What Is House Hacking? | Create Passive Income

What is house hacking?

What is house hacking? The term house hacking refers to using your primary residence to generate income by renting out a portion of it to either a long term, medium term, or short term tenant.

Below, we’ll outline the different methods to house hacking, as well as some of the pros and cons we have found with different rental terms. Finally, we’ll cover some of the common concerns or barriers people perceive with house hacking, and some ways to overcome those fears.

Ultimately, house hacking is the easiest way to dip your toe into real estate investing, so if if you are interested in generating passive income and own a house, keep reading!

There are different methods of house hacking.

There are multiple ways to use a house that you own to “house hack”, it all depends on how “uncomfortable” you are willing to be.

1. Buying a multi family property

This method would involve living in one unit and renting out the other units to generate income. You can buy a duplex, triplex, or quad with a traditional residential mortgage, so living in one unit and renting out the others is a very common house hacking method.

2. Buying a single family home that has an in law apartment (also known as a ADU) or has a layout that you could create a separate unit.

This is the strategy we have used to house hack. Many cities have guidelines on licensing for ADUs, so it is important to check with your local city or town to understand the requirements. For us, the requirements were that it couldn’t exceed 800 sqft, the utilities could not be split between the main house and the ADU.

The entrance to the ADU had to be on the side or rear of the house so it didn’t change the curb appeal for a single family residence. There also had to be at least 1 dedicated parking spot, and we have to live in the house. Finally, our house had to be zoned properly, which meant within a certain planning zone and built before a certain year.

As long as we meet these guidelines for our city, we were able to get a permit. Sometimes, though, an in law apartment doesn’t have to be inside your house. A detached garage could have a living space above it, or some cities will also allow a separate structure on your property to qualify as an ADU. Regulations vary city to city and state to state, so it’s important for you to check with your local municipality.

3. Renting out rooms in your house

This is a less popular option, but probably the most lucrative. This means buying a three or four bedroom house, living in one bedroom and then renting out the other 2 or 3 rooms to tenants. This means you would be sharing common areas (kitchens, bathrooms, etc). It takes a real level of commitment to pursue this strategy, however it has the potential to bring in more money than your mortgage will cost each month.

Pros and Cons of Long Term Tenants:

Typically, a long term tenant is someone who signs a 12 month lease to rent a property from you. Terms can fluctuate from 6 months to years, however 12 months is usually the average period for these types of tenants. Generally speaking, long term tenants will supply their own furniture for their unit, and will often have utilities placed in their name.

Pros:

You are signing these tenants to a 12 month or longer lease, which means you have steady long term reliable income for the unit. Also, you do not usually have to furnish the unit. Another pro to long term leases is that the tenant is usually responsible for utilities.

This can be a significant benefit if you have fluctuating heating and cooling costs because the tenant is incentivized to maintain a reasonable climate and minimize hot water use to avoid hefty utility bills. Think about when you go to a hotel, you are going to make the room feel as comfortable as you can, and take a long hot shower if you want, because you know that you aren’t going to have to pay the bill.

Cons:

The revenue that you get each month is usually less for long term rentals than for either of the other two. (For example: when we first began house hacking we rented out our ADU [accessory dwelling unit] to a long term tenant for $900/month. Although this is great passive income, you’ll see why we switched gears as we break down the other rental strategies we have tried below). Another con can be turn over cost.

Unlike some of the other strategies below, with long term leases, you may have a tenant that stays for 2 or 3 years, and doesn’t take care of the property like you would. They may create excessive wear and tear on the property which will end up costing you a hefty amount when they vacate.

It’s not uncommon to have to replace flooring and re-paint when turning over a unit after a long term tenant has vacated. With the strategies below, you (or someone you hire) is in the property far more often cleaning between stays, so you are able to identify and address any wear and tear before it gets too bad, and the unit is being thoroughly cleaned more often.

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Pros and Cons of Medium Term Tenants:

Medium term tenants will usually stay at your property for at least 30 days to 6 months. We have found that the most common term is for 3 months. An example of a medium term tenant would be traveling nurses. Many traveling nurses carry 13 week contracts at a local hospital before moving on. Term periods fluctuate, but it’s typically less than 1 year, and at least 30 days.

