Second home? Determine what you really can afford

Thinking about buying that cabin in the woods you enjoyed over the weekend?

There are two ways for determining how much cash you can afford to put toward a second residence solely for your personal use or part-time rental.

The first is the asset method. Start by taking stock of your present wealth. Create a balance sheet of your assets and liabilities. Don’t forget to include the equity in your primary residence, even though you may be dead set against borrowing against the roof over your head. Homes are no longer cumbersome and difficult-to-liquefy assets, thanks to the integration of home equity lending with other financial opportunities.

If you have refinanced your home recently or have children needing loans for college, you are familiar with filling out forms provided by mortgage lenders and universities.

You know the drill — list all of your debts including credit cards, cars, boats, mortgages and anything else you view as a “minus” on your financial chart. Balance these against all of your assets, including your savings, individual retirement accounts, home value, stocks and bonds, and other assets. The net of these two numbers will give you your net worth and be an indication of the amount you have available to transfer into your investment.

Although it sounds simple and gives you a good ballpark number, the actual net number is more complicated. Some of your assets might be unavailable for reinvestment.

For example, if your retirement program does not have a loan program attached, those assets are tied up until you reach age 59½. Withdrawing retirement savings prematurely subjects the taxpayer to a 10-percent penalty, and the withdrawal amount is included in ordinary income for tax purposes. It would take a rather large rate of return to make the alternative investment worth the withdrawal. So to determine exactly what you have available for investment purposes, subtract those restricted retirement savings. What’s left is your capacity for acquiring investment real estate.

The second method to determine your capacity to buy property is the income method. This uses cash flow, rather than net worth, as the deciding variable. Once again, it requires offsetting positives and negatives. Calculate all your monthly obligations — mortgage and other loan payments, credit card debt, tuition payments, etc. — and subtract them from your monthly income. We’ll call this discretionary net income, and it is the amount that is available to handle the cost of carrying the property.

As mentioned, rental income will cover a good part (hopefully all) of the negative cash flow. The ability of your discretionary net income to support an investment property is substantial because of the initial unknowns about the amount of the time the property will be rented.

To prove this to yourself, try a little exercise. Look on the Internet or contact a Realtor and research prices in your targeted area. Now calculate the gross cost of owning that property. This will include the mortgage (pick your own down payment), perhaps a property management fee (10 to 15 percent of the monthly rent) and some amount for replacing house components such as plumbing, electricity, roofing, siding and other depreciable items.

When you’ve calculated this figure, ask Realtors and present owners what you could expect to receive in monthly rent — especially if you are going to rely on rental income to make your plan work. If it’s strictly for investment, it’s critical to determine how often and for how long you intend to rent it. Decrease this number by 10 percent to account for likely vacancies.

Compare the estimated rental income with the gross cost of owning, and the balance will either be the net cash flow to you or the amount you need to supply to carry the property. Remember that this is a cash flow number and ignores the tax benefits of owning investment real estate.