Many buyers I meet find themselves looking for the perfect “starter” home. That is typically a home with 2 bedrooms or more, 1100 sq ft more or less, and they will generally settle for a single family house or condo/townhouse. Because prices in our area have skyrocketed, a relatively turn-key home that meets such criteria can run about $450k and up depending on the town. With interest rates and home prices on the rise, more and more home buyers are finding their purchasing power diminishing and have to make sacrifices in terms of the size and type of home they are seeking. And because interest rates are rising, they are more motivated than ever to hop off the fence and make the move.
Let’s talk a little bit about the “starter” home. This is a home that most buyers (downsizers excluded) will realistically occupy for two to five years, depending upon certain life events. So what is wrong with that timeline?
There is nothing inherently not smart about buying a short-term starter home, you just have to be savvy about it, especially when purchasing in a hot market. Chances are, you will be putting money into it for upgrades as you custom tailor it to your needs, whether it be refinishing the hardwood, replacing carpets or countertops, or simply repainting. Then you have moving and closing costs. Closing costs are among the highest in the nation in our area, mostly due to 6 months to 1 year’s worth of taxes that get escrowed by your lender. So for a home that costs $450k, with $12k in taxes, you could be looking at around $15-16k just to close on a property. Research suggests that median home values tend to fluctuate year to year, and the market is cyclical and unpredictable with highs and lows abound. Substantial equity gain may not be seen for about 5-10 years post-purchase. In fact, selling within a 5 year period could mean a loss, and if you’re purchasing at the height of a bubble, it could mean substantial loss. For example, those who purchased in 2004-2008 pretty much saw their value drastically plummet in late 2008. For those that purchased at the height of the bubble and needed to sell at this time, this was pretty much devastating. As a result, the country saw a bevy of short sales and foreclosures popping up like never before. This is a very dramatic but recent example of how you can get the short end of the stick if you have short term home ownership plans. But let’s just say you are in your home for a couple of years, the market has remained relatively stable, and you are ready to sell. Even if you are able to sell for a “profit” and get that extra $15-20k on the sale for the equity that you’ve earned, you probably are still at a break even point when you consider the closing, moving and refurbishing costs that came along with your purchase. You might even be somewhat at a loss depending on what you put into the home.
There are unforeseen events as well, independent of market fluctuations, that may affect your home’s value in the short-term. For example, in 2017, several towns were hit with a tax reassessment. Certain towns that were highly sought after by first time home buyers for their low taxes suddenly saw tax increases, often drastic ones. If you purchased a starter home in such a town a few years prior with ultra low taxes, and your home was a victim of the reassessment, you could see your value take an instant hit! If you haven’t built up enough organic equity, and buyer interest level has waned due to higher taxes, you could suffer a loss when you go to sell. This is yet another example of how short-term selling plans can leave you vulnerable to market conditions, and you may very well be a sitting duck.
What is the alternative when you have a limited budget and want to buy a starter home? But low and fix it up, baby! Consider this: 9 out of 10 times, buyers who are not particularly handy (which, in my experience, accounts for around 90% of you) want something that is totally move in ready. Such buyers have watched enough HGTV to conclude that a house is not a home unless it has the ubiquitous granite counters (and quartz is better, right?), dark-stained hardwood flooring and open floor plan. However, such homes in the starter budget are in limited supply. Every first time home buyer wants one, they are primed for bidding wars and as a result, command quite the premium. You will undoubtedly be hitting your ceiling to purchase such a home, if you even are able to win the bid. Also you will be effectively paying top dollar for someone else’s finishes. Nice as they may be, they are not custom to you and they start aging – hence, depreciating – the second you move in. Why not instead consider buying on the low-end of your budget and putting work into it? I know many of you shy away from such a notion, but hear me out. Even a modest amount of work can go a very long way in market value. If you have the time, and have somewhere to stay while the work is being done for 6-8 weeks (depending on the project), this is an excellent option. If it’s a month-long project, then stay in your rental an extra month if you can (your first mortgage payment is not due until the month after you close). And as unpalatable as it may be, if you can shack up with family for a few weeks, put your hubris aside and DO IT. It’s worth it. All your finishes will be done to your taste, will be brand new when you move in and, because there is such a high premium placed on finishes, you will literally be stepping into equity. A home that is reasonably maintained but not updated, say, with an older kitchen, or Pepto Bismol pink 1950’s bathrooms would be a prime candidate. Your competition mostly has no vision and will not be willing to pay a premium for such a home, and you will be able to get it for far less than you would the home across the street that is identical in layout but is totally renovated. The cost of renovations is a bit high in our area, but not as high as you may suspect. You can do a nice high-end stainless steel and granite starter home kitchen for as little as $10-16k, and newly redone baths can run anywhere from $6-8k. Seems a bit high, but not nearly as high as the $25-50k+ extra you’d have to shell out to buy a home with these finishes already installed. Also, homes that are not turn-key tend to have less buyer activity, so you won’t be fighting off the masses to get it. If you have to turn around and sell in a few years, the sweat equity is insurance against selling at a loss, and if the market is even more hot to trot, you could stand to make some dough!
So how to finance these renovations? Renovation loans are an awesome choice! There are excellent renovation loan products nowadays to tackle small to major renovations within the home, that will enable you to pad the cost of renovation into your mortgage, even if it’s as little as $5k. There are conventional renovation loans, which are standard for homes in need of mostly cosmetic updates. Then there is the 203k loan, which is an FHA product and is go-to for homes in need of more extensive repairs that will not qualify for conventional financing (e.g., missing or inoperative furnace, missing drywall, mold, etc.). Most bank owned foreclosures fall into this bracket, but even a home that has been winterized with no permitted ability to test heat or hot water will generally not qualify for conventional financing. Nowadays, however, there is a conventional Fannie Mae loan product called the HomeStyle® loan that some lenders offer which will enable you, if you qualify, to purchase a home in any condition and avoid the upfront PMI that accompanies the FHA product.
There are many benefits to wrapping the costs of renovation into the mortgage. One obvious benefit is that renovation costs won’t be out-of-pocket. And with exorbitant closing costs, that is very important. The other is that it helps keep the contractor accountable. Contractors and all their sub-contractors must first be fully licensed, insured and approved by the lending institution prior to getting the green light. All work must be done legally with permits where applicable, and all CO’s obtained. The work must be inspected prior to money being released to the contractor. And usually, payment is issued in drips or “phases,” so the contractor does not get a lump sum in advance, only after each phase is complete. This helps to ensure the work is done in a timely and consistent fashion.
What is the catch to the reno loan? Well, in most cases the interest rate is a little higher, but usually no more than around an eighth of a point or so, which translates to around $15 to $20 more month. When you consider the overall monthly payment and compare that to what you would spend per month to purchase a much more expensive move in ready property, you are likely still winning!
Ok, so we discussed the limitations of purchasing a starter home, so what about purchasing a condo or coop? Short term ownership plans may not fare well for those either. More to come in part II. Stay tuned…
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