Pros:

You generally receive higher rents because the unit is usually furnished. Many times the tenant lives in a different part of the country and is only staying for their work contract period, or maybe they are doing an extended visit to the area (e.g. snow birds going down south for 3 months) so they are less likely to be moving a ton of belongings like beds, dressers, TV’s, etc. Once we furnished our ADU and listed it on a medium term rental listing sit, we were able to rent our ADU for $1600/mo to a traveling nurse. This is the same unit that we were renting long term for $900 just 1 year before!

Another pro is that in our experience, when these tenants are not working or sleeping, they are out exploring the local area. This means lower utility usage and less wear and tear on the units because the tenant is spending less time at the unit. If it’s a traveling nurse, generally they are traveling for a reason, which usually includes being able to explore different parts of the country and get paid well to do it.

The final pro that we’ll list here is that many times, medium term tenants are traveling professionals, meaning they have a secure job, generally good income, and overall can be a better quality tenant. When we rent to a traveling nurse, we know that they nurse has already been vetted by the hospital they are contracted with, including criminal background check. If the hospital trusts them to care for patients, chances are they will be a responsible tenant.

Cons:

Unlike long term tenants you typically need to furnish the unit as these travelers will not be bringing big furniture with them. This adds additional up front cost, although the furnishings do not need to be luxurious or extravagant, the furniture just needs to meet the needs of your guest(s). You also need to find, screen, and approve tenants more often. For us, it is typically every 3 months. If the timing doesn’t work out just right you could be left with periods of vacancy.

Finally, we have found that, depending on the area you live in, Medium Term Tenant demand can fluctuate with the seasons (high demand in summer, low demand around the holidays).

Pros and Cons of Short Term Tenants:

Short term tenants are usually tenants found on sites like AirBnb or VRBO. Most times, guests that are secured on these sites are staying for less than 30 days. They are typically traveling for brief periods due to work or vacations. Think of your house as being a hotel, checking guests in for 2-5 day stays at a time.

Pros:

Out of the three types of tenants, short term tenants have the ability to generate the most amount of revenue. For our small ADU, which is a studio apartment, we were able to average ~$80/night with a $50 cleaning fee. If you do that math, it doesn’t take long for money to add up if you have low vacancy. Factoring in cleaning fees, we’d really only need to rent our space for a little more than half the month to make as much money as when we were renting to medium term tenants.

Cons:

Frequent turnover. Turnover can be time consuming. If most of your guests are only staying for 2-3 nights, that means you (or someone you hire) will be cleaning the unit up to twice a week. Additionally, aside from having to furnish the unit , you also need to provide household supplies and be sure it is properly stocked at all times.

Another con is that if you are living in the main residence, which will be the case if you are house hacking, you are constantly having new people show up on your property. Most platforms allow you to do minimal vetting on the guest(s), so you have a higher likelihood of having guests that don’t respect your space or that are high maintenance.

Finally, overall occupancy rate is correlated to how much income you produce. What I mean is that you will want to keep it occupied as much as possible to generate the most amount of revenue. This may incentivize you to lower your standards in order to keep the unit booked, which could result in extra headaches with less than ideal guests.

Based on the pros and cons above we have found that medium term rentals (MTR) are our favorite. The MTR strategy provides the best value for the amount of work and oversight required.

When we have had periods of vacancy between MTRs, whom we typically find on Furnish Finder, we list our unit on Airbnb to bridge the gap and have found that this strategy works well.

Overall, the house hacking strategy types tend to follow a scale from most comfortable to least comfortable. Meaning, renting rooms is least comfortable, where living in 1 unit of a duplex and renting the other may be most comfortable. The comfort level typically correlates to revenue, meaning the less comfortable you are willing to be, generally the more revenue you can make.

The reason that the house hacking strategy is so easy and the best way to start real estate investing, is because when you are buying your primary residence, you are often able to secure the best mortgage products (FHA, VA, or Conventional Mortgages). This includes low down payments and the best interest rates since you will be living in the property.

When buying a primary residence, the low down payment requirements allow you to buy a house with little out of pocket, compared to buying a stand alone investment property that you will not be living in. When buying a stand alone investment property that you will not be living in, most banks will want you to put down at least 20% of the purchase price.

Many people are nervous to start house hacking. Here are a few concerns we have heard, things that we have struggled with in the past, and how to overcome these feelings.

Possible Concerns with House Hacking

“I could never share my living space with a stranger”

This is certainly a valid concern and may cause you to choose one of the first two types of house hacking described above (not renting by the room). We have found that creating a completely separate unit with a separate entrance means that sometimes we don’t even notice that somebody else is in the house.

