Real estate as an investment has been a hot topic for debate after the bubble and corresponding crash from a few years ago. While I can understand the uncertainty and fear that comes with real estate after so much turmoil, I believe real estate is a vital piece of long-term wealth development. A rental property when properly leveraged can be a strong hedge against inflation. Additionally, a rental property that produces positive cash flow can be a viable addition to a passive income portfolio.
As I posted back in February, I have an unintentional rental property. This townhouse (not pictured, but very similar) represents my biggest financial mistake thus far. Since moving and being forced into a rental situation, this house has been a tremendous cash flow drain on my finances. Originally purchased with five percent down, there was no margin for error when the housing bubble burst in 2008. At its lowest point, the house was approximately $50,000 underwater.
Dealing With An Underwater Rental Property
Having a complete lack of equity in the house eliminated refinancing as an option to reduce the negative cash flow on the property. Complicating things further, because the house transitioned from a personal residence to a rental property, it was deemed an investment for lending purposes. When the various financial assistance programs were rolled out by the government such as Home Affordable Refinance Program (HARP) my townhouse was ineligible and did not qualify to be refinanced as an underwater rental property.
Without any options to refinance, I had pretty much given up hope of dropping the 5.875% interest rate on the original mortgage. As interest rates continued fall it was frustrating to be unable to improve the loan situation. Ticking down from around 6% when I bought the house, mortgage rates have gone from an average of 6.03% in 2008 to 3.66% in 2012 (Source: Freddie Mac).
In February, the day after I first posted about my unintentional rental property, I received a call from Wells Fargo regarding the status of my mortgage. Due to a change in the rules of HARP, although my house was a rental property, it was now eligible for a no-cost, no-appraisal refinance. Have you ever won the lottery? I haven’t, so I can’t compare the feelings, but it felt like a pretty big win in my book!
Since getting the call from the bank, the entire refinance has been arguably the most pain-free loan process as I’ve ever been involved with and took less than 45 days to close. Part of the ease of the process was it was a HARP refinance which greatly reduced the requirements. Those reduced requirements included an estimated value of the home provided by the bank, a verification of income and employment, a year’s worth of bank statements, and a few simple explanations. After that, the loan was off to underwriting.
New Financials For The Rental Property
I locked in a 4.125% interest rate for a 30-year, fixed-rate mortgage. As a rental property, the new rate suffers from a half-point penalty over market rates. Bottom line, after a little over five years since purchase, I was able to knock 1.75% off the original interest rate. With net closing costs of $2,104.21, my payoff period will be less than six months.
After all said and done, the refinance adjusted the overall financial picture on my rental property tremendously. Below is an updated financial summary of the house.
Townhouse Rental Financials
|Monthly Rent Income|
|Less: Management Fees|
|Net Rental Income|
|Escrow (Taxes, Insurance, and PMI)|
|Net Income (Deficit)|
So what does this do for me? By refinancing the mortgage on the rental property, I was able to increase my month cash flow by $355.45, saving me $4,265.40 per year. While the financials above show a net loss of $337.77 per month, $100 of this is repairs allowance, which is not realized until expenses actually occur. The rental property is performing just above the break-even point when netting the actual cash flow loss with the new principal repayment amount, which is in excess of $300 per month. None of these numbers factor in the tax benefits of owning a rental property.
Even with the overall decrease in negative monthly cash flow, my current plan is to still get rid of this property. With the rental located a few hours away, I have to rely on a management company to find my tenants, handle the smaller repairs, and assist with any other challenges. While this is convenient, it costs extra money. Lastly, I would like to be more involved and would prefer to invest in a property closer to my current location.
The financial benefits from refinancing put me into a situation where I can afford to wait until the property will sell for break-even or better. I do not intend on a selling the property for a price where I would have to bring cash to the table to close.
Prior to refinancing, make sure you have a good grasp of your credit score. Having good credit is a top priority for me, and as a result I use Credit Karma to monitor my credit for free. No monthly commitment, no credit card charges, no cancellation madness. Just monthly credit score updates for free. Stay on top of your credit like I do with Credit Karma.