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Should Long-Term Real Estate Investors Sacrifice Short-Term Cash Flow?

by Chris Clothier on January 2, 2013 · 76 comments

  
Cashflow

A few weeks ago I was speaking to a group of investors in San Francisco and I surprised many in the room when I made a statement that I did not believe you should buy real estate and leverage it for cash flow.  Given that I am a partner in two companies that specialize in helping investors find properties that provide a positive cash flow after leverage, this statement caught much of the audience by surprise.  But I followed that sentence with a bit of clarification.  I told the group that there are many ways investors can be fooled or even fool themselves today into thinking that they are making a positive cash flow on a property and some of the biggest mistakes investors make is sacrificing long-term stability for short-term gains.

30-year Mortgages

When I purchased my first home, I was given one option by the three different finance companies I visited…a 30-year mortgage.  The 30-year mortgage has become the staple of real estate investing and even Warren Buffet’s recent statement about the 30-year mortgage shook the real estate world.  What many people fail to recall about Warren Buffet’s assessment of investing in real estate is that he used the phrase “…if he could…” which, is very different than stating “this is what I am dong”.  But that is another story altogether.  The point is that a 30-year mortgage has become standard and not only standard for what companies want to show, it has become standard for what investors want to see.

Many companies, who provide investment opportunities, including mine, will show a mortgage projection based on the 30-year mortgage.  Why?  Because it is what the average, every day investor wants to see.  It is how we have been programed.  A simple search of the Internet will return article after article extolling the benefits on using a 30-year mortgage, especially for the positive effects it has on an investors’ cash flow.  When I first started investing, I was coached to use the 30-year mortgage as a tool to boost my monthly income while allowing a renter to pay down my note.  One thing that I missed and subsequently had to be taught over the years from some investors much smarter than me, was that for the first 25 years of my ownership of that property, I would be paying more in interest payments than I was earning in cash flow.  In the first 15 years it would be substantially more!

Owning Investment Real Estate Outright

Many homeowners and real estate investors will tell you that there is a simple strategy that makes a 30-year mortgage a good investment.  You simply place a 30-year mortgage on an investment property and pay it off like it is a 15-year mortgage.  Now I know that there will be some readers who will comment that yes, this is the precise strategy that they use and that they calculate each month exactly how much money to pay to reduce the principle each month.  They feel that they get a lower rate since a 15-year mortgage can cost as much as .25 to a .50 point more.  To those readers that follow this strategy and actually follow through on this strategy, I will say that I believe you are in the minority and congratulations!  It takes tremendous self-discipline to be able to make that strategy work and I have met many investors who claim this will be their strategy only to find that they like bragging about higher cash flow more than they like bragging about owning the property.

For me, a better strategy that more and more investors that I am dealing with are employing is, using leverage to allow them to purchase more properties faster at today’s pricing, yet for-going cash flow for faster payoffs.  Investors taking this route are usually financially secure and are not necessarily real estate investors.  They see real estate as a secure investment and rental properties as a product that will have continued demand in the foreseeable future.  They are using two different strategies to purchase the properties.

  1. They are purchasing property using a 15-year mortgage.  They then take the cash flow each month and use it to reduce the principle.  In some cases, this can reduce the term of the loan to less than eight years.
  2. They are structuring the term of the loan to match the monthly note to the rental amount received.

In both scenarios the investors are using leverage to increase their purchasing ability and using the cash flow produced to reduce the principle either faster than the term or in as short an amount of time as possible.  They recognize that there is only one fixed expense that the investor can be in direct control of and that is interest.  Management, taxes and insurance are all fixed costs which; the investor has little to no control over.  Vacancy is a variable cost that even with the most prudent management is going to affect an investor at some point and there is nothing an investor can do to prevent.  Routine maintenance and major replacement costs are also variable costs that, while an investor can prepare for and take steps to reduce, there is still little an investor can do to limit and nothing an investor can do to eliminate these costs.  That leaves interest costs as the only major expense that an investor has control over as it relates to earnings potential on a property.

Many investors that I am talking to today are choosing to do everything possible to reduce the over-all costs of interest including choosing higher interest rates to secure shorter terms and buying cash flow properties not for the cash flow, but to purchase more properties faster.  I want to make sure everyone caught that last sentence.  While in San Francisco, this was a big point I was trying to get across to the audience and based on their reaction, it made sense to them.

How I Buy Properties

As an investor, I believe in buying properties that make sense based on what I have experienced as an investor.  I have bought junk properties.  I have bought “cheap” properties.  I have bought properties and done the minimal amount of work to get them “rent ready”.  I have bought properties with creative financing such as ARM mortgages and even bought a couple with interest only loans.  Every one of those strategies was aimed at producing Higher Monthly Cash Flow.  And every one of those strategies almost sunk me completely as an investor.

Today, I buy properties where the fundamental economics make sense.  I told the crowd in San Francisco that when buying properties that produce a monthly positive cash flow, they should consider using that money to reduce principle.  I cautioned them that if they were attracted to real estate and cash flow because they needed to pay bills, then, in my opinion, they really needed to be positive they were getting sound financial planning before buying.  I told them that in my opinion, real estate purchased for buy and hold is a great way to build and maintain long-term wealth, but a lousy way to earn short-term money.  I told them that real estate has the greatest pay-off when you own it outright and that as an investor, getting to that point should be your highest priority.  Using leverage to build your long-term portfolio is a great tactic.  Using leverage to build your short-term monthly cash flow is not.

Am I off my rocker?  Am I spot on?  Let me know what you think…
Photo: Kevin Dooley

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{ 76 comments… read them below or add one }

Eric Zahniser January 2, 2013 at 12:24 pm

Excellent article.

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Chris Clothier January 2, 2013 at 1:14 pm

Eric –

I appreciate you taking the time to read it. Thanks for the kudos.

All the best in your investing!

Chris

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Keith and Kinsey January 2, 2013 at 1:24 pm

Great post! I agree with your thoughts. Although, I’m sure that there will be a lot of people that don’t. Many investors I talk to only care about cashflow and don’t want to pay ahead on their mortgages. 5-10 years ago I was the high leverage cashflow mentality. Although, after dealing with a few problems that could have sank me had I been leveraged any further, I’ve shifted to a more conservative payoff the mortgage invest for the long term approach. Let me tell ya, I sleep a lot better these days! :)

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Chris Clothier January 2, 2013 at 10:28 pm

Hey Keith and Kinsey –

Thanks for the reply! A lot of people are going to make very good arguments for not paying down the debt on properties, but you just made a very good argument for paying down the debt. When you factor in the risk that high-leverage brings, it can really focus a long-term investor on the priorities for the investment. For me, it has always been about owning the property and passing it on to the next generation and I am meeting more and more investors who feel the same.

