Houses are expensive. The two-family housing type became popular in American cities in the 19th century as a way to offset some of those costs with rental income. The structures continue to offer advantages today. However, compared with single family homes, two-family investments are more complicated because they have several considerations to account for (rental depreciation, expenses, interest rates, tax deduction for home ownership). So, I am sharing my proforma as a place to start for others who are evaluating their options.
This guide walks you through the calculation of how a real estate investment into a two-family might perform. It is specifically set up for one owner-occupied unit and one rental unit in the United States under the current (2019) tax code. I applied it during our search for a house in the greater Boston area to evaluate the anticipated financial results of investment.
To use this proforma, follow this link, make your own copy on Google or save an Excel version. The spreadsheet uses known or estimate inputs (sales price, costs, and rental revenues) to project cash flows and indicators of the financial viability — internal rate of return (IRR) and monthly cost of ownership. In the following sections I go into more detail about some of the calculations.
I also want to note that allowing for two-family buildings is good urban planning policy. As a housing mechanism, two-family buildings retain value within communities and should be promoted by local codes rather than restricted. From a community perspective, two-families more widely distribute the returns on rent to local people versus outside investors’ large-format multifamily projects. Neighborhoods with two-family houses tend to foster more lifecycle diversity (students, families, seniors) compared with homogeneous apartment blocks. Local control and community based housing developed is also favored by small-scale investment in two-family buildings compared with the major bankroll from outside investors required to develop large apartment blocks.
I recommend making a new copy of the spreadsheet for each property you are looking at to “run the numbers”. The fields can be filled or at least approximated with data from Redfin or Zillow and Craigslist (for rental income).
The proforma has fields for each of the two units: the rental unit and the owner-occupied unit. It makes a difference which is which when accounting for square footages for tax purposes later in the calculation.
There are fields for costs (purchase price, cost of anticipated renovations), mortgage terms (down payment percentage, interest rate), annual costs (property tax, insurance, maintenance), rental income (minus vacancy, management fees if applicable), and some tax information about yourself to figure out deductions and rental income tax/credits later on. You can also enter annual increases as a percentage. The default in the calculation is roughly inflation (2.5%).
With these inputs, the model calculates income, costs, and net cash flow over a 30-year period. It gets a bit complicated, so I am going to explain how the model works in a bit more detail.
The calculation assumes a 30-year fixed rate mortgage (360 months). Year 1 is the following equation:
=-pmt([interest rate]/12,360,[loan amount])*12
The annual cash flow is your rental income minus expenses and mortgage. Year 0 is the downpayment and other one-time, upfront expenses like renovation. This is an important data point for the IRR calculation later. In year 30, the calculation includes the sale of the property for 96% of assumed building value after 30 years of inflation. It assumes 96% because you will lose some to transaction fees and other expenses.
Taxable rental income for owner-occupied buildings is net rental income minus rental depreciation, rental expenses, and rental interest payments. Rental depreciation is calculated over a 27.5 year timeframe as follows:
=(1/27.5)*([purchase price]*[rental unit’s % of overall building finished area])
Rental expenses and rental interest payments are (for the purposes of this proforma) also the overall property costs multiplied by the rental unit area percentage.
Once you have the taxable rental income (which can be negative or positive), the model multiplies it by your income tax rate based on your tax bracket. Finally, you may also receive a tax deduction for ownership. This is calculated from the mortgage interest payments minus the rental unit’s portion of the interest payment and the unused portion of your standard deduction (standard deduction minus SALT) multiplied by your marginal income tax rate. If SALT plus your net mortgage interest payments is less than the standard deduction, then there is no tax deduction for ownership.
This last column calculates the IRR on the investment based on the annual net cash flow at five year intervals. The IRR can be seem small as the only income streams are rent and final sale of the property, but you also have to consider your foregone “rent” in terms of the monthly cost of ownership. Finally, the IRR is a good way to compare between different investment options’ overall performance.
The monthly cost of ownership is the cash flow minus taxes (or plus credits) from the rental and owner-occupied units, which you can consider your implied rent.
Everything else remaining the same, the comparative advantage of an investment a two-family house versus a single-family house with the same amount of space for the owner is in economies of scale, expected escalation in rental revenue from inflation versus a static mortgage payment, and receiving tax benefits from both rental depreciation and home ownership. These benefits can be quantified by a comparing against a similar single-family in terms of both IRR and monthly cost of ownership. The drawback is that being a landlord takes time that you could be spending in other ways.