Getting Started In Section 8 Rental Investing

10 years ago Mrs. C. and I bought a house at the tax auction for $6,000 with plans to either flip it for a big profit or rent it out.  We ended up doing neither and lost several thousand dollars on that house when we sold it to get the stress and constant cash flow leak out of our lives. Now we are ready to start investing in rental property again and are looking at low income housing to rent out primarily through the Section 8 program.

What Is Section 8?

Section 8 also known as the Housing Choice Voucher program is an anti-poverty program that subsidies housing costs for low income families and allows them to have more control over where they live.  Typically an individual or family is required to pay 30% of their earnings towards their total rent and the total rent for a unit must be at or below “fair market rate” for the area as set by HUD.  Some people in the program may pay nothing for their portion of the rent, while others may pay the vast majority of their rent with Section 8 providing a relatively small amount.

Benefits and Drawbacks of Section 8

Benefits:

The majority of rent is guaranteed and direct deposited by the housing authority. This is a major plus, especially if you do happen to have a tenant that is required to pay nothing towards their rent.

The tenant is likely to be highly motivated to pay their portion and not get evicted. If your tenant is required to pay a portion of their rent they are very likely to do so, and to do so on time.  If a Section 8 tenant is evicted they are likely to lose their assistance and get kicked out of the program.  In many areas the wait list is several years long.  In my market the wait list is 2 years long and is not open anymore due to the length of the wait list.

Landlords are more likely to receive a higher rent through Section 8 than they would on the private market. This is not always true, however in some markets this is spot on.  HUD fair market rent areas are typically set by county and inside the county there is a wide range of neighborhoods.  If you own property in a lower cost neighborhood in the county you are more likely to get an above market rent for your rental because the HUD values are based on the entire county.  For example, the “average market rent” set by HUD for a county for a 2 bedroom home may be $750.  In one neighborhood market rents could be $900 and renting to Section 8 wouldn’t make sense. In another neighborhood market rents could be around $500 and then Section 8 rents would be an excellent deal. *Note, the Fair Market Rents published by HUD are not the actual price a landlord can charge for rent.  These values include an amount for utilities, which is not clearly published.  I’ve read that this is generally around $90 though, so if HUD says fair market rent for a house is $750 a landlord could then charge around $660 a month.

Backlog of potential renters: Most Section 8 housing in my market is in large apartment complexes.  Many of these renters would rather rent a home, but there is a lack of Section 8 home rentals available in our market.  Vacancies would be extraordinarily low for Section 8 houses in my market. Why is this if rents are higher than true market rate in some areas?  Well renting Section 8 housing does come with some downsides as well.

Downsides:

Government inspections:  This may be a slight annoyance, I’ve read several articles complaining about this system, however if you keep your home in good repair this inspection is more of a formality. Some inspectors tend to focus on things that aren’t critical to safety that are prone to getting broken by tenants.  Screen doors and window screens is a complaint I have heard frequently.

Loss of assistance risk: If a section 8 tenant has an increase in income then their portion of the rent owed will increase and if it increases too much they may not be able / willing to continue to rent from you.

Tenant issues: No matter who you rent to you are going to have some issues with your tenants.  Many investors steer away from low income housing because they believe they will only get bad tenants.  This is far from the truth.  There are bad tenants on Section 8, but there are also good tenants as well.  It is still important to properly screen your tenants even though the Section 8 program pre-screens tenants to an extent.

Rent Increases are muted:  In most markets Section 8 will limit the amount you can increase rent on a tenant to a small percentage and may only allow you to increase the rent if you have provided upgrades to the property. Sometimes the Fair Marker Rental rate for the area will actually drop.  In a market rate rental, at least in Michigan, you can choose how much to increase the rent each time the lease is renewed and the tenant can accept or decline it. You don’t have to worry about getting approval from a government agency.  Over time if you have long term tenants you may see your rental rates falling behind the true market rate.

Delay in payment:  You won’t receive a Section 8 voucher payments until well after the tenant has moved in.  This isn’t an issue if you have proper cash reserves and are buying low priced property.

Why Invest in Section 8 Housing or Rentals at All?

Rental rates are much higher than we had previously thought: The only time Mrs. C. and I ever rented a place was when we rented a 2 bedroom apartment for $500 a month back in 2005.   I figured that market rate has been stagnant and that apartments and houses didn’t rent for that different of an amount.  Currently 2 bedroom houses in our area seem to rent for between $600 and $800 a month.  These houses can be purchased for around $20,000 to $25,000 a piece. Getting 3% to 4% monthly rent is an amazing cash flow.

This is a much higher annual yield than mutual fund investment portfolio: You saw those numbers above right? $20,000 purchase price and $650 rent price. Taxes are around $40 a month on a property in this price range, homeowners insurance around $30 a month, and I’m budgeting $100 a month for maintenance and repairs.  This reduces total cash flow from $650 a month to $480 a month.  Financing lowers it again by $80 a month to $400 of positive cash flow.  It will then take this property just over 4 years to pay for itself.  Once paid off the property will be generating $480 a month in income off of $20,000 in invested capital, a net yield of 28.8%.

There is a substantial lack of landlords willing to rent Section 8 in our area.  I have been looking up Section 8 houses for rent for months and it is rare that there is ever a single home available.  Most Section 8 properties are large apartment complexes because a lot of landlords in this area don’t want to deal with the hassle of Section 8.