All the best – Chris

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Rick January 3, 2013 at 4:10 pm

I appreciate this point of view. It is not one that I have heard of as common, but it makes sense. When you factor in all the interest paid out over the course of several mortgages – you see how much is left on the table. Keith/Kinsey/Chris – can you elaborate on how you almost got ‘sunk’ in the past using the leveraged cash flow strategy? I have always viewed it as a safe approach – that as long as your investment cash flows, you can avoid financial bleeding which is why many get in trouble. I am a new investor buying long term cash flow properties with 30 year morgages, planning to roll the cash proceeds into either 1)down payments for other properties OR 2) paydown of debt (after creating a cash reserve). What are the potential pitfalls I need to be aware using this strategy and do you have better approach given your experience? Thanks!!

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Chris Clothier January 5, 2013 at 9:01 am

Rick-

Sorry I missed this the other day. Thanks for asking the question.

The biggest pitfall is not understanding the risks associated with building a portfolio through leverage and growing beyond your capacity to handle the costs associated with owning and maintaining your portfolio. The reality is that the problems that come with having too many leveraged properties are associated with feeling too comfortable as an investor and losing sight of many of the basics. Sometimes it is hard to not feel like you have the world on a string and everything under complete control. So a little less is put aside in the fund this month because things have been going so good and we decide to buy a new car or justify a nice vacation. All of which is perfectly fine, but in real estate, the unexpected will happen and the things we should all be expecting will happen. Both have the potential to wipe out reserve funds for an entire portfolio very quickly.

So some ways to avoid the problems:

- Don’t buy more property just because you can – buy because it is part of your plan.
- Make sure every property receives the highest renovation to avoid deferred maintenance.
– Put aside money every month for on-going maintenance and vacancy
– treat every extra dollar as opportunity to improve your financial situation
- do you have another revenue stream to cover costs? if not, go slow and take extra precaution
- remember that owning a lot of property requires a lot of paperwork and attention. This of course only grows with leverage.

I’ll go into more depth on a future article.

All the best to you –

Chris

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Mark January 2, 2013 at 1:40 pm

Great article, thanks for writing about what most people in this business shy away from.

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Chris Clothier January 2, 2013 at 2:23 pm

Hey Mark –

Thanks for the comment. I’ve written satirically in earlier articles that when I first started in this business I knew everything. The longer I am in the business (and the more people I connect with and learn from) I realize that my hard work and determination helped me overcome some really dumb ideas about investing when I was younger. This topic is really not all that hard to discuss when you realize you should only buy properties that provide a positive cash flow. What you do with that cash flow is entirely up to you…but spending it like it is an income may not be the smartest decision…in my opinion.

All the best – Chris

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Jason January 2, 2013 at 3:30 pm

Chris,

Very interesting take on the pay off sooner philosophy. I see the logic behind the argument, but I also see the logic of inflation induced debt reduction and using the cashflow to buy more cashflow properties.

Many believe inflation to be greater than the govt reported 2%. The institute for economic research reports inflation at 8%. If you have a mortgage at 5% and inflation at 8%, are seems you are losing value by paying extra towards your debt? I’m sure someone has figured this out.

I suspect calculating your ROI when paying down debt faster or reinvesting cashflow would have to be done as well.

Another factor to consider is appreciation. One of the main advantages of leverage.

I see many arguments for and against paying down the debt faster. My coach successfully used leverage, I follow many successful investors who have done the same. I also follow many successful investors who have free and clear properties and have done well by them. I guess it depends on risk tolerance, capital reserves, and capital growth vs sustainable cashflow desires.

Jason

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Chris Clothier January 2, 2013 at 5:23 pm

Jason –

Thanks so much for reading and commenting and you make some excellent points. Unfortunately, and this is only based on my inter-actions with investors so the scope is limited, many investors are not considering inflation, debt costs, appreciation and capital growth. They are only hearing a very narrow part of the equation and that is that if it has a positive cash flow then it is a good buy.

You are right that there are many many factors for an investor to consider.

Thanks again for commenting.

John Alesi January 2, 2013 at 2:00 pm

Chris, I think your advice to purchase for the long term is probably best for “new” investors who are looking to diversify away from typical stock driven programs. If an investor has the ability to wait out the market, now is one of the best times to “buy and hold” and then take a profit in 5 to 10 years as prices appreciate if they need/want to cash out.

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Chris Clothier January 2, 2013 at 5:28 pm

John -

Thanks for reading and taking some time to leave a comment. You are exactly correct with your statement about now being a great time to buy and hold and when you add in the comments from Jason above, their is a good possibility of earning at least some appreciation in the next 5-10 years. However, and again this is limited to my discussions with investors, many are not looking for a buy and hold for 5-10 years to sell. Would hey be happy with doing that? Absolutely depending on the return. However, they are looking for a generational benefit. The opportunity to pass an asset on to heirs. And in that scenario, they are looking tp use leverage to build quickly, but faster principle reduction to hold down interest costs and capture more rent sooner.

all the best – Chris

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John Alesi January 2, 2013 at 5:38 pm

Chris, I was thinking strictly from a strictly business investment point of view but when you add in generational wealth building, holding on makes a lot of sense. It would be great to leave a fortune in real estate to my children and grandchildren.

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Chris Clothier January 2, 2013 at 10:37 pm

I will tell you John that i used to look at all of my real estate investments as strictly numbers and i really lost focus of what I was doing and why I was doing it. The decisions I made during that period of my investments cost me dearly. Today, I am very clear on why i purchase a piece of property. I want to own it outright as soon as possible and protect that property in a way that preserves it for my children. They payoff I receive from full ownership outweighs the benefit of longer periods of higher leverage in my opinion.

David Cooper January 2, 2013 at 4:21 pm

When you hit the 50% tax bracket in High Tax States like Cal, I want to find every legitimate deduction I can find. Interest on real estate means I am making a mortgage payment at 50% OFF. Second, when I can get 30 years investment mortgage at 5.25% and get appreciation of 15%, why in the world would I want to pay off early. Third, when I get an investment loan, and the bank puts up 70%, and I put up 30% my partner, the bank, is taking most of the risk. Floods, hurricanes, earthquakes happen and I walk away.

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Chris Clothier January 2, 2013 at 5:33 pm

David –

Thanks for taking time to leave your comments. All are very valid points and as Jason noted, the fact that money is cheap and inflation is higher is a good reason to hold onto that mortgage. I did not follow the 50% off on your mortgage payments I would love for you to expand on that one, but the other points are good and valid. This particular article was all about cash flow and the fallacy that some investors can fall into that they are maximizing their cash flow with a 30-year mortgage. That is simply not the case. They may be maximizing other factors such as tax advantages that you mentioned, but not monthly cash flow.

All the best – Chris

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Jonna Weber January 2, 2013 at 9:35 pm

Insightful article Chris – thanks. I particularly like the last two sentences about using leverage! We tend to be pretty conservative leverage wise, so this is validating. BTW, nice job on the Money Magazine article this month. You know the buzz on RE Investing is hitting the masses when it gets mentioned in every issue of Money lately! Next couple of years will be interesting.

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Chris Clothier January 2, 2013 at 10:35 pm

Jonna –

Thanks for taking time to read and leave a comment. It means a lot to each of the authors on here when we get feedback and get a chance to talk back and forth.

