Buying An Investment Property Before A First Home Makes Sense

Buying an investment property before a first home seems counterintuitive to a lot of people.

In fact, I admit I used to be in the camp that believed you MUST own your primary residence before purchasing rental property.

But as is the case with most things in life, the “correct” answer isn’t always black and white. It’s far more nuanced than that.

Many people believe you MUST own your primary residence. It’s hard to blame them.

Being a homeowner is very much ingrained into American culture. Our system is even designed for it with 30-year fixed rate mortgages and low down payment options for first time home buyers.

There are also people who believe home ownership is terrible and renting is the only way.

But, while this post will definitely walk a fine line, I do not wish to investigate whether buying is better than renting. 

I am purely looking to answer whether buying an investment property before a first home makes sense at all.

To do that, we have to be completely quantitative in our analysis. 

And if we are trying to decide if buying investment property is a better financial move than buying a primary residence we have to understand the number one FINANCIAL motivation of owning a primary home.

There are a lot of charts and numbers throughout this post. If you want to follow along with my calculations feel free to take a look at this Google sheet.

Buying A Home To Get Neutral On Inflation

Whether people grasp it or not, the number one financial motivation for purchasing their first home is to get neutral on inflation when it comes to their housing costs.

Think about it.

When you purchase a home you know what your monthly costs will be. 

A 30-year fixed rate mortgage has a very clear monthly principal and interest payment that will not change for the lifetime of the loan.

And once that 30-year term is over, the home is paid off. You own it free-and-clear and there’s no more loan payment.

That sounds pretty great. Why wouldn’t you want to do that?!

Buying Investment Property Before A First Home In San Francisco

Well, let’s look at what that looks like in a very high cost of living (VHCOL) area like San Francisco:

I know what you’re thinking… “wtf is that?!”.

THAT is the annual cost to own a home in San Francisco today. In fact, it is the annual cost to own this home that’s currently listed for $1,300,000. 

I understand this graph is perhaps equal parts confusing and jarring, so let’s unpack what’s going on here.

These are the assumptions I’m using for this chart:

Let’s focus on the lower section for now, the one breaking out the numbers for owning a home. 

Hopefully this is now starting to make more sense. 

Owning A Home Doesn’t Actually Get You Neutral On Inflation

In the first year of ownership we’re spending about $387,000 when we account for a 20% downpayment, principal & interest payments for the year, taxes, insurance, maintenance, and HOA fees.

I am assuming annual maintenance costs at 1% of the home’s purchase price as per a quick Google search.

I also include annual inflation assumptions for the non-fixed aspects of homeownership. These are the things that folks often forget about and it’s why, after 30-years of diligently paying your mortgage, you still aren’t living for free.

So while we see a drop in the cost of homeownership after 30-years, the costs start ramping once again.

Buying a home doesn’t actually get your housing costs neutral against inflation. But it does get you a fair bit there since the majority of your housing expenses are fixed now that you’re a homeowner. 

So how does owning a home in San Francisco compare to renting?

As you likely know, renting costs generally continue to rise with no break at the 30-year mark. 

To rent a comparable home, like this one, in San Francisco you’re looking at about $6,000 per month in rent.

That’s a lot of money. 

And if we assume that rent increases at about 3% per year, the annual cost to rent looks something like this:

OK, so clearly renting is the better deal initially but once we hit that coveted 30-year mark buying is the clear winner, right? 

RIGHT?!

Maybe…

Let’s take a look at the cumulative costs of buying vs. renting in our San Francisco example:

Hmmm, that’s… interesting.

It’s tough to see exactly where it happens but at year number 45 the homeowner’s total cost is finally lower than the renter’s.

Let’s pause for a moment and recognize how long 45 years is.

While you’re doing that, sign up for my weekly newsletter so you become a cash stacking unicorn like this guy:

OK, welcome back!

Yes, it’s a LONG time to wait to outperform renting but of course there’s now a paid off home that’s worth a ton of money.

And if this was a post about buying vs. renting and not considering any other factors we could really dig into a lot of things here. 

But that’s not what this post is about. It’s about trying to understand if buying an investment property before a first home makes sense. 

Determining How Long Until We Can Live For Free

So we now need to consider what’s missing from this picture.