Another important tactic is to insulate and sound proof the units from each other as much as possible. Because our ADU is in our basement, we added insulation to our ceiling with drop ceiling tiles that muffle some noise. We also added carpeting in our living area upstairs with the thickest carpet pad available. This cuts down on foot traffic noise, especially because we have little ones running around. This doesn’t mean that we don’t occasionally hear the tenant or that they don’t hear us, but overall we have had pleasant experiences.

Also, you will need to take screening your tenants very seriously. Don’t just accept the first person that applies, instead make sure you always do an application with a fee, background/criminal check, credit report, and call prior landlords. When checking with pervious landlords, always try to call the landlord prior to their current landlord. If this tenant is a trouble tenant, their current landlord may just want them to leave and may not give you the full picture. If you find the right tenant, we found that sharing the space is really no problem at all.

“I don’t have enough room in our house to make a unit”

You have to have a long game attitude when real estate investing. Like we covered above, comfort correlates to revenue. How much space do you really need to live, versus how much space do you need because you have unnecessary stuff that is taking up room. If you have 500 sqft of space that is just storing stuff you don’t need, convert that to a living space and start making your house generate revenue.

We’ve lived as a family of 5 in 1200 sqft of space with one bathroom. Does it get crowded sometimes? Sure, but eventually you learn to adapt to what you have, and you don’t miss what you don’t have. Take a good hard look at the space you have, and ask yourself, would I rather keep this space in its current use, or have it start working for me to generate passive income?

“I don’t want to manage tenants”

As long as you have systems in place and you don’t waiver, boundaries will be drawn and everything will run smoothly…most of the time. Of course there is always the chance that you get a bad tenant or guest, but if you do proper due diligence, the risk goes way down.

Before you begin advertising your space, you need to write down your expectations and determine the house rules. Once those are established, you create awareness and stand firm. If you do not want to have a tenant that has a pet, and a tenant asks you to have a pet, stick to your guns that you have rules and you don’t waiver on them.

Tenants may try to test the boundaries to see how lenient you are, but after one or two scenarios where they see that you are by the book and firm but fair, they will get the message. If this is still a barrier for you despite the above advice, or you don’t feel like you can be the firm but fair type, then hire a property manager. Property managers are in business to be the mediator between you and the tenant.

If you hire a PM, plan on paying between 7-10% of the revenue. This expense may be entirely worth it because not only do they handle the day to day issues, they can also show the property, market it, screen and approve tenants. They also handle maintenance requests and overall be an insulator between you and the tenant so you can be as passive in the process as you want.

“I don’t have the money to build out or furnish an apartment in my house.”

Over the past few years, if you’ve owned your home for three to five years you have probably enjoyed a fair amount of appreciation as the market has increased. Although interest rates aren’t favorable at this point it is possible to get a small HELOC to finance the build out or furnishings. If you take that route, be sure to run numbers first to make sure the return on your investment makes sense. You do that by analyzing what it could rent for versus what you need to spend to create the space.

For example, let’s say you take out a HELOC with a 5% interest rate, and withdraw $25k to build out and furnish the space. Typically, HELOC’s require interest only payments for a certain term (many times it’s 10 years). In the scenario above, you would have to pay $105 a month on the $25k you withdrew. If you are renting it for $1000/mo and set aside money for utilities and maintenance (say 10%), you would have $795/month that you could make principle only payments with. This practice is called “using other peoples money”. Effectively, you are using the bank’s money to create an asset that generates cashflow for you each month. You get to decide how much to pay over and above $105, and how much you pocket.

I hope you can see how house hacking can be very beneficial toward generating passive income by leveraging an asset that you already have…or need. Everybody needs a place to live, why not have a nice place to live that also generates you money. Robert Kiyosaki, from Rich Dad, Poor Dad, defines an asset differently than many people. Many people would consider their home an asset because it has x amount of value. However, Robert says if it costs you money every month it’s a liability, if it generates income for you, its an asset.

Looking at your primary residence through this lens may have you think different about the “assets” that you own. When you start to think about it, you might realize that many of the “expensive” things you own can be used to generate income. Your car, your boat, your camper, and most importantly, your house. Are you willing to sacrifice a little so that you can create passive income that brings you one step closer to financial freedom?

House Hacking Book Recommendations:

Rich Dad, Poor Dad

The Book on Managing Rental Properties

The Book on Rental Property Investing

The House Hacking Strategy

More Resources:

How To Rent Out Your Camper

How To Retire Early