As for validation, I can tell you congratulations is absolutely in order just or taking action, getting in the game and having a strategy. If you are following a strategy that you laid out and are comfortable with it – no matter all the advice you get from other experts, that is what is most important. What makes you comfortable and feel safe as an investor. Thanks for the shout out on the Money Magazine article. I spend a lot of time speaking with writers around the country about real estate and property management and every once in a while it shows!

All the best with your portfolio – Chris

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Jeff Brown January 3, 2013 at 10:44 am

Been screamin’ much of what this post says from mountaintops for two generations, Chris. You’ve no doubt built a bridge over some pretty troubled waters (they’d of created for themselves) for many who read this.

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Chris Clothier January 3, 2013 at 1:03 pm

Jeff –

Takes me a while sometimes to come around! Those waters don’t always have to be troubled, but you are correct that it is usually ourselves who make them that way. I simply prefer this method of investing today.

All the best to you in 2013!

Chris

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Tom January 3, 2013 at 10:50 am

You make good points, but you’re still off your rocker. I admit my market is way different from SF; as a bottom feeder I can buy decent SFHs and duplexes and get them ready to rent for $25-50k. I have about 60 properties currently, nothing over 4 units. Often I buy with cash, and refi them once stabilized. Obviously I never refi for over 80% of value, don’t want to ever be upside down. Then I rinse and repeat. But my next point is valid in any market. I will only repay a loan faster than I have to if I can’t earn a better return than that loan’s interest rate elsewhere. If I did repay loans, I’m paying Peter to rob Paul, and I’d be giving up my high RE returns just to pay down some paltry 6-7% loan. I’m better off buying more cash-flowing properties with my cash, earning my 20 to 50%+ return on my investment, and/or improving my property so I can generate more rents, and increase the value of my properties for when I do sell. Think about it.

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Chris Clothier January 3, 2013 at 1:08 pm

Hey Tom –

Thanks for taking time to read and comment. I know you read the whole thing because you answered my question! And I’m ok with being called off my rocker…

Let me clear this up though, I operate out of the Memphis and Dallas markets. I just happened to be speaking to investors in San Francisco who were interested in purchasing properties in Memphis and Dallas through my company. Those two markets are lower priced and probably closer in definition to the market you are in. It is rare that you find investors having your level of success with the exact strategy that you use for an extended period of time. You are successful, most likely, not simply because of your purchasing and finance strategy but also based on how you run your entire operation. I have met far more investors who have crashed and burned badly using the exact strategy you laid out than I have met who have succeeded for any length of time. So for that, I applaud yo and tell you to keep up the strategy that works best for you!

All the best to you in2013.

Chris

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Jay C January 3, 2013 at 11:24 am

Good article…but may not necessarily work for everyone…will work for someone who have other full time occupation that pays their bills. I like both approaches, but I like to use leverage in times like these to add to the portfolio – keep the cashflow coming so i can buy more sooner, or refi to take out equity to grow portfolio. Ultimately yes – nothing to beat owning free and clear.

I have used a combination of strategies and find no one strategy works well across the board. Some cash only, some levered…depending on what the property is etc. Aim though is to grow the portfolio with cashflowing properties….bring cashflow to a decent number. Bottomline is to maximise yield. If interest rates are at 4% on a fixed mortgage – i am inclined to think it doesnt make sense to pay off now when I could use money to acquire another property that yields 8 or even 7%, if i focus on paying off now when yields are low, I probably will not see this many cashflowing properties in a few years… Just my 2 cents.

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Chris Clothier January 3, 2013 at 2:59 pm

Jay C. –

Thanks for taking time to read and to write a comment for the article. You make great points and offer up some very sound reasoning. I especially like the fact that you recognize that one investor can use two different strategies on two different properties. However, I am still not sure how an investor can expect to purchase more properties with a cash flow of $300 to $500 monthly. So many times I hear investors make that statement that they are inclined to use the cash flow to buy more cash flow properties, but I am not sure this strategy pencils out. I can understand not using available capital to reduce principle, but instead to purchase more properties, but if your only available capital is the monthly cash flow, you are going to be hard pressed in many scenarios to build sufficient funds to continue buying quickly. Not that I disagree with your points, I would just like for you to clear that point up and show how quickly you think you can purchase another property with the cash flow.

Thanks again for jumping in the conversation!

All the best – Chris

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Marc January 3, 2013 at 11:27 am

Personally, I am not planning to leave 10 houses to my kids but if that’s how things work out, it would be good for them.

My goal is to build as much EQUITY value as possible while building the portfolio and then cash it in slowly as an income stream in semi-retirement. When I retire early and have no job income, I will sell one house once in a while as an income stream. My taxes will be at the capital gains rate rather than regular income.

If I sell one unit at a time from 60 yrs old to 70 yrs old, I can afford to take vacations, spend time with family, etc. No need to work until 67! And each year i work less on managing my RE portfolio.

Equity comes from paying down principle, refurbishing, and asset price appreciation. If your horizon is 20 years like mine, it makes the most sense to use the cash flow and maximum leverage to buy as many properties as possible while the prices are low. Then, spend the next several years trying to pay off the loans, higher interest first. Lastly, when asset prices are much higher and getting ready to sell, use the cash flow to make minor or major updates to make the home one of the nicest on the block for sale.

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Chris Clothier January 3, 2013 at 3:03 pm

Marc –

Thanks for taking the time to read and jump in with a comment. Far be it from me to try and convince you otherwise. If you have a plan and are sticking to it, then by all means continue. I will tell you that at one time, I thought I was going to let all of my houses go thru the full amortization of 30 years. Until I calculated how much of my collected rent would be going to interest. That was when I decided my best bet was a reduction in principle and allow myself the flexibility that comes from no mortgages and full ownership. I will save millions of dollars in interest payments across my entire portfolio by reducing principle faster. That gives me the ability to retire much sooner than if I waited. BTW, I am not sure I will ever retire, but most people my age are on the 20-year horizon as well.

Best of luck in 2013 – Chris

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Jay C January 3, 2013 at 11:46 am

This one is for Tom,

Tom which area are you in where you acquire for 25-50K? Sounds like an excellent area to be looking :)

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Tracy Royce January 3, 2013 at 12:05 pm

Great article Chris.

Many investors I know here (in the Phoenix-metro area) could give a hoot about cash flow; the name of the game is acquisition right now.

But, that’s under the understanding that the cash flow will be through the roof shortly (relatively speaking), since they’re either paying cash for the houses or leveraging them to free up equity to re-invest, and renting them out between $600-$1,200.

Let it be said that the majority of the homes are under 150K, so breaking even and making a little every month is less important than the long term cash flow and equity gains, since the size of the mortgages are easier to pay off. Even if they’re paying cash and breaking even with the rents for 3-5 years, a cash on cash return (afterwards) of 12-20% isn’t unusual.

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Chris Clothier January 3, 2013 at 3:09 pm

Tracy –

Thanks so much for leaving your comments. Phoenix is a funny market right now and you certainly have your hands full with investors over there. Best of luck with your 2013!