And while this whole exercise relies on a bunch of different assumptions, we need to make a few more.

Let’s assume that our San Francisco homeowner and renter have identical financial profiles. 

Both households could afford to purchase a home.

But one decides to rent. 

And instead of purchasing that $1,300,000 home they decide to crunch the numbers and invest the difference between their annual rent and the cost to own a home.

That gives our renters 30 years to invest before their annual costs would exceed that of our homeowner. And remember, the first year they get to invest a large lump sum that would have served as down payment.

Our renter is pretty savvy. 

Instead of just throwing the money they are saving by renting into index funds they decide to invest in real estate. 

After all, the goal is to get neutral on inflationary housing costs, so why wouldn’t you purchase investment property?

That’s exactly what our renter does.

In fact, they did their research and learned Detroit is a fantastic place to invest for cash flow and appreciation. In that market, they can easily find 8% or greater cash-on-cash returns.

Our renter decides not to bother with financing. After all, this money would be tied up in their primary residence anyway.

Instead, they pay cash and hold cash. 

And, since they don’t need the income that their properties are generating (yet) they decide to just roll it into their investable capital and buy more investment property.

Here’s what that would look like if they were to diligently do it over a 30 year period:

Woah!

What exactly is going on here?

The purple line is what we just discussed.

This is the annual income generated by our renter’s rental portfolio assuming it’s initially invested at an 8% cash-on-cash return and rents experience 3% annual inflation. 

After 30 years, our renters are generating nearly $1,200,000 in annual income. 

That’s $100,000 per month!

The black line is the annual cost they are paying to continue renting in San Francisco.

Now we could argue all day about whether it’s realistic for someone to do this for 30 straight years. 

To me, that doesn’t matter. 

What matters is where that purple line, the annual income, crosses the black line. 

That is where our renter is literally living for free. 

The income they generate from their Detroit rental portfolio is outpacing their annual cost to rent in San Francisco. 

What’s absolutely nutty to me is that this happens at year 8. 

In just 8 years our renter is living for free. 

Meanwhile, our homeowner has 22 more years of mortgage payments before they are then able to reduce their living costs by about 50%.

Oof!

And yes, we could argue that 8% is too much even though these are very realistic numbers in the right markets.

So let’s dial it down to 6%:

Our “live for free” milestone is now pushed out to 12 years instead of 8. 

But what about total net worth?

Surely, our $1,300,000 home’s appreciation after 30-years outstrips our savvy renter’s portfolio’s value, right?

Nope.

Our renter’s portfolio value surpasses our homeowner’s house value at around year 12:

OK, so at this point if you’re anything like me this is all a bit sobering.

It’s extremely evident that buying an investment property before a first home is the way to go.

In fact, it seems you should just keep buying investment properties and consider never buying a primary residence!

Investing In Rentals Before A First Home In A Median Cost Of Living Area

But is that always the case? 

Let’s drop down to today’s median home price and median rent.

With a bit of Google’ing we have the following assumptions:

I’m not linking to any Zillow listings this time because we’re simply taking averages.

In this situation the breakeven point for our homeowner is actually a bit longer at 48 years:

It takes our homeowner even longer to “beat” a renter when it comes to total cost than it did in a high cost of living area like San Francisco.

But where our median renter really shines is the time in which they are able to reach the holy grail of zero living costs.

Getting to that point is just 4 short years:

And by year 31 they are generating over $920,000 in annual rental income.

So clearly, once again, buying investment property before a first home makes sense at median home price and rent too!

That’s interesting.

So does it ever make sense to buy a home before investing?

Buying An Investment Property Before A First Home In A Low Cost Of Living Area

Let’s drop down to a lower cost of living area because, after all, that should make the most sense to buy instead of rent, right?

In Detroit, where the median home price is $80,000 let’s say we go absolutely nuts and purchase this great looking bungalow in the fantastic Detroit neighborhood of Morningside.

We pay $144,000 for this home that would cost us about $1,400 per month to rent.

Doing this, we find that after just 7 years we’re hitting our breakeven point from buying rather than renting:

That sounds pretty good.

Seven years isn’t that long in the grand scheme of things.

And this grossly outperforms what we’ve seen in our high and medium cost of living areas.

In fact, buying costs us considerably less over time and it seemingly would not make sense buying an investment property before a first home in a market like Detroit.

