multiple benefits, especially to rookie investors.
You Live Rent-Free
The first big benefit of house hacking is living rent-free! A mortgage payment is composed of the principal amount, interest payment, and potentially mortgage insurance. However, the tenants are the ones paying back the debt service.
Lenders offer lower interest rates to people who will occupy their property compared to investors who do not. They do this because people who live onsite tend to take better care of the property. Thus, these investments are less risky. My rental properties’ interest rate is about three to six percent higher than my primary residence’s interest rate.
Low Down Payment
Owner-occupied properties don’t require as much of a down payment compared to non-owner occupied borrowers. For example, the Federal Housing Administration (FHA) insures mortgage loans and only requires a down payment of less than five percent of the purchase price.
Non-owner occupied properties require 20 to 25 percent of the purchase price for a down payment. The down payment for owner-occupied borrowers is significantly lower compared to non-owner occupied borrowers. I won’t bore you with the math. But, this low down payment makes house hacking a steal!
Aside from living rent-free, successful house hacking can generate monthly cash flow, known as the net operating income.
You can calculate the net operating income (NOI) by subtracting the monthly operating expenses from the gross rental income.
Net Operating Income = Gross Rental Income – Operating Expenses Below is a list of monthly operating expenses to consider:
- Mortgage payment
- Property Taxes
- Property Insurance
- HOA fees
- Property Management Company
How To Get Started In House Hacking?
Step 1: Become Creditworthy
The most powerful thing in real estate is leveraging other people’s money. Therefore, for a lender to approve you for real estate financing, you need to be as creditworthy as much as you can. You can become creditworthy by improving your good credit score, having a stable income source, and reducing your debt-to-income ratio.
Step 2: Build a Relationship With a Local Bank
I always recommend new investors to build a relationship with a local bank or a credit union. A banker at a local bank can sometimes have more influence over your loan than a banker at a “big name” bank.
Communicate with your banker what you’re trying to accomplish with house hacking. A creative banker can develop loan suggestions to help you reach your goals, such as an FHA, 203k loan, or HomeStyle Renovation loan. My banker works with many investors, and I’m fortunate to have built a great relationship with her. Her motto is, “I don’t invest in houses. I invest in people.” We’re at a point in our relationship where she increased our credit line, allowing us to purchase more properties.
Step 3: Study Your Local Real Estate Market
Study your local real estate market and look for areas with good opportunities: research property values, rental income, and the kind of tenants in your market.
I practiced analyzing multiple properties before I made my first offer on an investment property. I calculated various numbers, such as the cash-on-cash return and the return on investment. By the time I receive a lead, I know off the top of my head if it’s a potential deal or if I should move on.
Step 4: Create a Process to Find Leads
Finding real estate deals is the hardest part of real estate investing. Hence, you need to create a process that leads to potential deals, such as finding absentee owners. Below is a list of ways you can generate leads:
- Driving for dollars
- Direct mail campaign
- Online marketing
- Reviewing property tax records
- Work with a real estate agent.
Step 5: Make an Offer
There are always other investors looking for great deals. So, once you’ve analyzed the property, it’s time to pull the trigger and make an offer! But, don’t be discouraged if you don’t get your offer accepted.
As you make more offers on multiple properties, you’ll grow to see that you can’t win them all. You need one. One year, I’ve analyzed over 50 properties, visited 12 of them, and made over five offers. Only one of my offers got accepted, and it was a great deal!
How to Grow Your Real Estate Portfolio
Rental property investing is a great way to generate passive income. However, if you’re looking to replace your income or become financially independent, you’ll need to scale your real estate portfolio.
BRRRR stands for Buy, Rehab, Rent, Refinance, and Repeat.