The funny thing about this blog article and the discussion that happens around this topic every day, is that so many assumptions are made by investors to justify carrying a 30-year mortgage. And I am not saying that is a bad idea. But, it seems that you and I may be talking to many similar investors in that their approach is built on capitalizing on the full income stream and reducing costs as much as possible to boost the return. Regardless of how much you leverage, the longer the property is leveraged the higher you interest bill over the life of the property. If an investor is looking to sell out quickly then by all means, leverage up and play the appreciation game. But, IMO only, I am a long-term investor looking to leave a portfolio to my children and I reap the greatest benefit by not spending the hundreds of thousands of dollars per property on interest over the life of a loan.

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Reuben Rosofsky January 3, 2013 at 12:17 pm

yes, you hit it on the spot, but I would say that cash flow is important to me as I am using it to pay down the principal of short-term loans that I have as I only have four rental properties mini me about $1300 a month cash flow with the average purchase price at 55,000. I am using $1000 a month to pay off the principal which would take just under six years to achieve open the global rental portfolio to at least 10 properties this year to increase the amount that I could put towards the principles to pay them off quicker as they use the income from my fix and flips to live on. Some people would already made that there is such thing is good debt that may be partly true, the debt is debt.

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Chris Clothier January 3, 2013 at 3:11 pm

Reuben –

Thank you so much for taking time to share your thoughts. I like the last sentence the most. Debt is debt and as investors, we absolutely have to be careful about how we use debt as a tool too build our wealth.

All the best to you –

Chris

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Jay C January 3, 2013 at 3:05 pm

Chris,

On your comment as to how do you use 500$ cashflow to buy more properties – simple, accumulate them. ofcourse if you have 1 property it doesnt make too much sense, but lets say you have 4 properties and each producing 500$ monthly cashflow ( lets just say). You now have 2000$ cashflow. With that money in 6 months you have 12K to use as downpayment for a 50K house. It gets better with scale…i started in 2010 and while scaling takes time, this is very much possible. I have also done what you said which is try to pay down – while safe this is simply not the best in many cases that i have seen, and i have not stopped paying down actively ( other than scheduled principal). Ofcourse nothing is perfect, but in todays scenario, i have a never ending need of cash to buy more…

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Chris Clothier January 3, 2013 at 3:21 pm

Jay C –

One of the fundamental flaws that many investors make when deploying this strategy is failing to account for variable costs. I know this because it is the biggest mistake I made when purchasing my first properties. I too was buying properties at the very low end of the purchase scale and often for less than $50,000. Unfortunately, it is a reality that lower end homes can and most often will cost more to maintain over time and often those costs begin to come due earlier. If an investor is smart enough and savvy enough to purchase properties for $50,000 that can produce a $500 monthly cash flow after leveraging 80%, then they need to understand that soft costs (unforeseen vacancy and maintenance) will eat a portion of that amount and usually a large portion. When investors accumulate their cash flow and use it to purchase the next leveraged property without holding back for variable costs, they are caught in a trap of having to come out of pocket to pay for those costs. And now, they have two properties to pay for going forward.

My point in the article is that I am seeing more and more financially secure people reducing principle rather than accumulate cash flow. And, in my experience, I would like to see more investors who are not quite as financially secure approaching their investments in a similar way rather than continuing to accumulate as fast as they can. It sacrifices long-term stability for short-term cash flow. In my opinion only.

If you can make that strategy work just as you laid it out then I absolutely wish you the best of luck and really hope to see you do well as you scale your business.

All the best – Chris

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Jay C January 3, 2013 at 3:26 pm

Chris
If your point is “dont be over-levered”, I agree. But many of us are far from that, and I am sure there are folks who are over-levered as well. Like i said nothing is perfect, one needs to strike a balance based on their individual situation.
But having zero-debt when debt is available at 4-5% fixed for 30yrs to me is like throwing money away – when rents, prices, taxes are ever increasing.

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Jay C January 3, 2013 at 3:13 pm

Chris,

If you were a fund and had a limited amount of investment capital lets say 1mm. Would you buy 10 properties 100K each or would you buy 40-50 properties at 100K each using 80LTV loan ( assuming thats possible). What would you do today? Your aim is to maximise return to the people who invested in your fund. Do this in two scenarios – 1. assumes home prices remain flat. another assumes an environment where home prices go up by about 2% annually.

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Chris Clothier January 4, 2013 at 4:16 pm

Jay C –

Give me some time on this one. But, I will repost on this. I will give you a short quick answer though and that is that for short-term returns where you are earning on the spread – then you absolutely want to use leverage – it is how you build that spread. So If I were a fund I would absolutely use leverage for short term returns.

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Karen Rittenhouse January 3, 2013 at 4:27 pm

Buy and hold can create generational long-term wealth.

Cash flow today, however, not so much.

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Chris Clothier January 4, 2013 at 4:19 pm

Hey Karen –

Thank you so much for jumping on here with your comments! I am not knocking cash flow properties as a way to build generational wealth. That is in fact how I am doing it and many before me have. The difference is, I buy properties that cash flow because the fundamentals of the property work and then I seek to pay off the leverage as much as possible to hold down my interest costs. Unfortunately, in my opinion, too many people see holding cash flow properties for the entire term of leverage as a way to build wealth and for some it may be – but for others it is definitely not the shortest route.

Thanks again so much for taking time to read and comment.

Chris

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Peter January 3, 2013 at 5:20 pm

To comment on the post above concerning incurring debt as a long play on inflation, I agree that borrowing debt will be advantageous in an inflationary environment but it doesn’t particularly hurt you by paying it off quicker either. As inflation rises and your debt payments remain fixed, you will essentially be paying back your debt with dollars that are worth less and less.

Say inflation is at 8% and your mortgage is 5%, you will effectively be paid to just sit and wait, and if in inflation is 8% and your mortgage is also 8% then you are at least effectively getting the property for free. However, even if you make curtailment payments on the principle and shorten the term, you still end up owning a real asset. As everyone knows, when inflation rises people tend to move their money into real assets as a store of value. Thus, although you might not get “paid” to own your asset or own it for “free”, you still own an asset that won’t go down in the face of an inflationary environment.

With Ben Bernanke printing unlimited amounts of money in his attempt to keep the economy from stalling, God knows we’ll all need to own real assets to preserve our wealth and purchasing power as inflation most definitely eat away at it.

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Chris Clothier January 4, 2013 at 4:37 pm

Peter –

Thanks for sharing your thoughts. You definitely have a grasp on economic fundamentals that many investors over-look. I would love your thoughts on this.

I reviewed a GFE recently and it showed that an investor would borrow $80,000 from a lender at 5.0% They will pay back $74,000 over 30 years. In that same amount of time they will earn a positive monthly cash-flow after accounting for all expenses of $150. And that is setting aside 15% for vacancy and maintenance and paying 9% management fee.

Effectively a borrower is earning $1800 a year on this property or $54,000 over 30 years. If they paid $150 toward the principle, they would pay $39,000 in interest and pay the property off in roughly 17 years. Saving $35,000 in interest and recouping the full rent every month on the property 13 years earlier.

My point has always been that if you buy 5 properties in this fashion, rather than combining monthly income on them and saving to buy #6 – reduce principle on them and pay them off early. You are in a better position from a risk standpoint and you used leverage to acquire, not hold property – saving yourself thousands of dollars in interest and allowing those dollars to flow to you directly sooner.