Or would it?

This is where things get a bit tricky. 

In this situation, our renter’s annual housing cost is only cheaper in the first year purely due to the down payment the homeowner needs to spend to acquire their house.

When we look at the annual cost to rent versus the annual cost of homeownership in our low cost of living area it looks like this:

This makes sense, right?

Our renter’s annual cost will go up each year while our homeowner spends their hefty down payment in year one. 

After that, our homeowner sees costs rise until the thirtieth year when principal and interest drop off. Then they experience inflation on their taxes, insurance, and maintenance costs going forward.

This clearly looks like a situation where it makes zero sense buying an investment property before a first home.

And when we look at the amount of investable cash our renter has versus our homeowner it seems like an even bigger win for the homeowner:

Remember, our renter has the full downpayment to invest in the first year. But after that, renting is more expensive than owning, so there is no excess cash for investments.

Instead, the script flips and our homeowner is the one with extra cash to invest (the difference in cost between owning versus renting).

And we see the spike higher in investable cash at the thirty-first year because principal and interest payments are gone.

Now, as we have in our previous examples, we assume this investable cash is invested in real estate yielding 8% cash-on-cash returns and 3% annual rental inflation.

When we plot out both scenarios we have this:

Whoa!

This seems… counterintuitive.

Our renter is drastically outperforming our homeowner when measuring rental income earned from their investable cash.

How can this be? 

It’s simply the power of investing early and compounding. 

Our renter gets a huge head start by investing the down payment amount as a lump sum. And even though they don’t have extra money to invest, by reinvesting their rental income each year, they manage to do quite well!

For comparison, it takes our homeowner eleven years to surpass the rental income our renter was generating in their very first year!

But the amount of rental income isn’t our benchmark. 

Remember, our true goal is getting to the point where our investments pay our entire living costs as quickly as possible. 

Who wins in that situation?

It’s actually pretty darn close to a tie!

Our renter reaches this milestone in year thirty while our homeowner is just $500 shy of the milestone in the same year, but jumps well beyond it at year thirty-one:

To me, that’s a tie.

But it’s hardly a wash!

At this point we need to take it a step further and look at the delta between rental income and housing costs. 

In other words, who has more annual rental income after paying for their housing costs?

Would you believe me if I said our renter wins?

This chart is super fascinating but it makes perfect sense.

Our renter starts out slow with the increasing cost of renting outstripping the growth in income from their rental portfolio. 

But by about year fifteen this starts to change. We see that as the net rental income bottoms out and starts heading higher.

By year twenty-nine our renter is actually out performing our homeowner on a net income benchmark. And by year thirty our renter is officially living for free. 

This supports our findings from previous charts.

Meanwhile, at year thirty-one our home owner’s net rental income surpasses our renter’s, but this only lasts a couple years.

Our renter’s early start coupled with years of compounding is just too much to overcome. 

Forty years in and our renter is generating $66,000 in net annual income while our homeowner is generating half that.

I think it’s safe to say our renter wins yet again!

Buying An Investment Property Before A First Home DOES Make Sense!

It doesn’t just make sense.

It might be wise to just keep investing in real estate rather than purchase a primary residence at all.

Yes, we can poke holes in my assumptions. 

For instance, can someone constantly invest their extra capital at an 8% cash-on-cash return with 3% annual growth for decades?

We can also argue the nuances of the key inputs like home price, rents, etc.

Or we might simply be in a time where home affordability at all time lows and interest rates higher than they’ve been in decades favors renting.

I’m not arguing that any of those points aren’t perhaps valid. 

And I invite you to download my Google sheets and tinker around with it, input your own data, and see where it takes you.

The reality is, in many instances it is clear that buying an investment property before a first home is clearly a winning strategy.

That is, if you’re purely looking at this from a financial standpoint.

This has been our only consideration throughout this exercise. 

And we could use this as a starting point to decide whether buying is better than renting when considering factors beyond just financial ones.

Perhaps I’ll do that in another post. 

What do you think? Are there other flaws in my logic I’m not seeing?

Are you buying investment property before a first home? Do you plan to buy investment properties until they can pay for your primary residence?

Or maybe you plan to never buy a primary residence at all. Let me know in the comments!