The BRRRR Method is a real estate strategy that allows investors to recoup their initial investment and put it towards another investment property. I often use this strategy. In less than two years, I acquired three properties. The method can be challenging to grasp at first. Therefore, it’s easier to explain through an example:
BRRRR Method Example
Joe BUYS a $100,000 property. His down payment is $5,000, while a bank lends him $95,000. For the sake of simplicity, I’ll ignore closing costs. He spends $10,000 on REHAB costs to increase the after-repair-value and RENTS his property for $1,300 after he made improvements. Therefore, his overall initial investment is $15,000.
After a few months, Joe requests a bank to perform a cash-out REFINANCE. The property appraises for $150,000, and a bank creates a loan 75% of the appraisal valuation. Therefore, the principal balance of the loan is $112,500 ($150,000 x 75%). The new loan of $112,500 replaces the other loan of $95,000, pays Joe back his down payment of $5,000, and the rehab costs of $10,000.
Refinanced Amount – First Loan Balance – Down Payment – Renovation Costs = $112,500 – $95,000 – $5,000 – $10,000 = $2,500
The rental income of $1,300 pays down the $112,5000 mortgage loan. Joe recouped his $15,000 investment along with an additional $2,500 from the cash-out refinance.
Joe can REPEAT the process and use the $17,500 as a down payment toward a new investment property. The key to this strategy is purchasing an undervalued property and force appreciation through renovations.
A 1031 exchange is an Internal Revenue Service tax code that allows an investor to defer paying capital gains tax on their property’s sale. According to the 1031 exchange rules, an investor needs to exchange their current property with one that has a replacement value greater than or equal to its own.
Regarding house hacking, you’ll need to own the property for at least two years before you can take advantage of this tax code. For example, Nathan purchased a house hacking duplex for $150,000 and made improvements to the property over time. After a couple of years, the property value became $600,000, and the net proceeds of the sale are $500,000.
- Original Purchase Price: $150k
- Fair Market Value: $600k
- Net proceeds: $500k
Nathan can keep the net proceeds. However, the government will heavily tax him. He can also scale and put it towards a more significant investment property, such as a 24-unit apartment complex or multiple short term rentals!
Besides paying capital gains tax, Nathan has also increased his ability to generate more monthly cash flow, reduce his maintenance costs, and improve tenants’ quality. He went from a real estate rookie living rent-free to becoming an experienced real estate mogul!
Common House Hacking Mistakes
Treating Investing as a Hobby
Real estate investing is a business and should be treated as one. A common mistake that new investors make is treating it as a hobby. They don’t give their investing the necessary attention required, which can lead to financial ruin.
Not Following The Law
The city can shut down your business if you ignore any rental laws, such as not following local zoning ordinances. I visited a property for sale because the owner was attempting to do creative house hacking. He illegally created a duplex from a single-family house, and none of his work was up to code. Thus, the city shut him down. He had to cut his losses and sell.
Not Property Screening Tenants
Screening your tenants and doing a background check is essential! You might feel desperate to have anyone rent your property to pay the mortgage. However, unfavorable tenants could lead to damages to your property. Those damages could cost thousands of dollars in repair or even force your property into vacancy.
I had potential tenants applying for one of my properties. Unfortunately, they had two large dogs that I don’t accept as part of my policy. Even though it would be nice to take their application, I still had to weigh the risks and move on.
Not Budgeting For Repairs
Another common mistake is that new investors don’t account for potential repairs or vacancies as part of their analysis. Also, they don’t have sufficient cash reserves to pay for these potential expenses. I strive to maintain at least three months’ worth of rental income for each of my properties in cash reserves.
I did my first house hack unknowingly. However, if I had a plan when purchasing my first property, I would do a 1031 exchange and scaled my real estate portfolio. I purchased that house for $135,000 and rented it out for $1,300 before selling it. Zillow says the estimated rental income for that property is now $1,600, and its market value is over $200,000. These house hacking strategies are a great introduction to anyone interested in getting into real estate. Like any investment, you need to analyze your local market to make sure it’s a great deal!
This article originally appeared on Your Money Geek and has been republished with permission.