I’m not an economist, just have a certain way I like to invest and I am meeting more and more people like me. Am I crazy with my math?

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Peter January 4, 2013 at 7:29 pm

Yes precisely, I definitely agree from a risk standpoint you are better off. Rather than control six properties and their expected cashflows, its is much less risky to own five of them outright and then start looking to make additional acquisitions. As Ben Graham said, an investor’s rule number one is capital preservation. In other words, a return OF capital is more important than a return ON capital.

I recently read a book by Marc Faber, one of the smartest (and richest) investors/economists I’ve ever heard of, called “Tomorrow’s Gold: Asia’s Age of Discovery.” It may sound like a book on “Asian investments,” but its about 300 pages and covers primarily investing and macroeconomics in general. He wrote it in 2002 after predicting the tech bubble in the late 1990s and in it he predicted the ensuing real estate bubble before it even began inflating. I’d say its one of the top five books I’ve ever read and I highly recommend it to anyone who wants to learn more about economic cycles, trends, and bubbles.

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Yuliany January 3, 2013 at 5:24 pm

Hi Chris,

Great article. I am a buy and hold investor as well. I recently bought a property for cash due to fierce competition and have been regretting it ever since. I also came from the “leverage as much as you can” school of thought. However, I must admit that life is so much simpler when you don’t have to worry about paying the mortgage and the bank account also fills up faster.
I still plan on refinancing that property to take advantage of the current prices and interest rate though. But for now, I’m just enjoying it.
On a totally different note, I’m currently facing a priority dilemma. I live in the Bay Area but I invest in Arizona. Like you, I also would like to pass my investment properties to the next generations. I have been considering to purchase something in the Bay Area but since properties here are so expensive, it might slow me down in purchasing investment properties in other cash flowing area.
I’m aware that now is a great time to buy, however I have limited resources. Therefore, there are choies to be made. If I only use my resources to invest in Arizona I might miss out on the good deals in the Bay Area and probably will not be able to afford them later in the future.

I have met you and heard you share about your real estate investing experience when you were in the Bay Area {there wasn’t a single boring moment :-)}. Your thoughts will be highly appreciated, and looking forward to read your next article.

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Chris Clothier January 4, 2013 at 4:45 pm

Yuliany –

Thank you very much for your kind words and for taking the time to read and comment here at BiggerPockets.

The Bay area is such a specialized location. You can invest in some unique ways there and reap so many benefits in a short term, but I understand it is also highly competitive. Remember, you do not have to invest in one single market such as Arizona or the Bay Area and with limited resources – I would absolutely advise you to research markets and teams before deciding anything. But, If you the ability to take advantage of the great short-term investment opportunities there in California and can make them work to your advantage with a great team helping you, I would really consider investing there right now while you can. The great thing you will find when you research investing out of your area and that there are always pockets around the country and each will have a highly qualified team you can work with, that are great areas for investment. In any market and at any time, you can find great long-term buy and hold investments. But you are not always able to find opportunity for quick turn around like you can in the Bay Area right now.

So if you have opportunity to quickly turn property there in California, I would take it.

Thanks again for reading and commenting.

All the best to you!

Chris

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Monika January 3, 2013 at 6:25 pm

Thank you for this article–it’s always helpful to read about other investor strategy. My strategy based on a long term horizon where I expect inflation to increase dramatically, due to the unprecedentedly low cost of investing now. So, my strategy is to (a) reasonably leverage myself as much as possible with cash flow positive properties now, (b) maintain significant liquidity per property, and (c) not pay down the loans early as I expect inflation to eat away at the real value of the mortgage payment 20 years from now, significantly improve the actual cash flow as well. I use the extra cash generated from income to diversify into other investments–this will give me the flexibility to pay off the mortgages later if the inflation rates do not increase as expected.

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Chris Clothier January 4, 2013 at 4:47 pm

Monika –

Thanks for sharing!

I love hearing about investors that are doing exactly what they want to do and following their plan. As long as you have a road map for where you want to go and are sticking to it, then I am sure you find success!

All the best –

Chris

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kyle hipp January 3, 2013 at 10:24 pm

Great article as always Chris,

I started my real estate investing career in 2006 and had the 30 year strategy. I was gonna retire by 55 with several properties paid off and a whole slew in the pipeline. Well now I decided I can’t see myself working for someone past 40. I now only do 15 year ammortizations. The one property I had in a 30 in 2007 has been a thorn in my side for years. Just now with a creative financing strategy have I started the process of refinancing it to a 15. I have paid down $7,000 in principal in 5.5 years and $35,000+ in interest. I can now pop it in a 15 and flip those numbers and save each month. When I pay down on a 15 year mortgage I still cashflow a great amount and that is from buying right in the begining. Now with these 15 year loans I can still get $300+ a month cash flow but also have the financing flexability to use that equity that has built up. Every 3 -4 is enough to be a down payment on a new property.

I love flexibility and a 30 year note in the way it is structured just doesn’t do that for me. If I add my principle paydown to my cashflow each month I come out ahead by having lower cashflow on a 15 and the higher principle paydown and as an added benefit lower interest rates. With the 30 my cashflow is high but principle paydown low. On the risk side I still have more options with a vacancy as I guarantee the larger principle paydown by just making the payment whereas the benefit favored being cashflow is wiped out with vacancy so no benefits.

I think regardless of a person’s investment strategy this topic needs to be addressed on a regular basis in order to properly analyse the best course of action in an ever changing environment.

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Chris Clothier January 4, 2013 at 4:49 pm

Kyle –

Thanks for your comments. I always appreciate you reading and commenting on the articles.

You talked about risk, you talked about flexibility, you talk about benefits and constant analysis. These issues are so important for investors and no one says that you have to follow the same path you started out on. You are a great example of that.

All the best to you in 2013.

Chris

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Al Williamson January 4, 2013 at 3:46 pm

Some good thinking Chris. Thanks

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Chris Clothier January 5, 2013 at 9:04 am

Al –

Thanks so much for reading and leaving a comment. When are we going to see you writing articles on here? I love reading your forums posts and know you have a ton of good insight and ideas especially when it come to working together to rebuild communities.

Looking forward to reading more on the forums!

Have a fantastic 2013 –

Chris

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Matt January 4, 2013 at 6:52 pm

Important question with only one problem: I’m not sure if there is a legit right or wrong answer.

As most, if not all, of us here have found out the hard way at one time or another, real estate investing is a multivariable equation where many probabilities are in constant play. And the first tool in our tool belt to deal with them when they arise is either cash reserves or credit line access.

So while prepaying a mortgage early is a proven strategy to early ownership and an eventual increase in monthly cash flow, without ample cash reserves (or credit lines) to replace a furnace or a tenant sues you for slipping on the proverbial banana peel, it’s probably not the go to strategy 100% of the time for investors without alternative income stream(s), a substantial line(s) of credit or a sizable cash reserve.