Our Strategy:

There are two separate types of houses we are looking into 2 bedroom and 4 bedroom houses.  Most investors want to concentrate on 3/1 houses. So this strategy right of the bat provides us with less competition. We are buying houses that are close to move in ready that need some work, but not full rehabs.  That house we had bought at the tax auction needed everything, from an entire kitchen gut down to studs, a furnace, a new roof, all new windows and more.  We are not rehabbers and with our current schedules doing full rehabs is not up our alley.  We are initially planning to manage our own rentals, however we are open to using a property manager and I think long term we will go that route if we find one that is a good fit.  Paying roughly 10% of the gross rents is in my opinion an overall great deal to reduce the headaches that come with hands on property management.

Two Bedroom Houses:

2 bedroom houses provide the most basic dwelling units in the area.  These tend to be sold at a discount because fewer people buying primary residences and fewer real estate investors are interested in them.  Further discounts can be had by paying in cash because most banks don’t want to deal with sub $30K property, and even if they did, the closing costs as a percentage of the transaction are extremely high.  These homes are also smaller, and thus easier and cheaper to maintain.  All of these factors increase the overall rate of return on 2 bedroom homes. There is a permanent demand for these homes through Section 8 because Section 8 issues vouchers based on family size.  2 bedrooms for 2-4 people, 3 bedrooms for 4 – 6 people, and 4 bedrooms for 6 to 8 people.  The vast majority of Section 8 tenants are single moms, so a mom with 1 or 2 kids would be your typical 2 bedroom house tenant.

Four Bedroom Houses:

4 bedroom houses on the other hand fill in the opposite end of the spectrum.  Larger families have a tough time finding homes to rent because many landlords don’t want to buy larger homes.  Larger homes means more people in the unit and more people, especially more kids, means more property damage.  4 bedroom homes don’t tend to sell for much more than 3 bedroom homes in my area, but the rent you can receive from them is quite a bit higher.  We also want to be able to provide housing to larger families on Section 8 who otherwise would not be able to find a home in our area.  Families with young kids are more likely to stay in a home longer than those without.  Renting a house to a large family increases the probable length of time the tenant will stay in the home.  Turnover is expensive and investing in 4 bedroom homes may reduce the cost of turnover.

Financing:

For the first 2 houses we will be financing using a HELOC, and paying it down with all of the rental income generated.  This will allow us to buy 1 house a year while we finish paying off our primary mortgage (the house mentioned above will be our 2019 purchase, even though we will close in December 2018).  Once our mortgage is paid off we will be able to use that cash to purchase more rentals with cash.  We should be buying roughly 1 house every year to 18 months for 5 to 6 years, then increase to 2 houses per year.

Our First Rental:

We are currently under contract on our first dedicated rental property.  We are paying $19,000 for this 2 bedroom house. This house needs very little work and we should be able to rent it out for around $600 to $650 a month through Section 8. It is pretty basic, with 2 bedrooms, a living room, a kitchen, and a bathroom.  The house has a full basement which is a big plus and is also in a small neighborhood.  The backyard is partially fenced in and we will get it fully fenced in after we close on it.  I will write a more detailed article on this house in the future.

Diversification of Assets

Currently the vast majority of our wealth is in our primary residence and in stock mutual funds inside of retirement accounts.  Neither of which provide any positive cash flow.  Investing in rental property allows us to receive current cash flow and to diversify our assets further.

After Tax High Yield Investment Portfolio:

All projections we have ever made for retirement income have been based off of a 5% withdrawal rate through stock mutual funds.  With CAP rates on these rentals between 25% and 33% our numbers change substantially and we may be able to hit our F/I numbers a few years ahead of our previous targets.

For our wealth building we have 2 sources of income: pretax and post tax.  With our current tax situation we are in a position to put roughly half of our savings into pretax and half into post tax accounts.  To date all of our post tax savings has gone towards aggressively paying down our primary residence, which is on track to be paid off by May of 2021.

Currently the vast majority of our investments are in tax sheltered retirement accounts.  We have recently passed the point where if we never contribute another dollar, with average 7% net returns we will have more than enough money to fully fund a comfortable retirement at a normal retirement age (62).

I hate to say it, but to keep our health insurance where it is at we want to keep our AGI <212% of the poverty level.  For 2019 this $71,528.  Any income over this amount we will be putting into our pretax investment accounts and any income below this, but above our budgeted spending, we can use to build our after tax portfolio. I hate jumping through hoops for government incentives, however the number 1 rule of economics is that people respond to incentives.

Additional Costs:

In addition to the costs of acquiring the property, maintaining it, and paying taxes and insurance on it, we also have to adjust our current insurance policies in order to buy umbrella insurance in case of a lawsuit.

These changes increased our current car insurance and home ownership policies by roughly $150 per year and then we had to pay around $450 for a $1 million umbrella insurance policy.

For further information on investing in low cost affordable housing and renting through the Section 8 program, check out real estate investor Jesse Wright’s Youtube channel and the book Investing in Rental Properties For Beginners: Buy Low Rent High by Lisa Phillips.

What do you think about renting homes in the Section 8 program, or renting out affordable housing in low cost neighborhoods in general?

John C. started Action Economics in 2013 as a way to gain more knowledge on personal financial planning and to share that knowledge with others. Action Economics focuses on paying off the house, reducing taxes, and building wealth. John uses the free tool Personal Capital to track his net worth and posts quarterly updates on his finances. Check out the Action Economics archives section for all past posts.

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