That said, I’ve prepaid every loan I’ve ever had. An alternative prepayment strategy I prefer to use is quarterly prepayments — similar to company that pays quarterly dividends to shareholders — where I pay out any funds above my emergency fund minimum savings amount toward the loan with the highest interest rate. This keeps the emergency fund fully loaded at all times and simultaneously pays down the loan that will cost me the most money in amortized interest (the so called debt avalanche method).

But to switch topics a bit… the major caveat to prepaying loans vs keeping positive cash flow is inflation.

The scenario that I haven’t seen mentioned here is *if* an investor can get a 15yr or 30yr mortgage in the 3-4% range from a conventional lender, or perhaps even a private lender, prepaying this mortgage may be the wrong thing to do considering the USA’s current “inflate our way out of this debt problem” monetary policy.

Ex) those of us old enough to remember when gas was < $1.50 know what I'm talking about.

Moreover, in 15 years, a monthly mortgage statement of $1000 may make us LOL and smirk at how cheap a $1000 will be in 2028 dollars. Perhaps even more so in 2038 dollars.

So if you can score a mortgage that rivals the rate of inflation, it may be in your best interest to let inflation do it's thing and you harvest any positive cash flow to build up your reserves and/or use in future deals.

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Chris Clothier January 5, 2013 at 9:13 am

Matt –

Thanks for reading the article and leaving your thoughts.

I agree with the first sentence of your response in that there is no right or wrong answer. There almost never is.

Every situation will be different because of the investor, the property, the terms and the intended outcome. But, I wanted to point out that more and more investors are turning to real estate because of the underlying value of the asset. I am meeting and connecting with so many investors who have already been successful in many different walks of life and are very savvy with their money and they are not taking the bait of the 30-year mortgage. They are choosing to use leverage as a strategy for acquisition, but they are choosing to pay those debts off in shorter time periods and choosing not to pay $2 back to the lender for every $1 borrowed. That is essentially what happens on a 30 year mortgage at 5%. I have even met many who are borrowing at 9 and 10 percent for 7 years in order to gain access to more capital leverage. In the end, they pay a fraction of the interest expense and double (if not more) their ability to build their portfolios.

I’m not saying one way is right or wrong, but I wanted to point out that a lot of smart people are choosing to own rather than hold long-term leverage.

Thanks again for sharing.

All the best -

Chris

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Thom H January 5, 2013 at 4:18 pm

Chris,
Its good to finally read someone describing a philosophy, that I’ve been quietly following for many years. I’ve always taken a conservative approach with RE investing. I’ve never had a taste for extreme leverage, and have always attacked my mortgages with every penny available from my cash flows and excess earned income. Whether its always the best approach for everyone, I can’t really say, but it has been the right approach for me (and that’s all that ultimately matters). Almost all of my properties are free and clear properties, but I do use reasonable leverage to obtain additional properties (and plan to as long as I’m breathing). I just use the snowball approach to pay down properties, and as a result, I can payoff new properties in very short periods now. It’s slow, it’s effective, and I sleep like a baby at night! Great article and great advice for young investors ( in my opinion).

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Chris Clothier January 5, 2013 at 10:48 pm

Thom –

Thanks for your response and for reading the article. You are correct. Ultimately, all that matters is what makes each investor most comfortable and helps them find a level of success that they are looking for. I also think that you totally understand the concept of using leverage for obtaining properties, but not for holding properties. There will be many that tell you that you are foolish for paying off low interest notes, but as your goals change, your methods change and now that you are in a position of owning many of your properties, the need to long-term borrowed money no longer exists.

Great job! Thanks again for taking the time to comment.

All the best – Chris

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Tim Delp January 5, 2013 at 5:18 pm

I’d have to say I think you are mostly off your rocker. First you referenced paying higher interest rates for 15 year mortgages than for 30 year mortgages. Mortgage rates are cheaper the shorter the term so if you want to pay the loan off in 15 years and feel comfortable with the cash flow the borrower should take the 15 year, the arguement against that would be if you are not comfortable with cash flow and do not have adequate reserves to weather the storm in a tough period you would be better paying the higher rate of interest on a 30 to have the flexibility of the lower payment.
From a return perspective if I’m buying a property that produces in excess of 10% return why would I aggressively pay down tax deductible interest at current rates much lower than my return?
I feel each investor has to make their own decision about when they might want to pay down aggresively versus build up the cash for the next acquisition. If my goals are to own 10 free and clear properties and I have limited cash using my available cash to leverage and purchase a couple properties and use a 30 year mortgage and save my cash flow to buy the 3rd property and 4th etc makes the most sense. Once I have 10 if my goal is to own them free and clear then it might make sense to then aggressively pay them down.
As far as seeing investors fail I would believe that investors you are referencing that have failed are investors that have taken every opportunity to take equity out of their properties as values increase and got upside down and when they are upside and with minimal to no cash flow what’s the point of holding on. If they bought and never took the equity out at the peak of the market and they’ve had cash flow above and beyond their 30 year mortgage how would they lose the property?

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Chris Clothier January 5, 2013 at 11:10 pm

Tim –

It only took about 50 some odd comments to get my second off the rocker! I really thought I might have a few more by now…

I was incorrect in my earlier comment about the cost of the 15 year mortgage and stated it backwards. You are correct that you will pay a slightly lower rate and I think today the average difference between the two is roughly .75 percent. You make very valid points, but I think many people will still tell you that borrowed money is still borrowed money. Even if the amount of extra money each month gives them a great return on the amount they invested, on the day they are able to pay off the full amount of borrowed money they will be earning a much, much higher return and for many investors that I am meeting today are opting for this option.

I didn’t get into detail on investors losing property from being over-leveraged, but i will tell you that many of us know the reason you listed is absolutely one of the reasons investors have failed. Aggressively financing a property and treating the proceeds as income instead of borrowed money is a sure fire way to lose. But that was not what I was talking about. Investors can make mistakes in so many areas of a deal. From allowing a minimum of work to be done to get the house rented to using the cash flow for a major purchase instead of an emergency fund and everything in between. The problem is that too many investors view the words “Cash Flow” as a monthly guarantee and any investor who has been investing for a period of time will tell you that is not the case. Roofs will need to be replaced along with water heaters, furnaces, A/C systems and at some point, the averages tell us, an investor will deal with a tenant that causes major damage.

These costs often eat cash flow up and when adding in vacancy, a property can get wiped for a year. This is a little off the topic, but the poster was asking a question about over leveraging. It does not necessarily have anything to do with paying off a mortgage early, but absolutely has to do with the attitude you take when building your portfolio and how you protect yourself as an investor to get your properties where they are self sustaining.

As far as the topic…i don;t mind being called off my rocker! I think the conversation has been great and we’ve shown once again that there can absolutely be differences of opinion and approach when investing in real estate and neither has to be right or wrong.

All the best to you –

Chris

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Rick January 6, 2013 at 1:48 am

Great discussion. I know this discussion is about the pros and cons of using leverage against investment properties, however I wanted to know what others thought of leverage used against a primary residence. My assumption based on the responses so far, is that there is more likely the viewpoint that ANY leverage on a primary residence is really not a good thing (not matter what the interest rate) and should be paid off asap. Chris I’d like to know what you think about that. Thanks!

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Chris Clothier January 6, 2013 at 1:52 pm

Hey Rick –

Thanks for reading the article and taking the time to leave your comments.

I recently sat down with my mom who at the age of 60 is retiring. Her and my step dad are both retiring and planning how they are going to spend the rest of their lives. One thing they are not worrying about is debt. They didn’t really even start thinking about retiring until their early 40′s when they bought their current house. They paid their 30 year mortgage off in 17 years and have attacked any debt they had on any of their investments.

I was happy to help them and review their plan and I told them that they are looking excellent for retirement and if they never make another dollar off of their other investments, their current passive income from having NO DEBT covers their current standard of living and allows them a monthly trip to visit their grandchildren around the country. That monthly visit is another article all together!

So needless to say, they spent roughly 17 years paying off all of their mortgage debt and are able to retire very, very comfortable at a young age of 60 and they saved over $100,000 in interest payments.

Hopefully, that tells you what I think of the power of using leverage to acquire but not own real property.

All the best –

Chris

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Erik January 6, 2013 at 2:46 am

Chris,

Provoked some great comments, but you still might be off your rocker….or, at least, lead your readers to some conclusions that may do the opposite of intended.

You bring up two fundamental real estate principles:
1. Try to maximize overall return.
2. But, stay solvent. Rent must be greater than expenses and debt service. Otherwise, game over–foreclosure, no returns.

The best way to stay solvent (#2) is to own the property free and clear. Risk of default: zero, zilch, nada. No doubt about it, I agree.

Your article is about decreasing risk. Your method is to make the term of the loan as short as possible. Instead, I would manage risk by putting more money down (decreasing payment size), keeping a larger reserve fund, and using cash flow to pay off the mortgage as soon as possible.

You acknowledge that leverage, given today’s environment [negative real interest rates (i.e., prime rate less than inflation) & low Price to rent ratios}, will in general increase risk but also your overall returns (#1). Also, it could actually *increase* your solvency (#2) and decrease risk if it increases your cash flow. Let’s say instead of paying down your mortgage, you invest in a second cash flowing property–that increases your risk, but the extra cash flow could also increase your ability to stay solvent if you had unexpected expenses on your other property.

You suggest paying off a mortgage early, or trying to get the shortest possible terms to reduce overall interest paid. You’re correct, this will help you increase your chance of staying solvent: decrease risk by owning the property free and clear quicker. But using cash flow to make extra mortgage payments won’t help you stay solvent if you have unexpected vacancies or repairs. In fact, it could hurt you (instead of sitting in your bank account available to pay expenses, it’s tied up equity given to back to the mortgage company). And taking a shorter term loan increases your risk of insolvency by giving you a larger payment which you now must make every month with less cash flow available to go toward expenses.

Here’s the crux: Getting a shorter term loan means bigger Mortgage payments. Yes, it decreases your interest, but that very small interest benefit is offset by much higher principal payments. This actually *increases* your chance of becoming insolvent and losing the property.

In sum, you are saying use financing and leverage, but take a shorter term loan because it will decrease your risk of become insolvent. ***It only helps you avoid the risk of becoming insolvent in that you shorten the time that you expose yourself to mortgage payments, but during the time you have those mortgage payments actually INCREASES your risk.***
************************
Here’s what I’d tell your readers who are worried about too much leverage or insolvency:
1. If you’re not close to retirement, use as long a term mortgages as you can.
2. Fundamentals (Inflation, interest rates and price-rent ratios) are favorable, are just begging you to take on risk. Ridiculously favorable risk-reward ratio. Leverage will greatly increase your returns.

3. If you want to decrease insolvency risk, put more money down, but still use a 30 year fixed. This will decrease your payments, you’ll have more cash flow to meet unexpected expenses.

4. Don’t worry about the extra interest from a longer term loan–consider it cheap insurance for those rainy day expenses. The spread between 15 and 30 year loan is small, only 0.5-0.75%. At 0.75% on a $100,000 loan, you save only $40 per payment in interest, but pay $300 more in principal. With shorter term loan, you have less cash generated to meet unexpected expenses–this is riskier during the time you have to make mortgage payments.

5. Finally, you MUST have a reserve fund for expenses. More worried? Just make the fund bigger. Then, use leftover cash flow to pay down debt. Once you own it free and clear, default risk =0%.

*************************
Lastly, an off-topic compliment: Your family has built a great company in Memphis. As an outsider, I admire the data-driven, analytical property management style you bring which I think may be severely lacking from most property managers. Your article on how to evaluate a property management company presents some very powerful, yet elegant metrics….one of the best articles I read in 2012 (perhaps you could re-post the link).

p.s. (you probably misspoke–the interest rate on a shorter term loan is actually lower, not higher)

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Chris Clothier January 6, 2013 at 2:45 pm

Eric –

Thanks for taking the time to leave such a great and detailed response. Obviously, when someone takes the time to read the article and the comments and then leave a comment, that means a lot to not only me but to other readers, so again thanks.

My real intention with the article was two fold.
1. To stimulate discussion that some investors may or may not want to have for fear that they may be perceived as doing something wrong. Hopefully now everyone understands that you can have a great discussion without judgement and certainly with the possibility of maybe becoming a little more educated as you make your next decisions.
2. I wanted to point out that there are A LOT of investors entering the market today that are not traditional real estate investors. They are intelligent investors who are entering the real estate market because it is a great place to protect their capital and they can get some leverage to make their dollars go a little further. Yet, they are not using the leverage to hold long-term. They are using it to acquire and then are paying it off.

I think all of the comments make it pretty clear that there are variables in every real estate investors decision from the decision to get started to which property to purchase and how to go about the entire process every single day you own that investment. I don’t think there can ever be a “one-size fits all” response to whether or not you carry low interest debt. Regardless of the positive side to holding debt, there will always be investors who find a level of comfort from owning the property out-right and keeping every dollar earned on the property.

On the off-topic note – thank you very much. We have worked very hard developing our company and have surrounded our selves with excellent people. We have always had the belief that you try to improve every day and you do it in as transparent a way possible and the property management company is no different. We will be managing over one-quarter of a Billion dollars in investment property for individual investors soon and that only requires even more open and transparent accountability.

All the best to you in 2013 and thanks again for such a great response.

Chris

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Chris Clothier January 6, 2013 at 2:46 pm

Also – Here is the article on the BiggerPockets Blog you were referring to. I’m glad you liked it:

http://www.biggerpockets.com/renewsblog/2012/08/08/investment-property-management-metrics-to-track/

Chris

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Erik January 6, 2013 at 10:34 pm

Chris,

Sorry, I reread your article and I did I miss the point. Glad you didn’t take my response the wrong way!

Your investors are very confident about their ability to meet future expenses, and simply want higher return on invested capital without paying too much interest.

No doubt, to each his own; and there are many, many different situations and “solutions.” Cheers.

(I’m still, however, partial to the 30 fixed mortgage because the rates are so ridiculously low (accounting for tax break and future inflation), the interest is practically free, and the spreads among the loan terms are relatively small, but that’s an opinion and I’ve already said too much so I’ll leave it at that!)

Best to you in 2013, looking to learn tons more from your experiences!

Eric

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Chris Clothier January 7, 2013 at 8:30 pm

Eric -

Thanks again for sharing and being willing to throw your ideas out there even though they are different than the article. It really gives people a difference of perspective.

I look forward to sharing more in the new year and many more spirited and healthy discussions like this one.

Take care – Chris

Jim January 6, 2013 at 5:42 am

Love the article, Chris, and I DO NOT believe you are off your rocker. I’m a relatively new investor, with one of my first investment properties bought through your firm. And the message conveyed by my Portfolio Advisor that you’ve written about here will ring true for me over the next 10 years as I build my portfolio.

I don’t need or want the cash flow NOW. I will when I’m retired in 10 years, however, and after my systematic pay down of debt, I’ll own those suckers free and clear!

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Chris Clothier January 6, 2013 at 4:33 pm

Jim –

Thanks so much for reading and writing here on the article! I am also very grateful for the trust you have put in my company as you look to build your portfolio. You are like many investors we are dealing with today who are in a position where they are lucky to not need the cash flow today, yet they are smart enough to purchase investments where the fundamental economics provide a positive monthly cash flow on each property.

That gives you a lot of flexibility and leaves the choice there with you on what to do with the extra cash flow after reserves. Your decision to use leverage to purchase is a very good one and then creating a plan to own those properties out right to enjoy the benefit of the full rent is going to leave you in an excellent situation.

All the best to you for 2013 and please don’t hesitate to let me know if there is anything I can do for you.

Chris

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Brian Hoyt January 6, 2013 at 12:08 pm

Chris,

Let’s say you are at prop 1 and have a modest mortgage and some decent cash flow. So the canned strategy right now from most investors is to save up all money possible and get another levered property ASAP.

Your strategy would result in slower acquisition of prop 2. Let’s say investor is okay with slower acquisition. If so, might it be better to use that extra time to save up to put a larger dwon payment on prop 2 than to pay down prop 1? In this case, you are paying down the leverage in a property (the one to be bought) which will increase that property’s cash flow and make it possible to pay off sooner at the same time – as you are advocating. The only disadvantage I see to this approach is that interest rates could increase during this time. But given equal interest rates, I think you benefit more from sacrificing ROI into larger down payments than by sacrificing ROI to principal paydown AFTER the loan is originated. Yes, you can refi once you have paid down the loan to get a similar effect later, but there are refi costs and the interest rates could go up in that scenario as well.

What are you thoughts about this?

Brian

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Chris Clothier January 6, 2013 at 4:39 pm

Brian –

Thanks so much for throwing your comments out on the blog. I am so accustomed to reading your comments and thoughts on the forums and I am really glad you took the time to comment on this article.

I think that with each different situation an investor has to be extremely diligent and honest with their own personal situation. Many new investors will find themselves in a position to start building a portfolio and leverage will be a tremendous benefit to them, but that may not always mean they need to start reducing the principle immediately. That doesn’t mean they need to jump into property #2 right away either. There are many factors that go into the speed at which we should acquire rental property and the proper amount of time and leverage used to acquire those properties.

I just think each investor and each investment are so unique that for some a higher down payment or shorter term or even a straight cash purchase will be the right decision and others will need to work the exact opposite.

I hope you have a great year in 2013 and best of luck with your properties. If I remember correctly you are in the Arlington area of the Dallas/Ft. Worth Metroplex, is that right?

All the best –

Chris

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Michael January 7, 2013 at 7:03 pm

Hello Chris –

Thanks for an excellent article & the difference of opinions in the comments by some intelligent investors just shows you how with real estate it is all about being creative but being responsible in your projections and put in safe guards. NO one really has a crystal ball & we all learn from experience both good and bad and learn what to repeat and not repeat. I have to tell you handled some comments with complete professionalism and did not take anything personally.
A true professional I must say and thanks for sharing your idea’s as I never stop learning and improving as I build my real estate investment portfolio.

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Chris Clothier January 7, 2013 at 7:22 pm

Michael –

I appreciate the comment and am thankful that you found the article and wanted to leave a response. I have to give credit to Josh Dorkin a lot of credit for creating an incredible site in BiggerPockets.com and building a blog that is dedicated to education. Then he surrounded himself with some good people on the site and every writer on here is excellent. So I really do appreciate the compliment, but I have to give some of the credit to Josh as well for creating a environment where good people can have great discussions…and even disagree without getting personal.

All the best to you in 2013 –

Chris

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Joshua Dorkin January 7, 2013 at 8:17 pm

Thanks Chris.

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Cheryl January 16, 2013 at 11:01 am

I loved this article! I’m a newbie buy and hold forever kind of investor because I’m in the business for different reasons. My goal is to restore historic properties all over the country. I just bought my first property cash. I want to do the same for my next property. I would be up at night if I had to depend on tenants to pay the mortgage.

My rule I’m following is if I can’t afford to pay my own mortgage PLUS the mortgage of the investment property with my regular job, I won’t get it. And the mortgage for the investment would have to be low enough to cover if God Forbid I’m out of work. Doing it this way will make me acquire properties very slowly, but it keeps what I’m doing enjoyable and not stressful.

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Chris Clothier January 16, 2013 at 3:10 pm

Hey Cheryl –

Thanks so much for the kind words on the article and for sharing your thoughts. I really like the fact that you have a plan and are being extremely conservative in your approach to your properties. It may be a slower path, but you are in control of your own future and you are going to be able to progress to a level of financial security or freedom that you began investing in real estate for in the first place.

All the best to you in 2013!

Chris

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Ira S. January 21, 2013 at 3:39 pm

Chris, excellent article. I agree wholeheartedly. Look for good economics so that the property works in the long term. My real estate investing philosophy has always been that the positive cash flow must be reinvested into the property; that could mean paying down the mortgage, or doing certain repairs that increases income or produces zero vacancies. The payoff for me is when the mortgage is paid off, I now have another stream of income that does not take much effort on my part, because, the property is well maintained in an area that continues to be in demand. The icing on the cake of course is the capital appreciation.

If you need the positive cash flow to live on, then, you have no business buying real estate as an investment.

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Chris Clothier January 22, 2013 at 6:05 am

Ira –

Thank you so much for taking the time to find and read my article and I really appreciate the comments. Your insights were excellent and you really nailed it with your last sentence. Your philosophy is spot on and as long as it is a plan and philosophy that works for you – that is all that matters.

All the best – Chris

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Jeff December 21, 2013 at 7:22 pm

Good article and I agree with paying off debt quickly. I believe in being as debt free as possible. Loans are helpful tools, but one should avoid over leveraging and juggling debt while chasing after cash flow.

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Jordan T. July 19, 2014 at 9:31 pm

Solid article Chris!

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Ricky August 21, 2014 at 11:31 pm

One thing I don’t understand is why you are saying you have greater cash flow when you leverage. Isn’t the reverse true? More leverage = higher monthly payments = less cash flow. No?

Also, 15yr mortgages are cheaper than 30 so why are you saying that they are .25 to .5 points higher?

Full disclosure: I’m a newbie here so maybe there’s something not glaringly obvious that I’m missing.

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