Should You Pay Down Your Debt or Recycle Your Cashflow Into Capital?

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In my last post, I provided a rough outline of the best real estate investing strategy for regular real estate investors in five steps. One of the cornerstone elements of that strategy is a concerted effort to use the positive cashflow to aggressively pay off the mortgage debt in your real estate investing portfolio.  This produced a very interesting follow-up question in the comment thread from Neil:

I routinely see suggestions that buy and hold investors should always use a pay down strategy as you have suggested here. However, with today’s rock bottom interest rates and the powerful leverage that financing produces, I plan to milk those low rates for as long as possible and to recycle the cash flow from those properties to purchase more properties instead of paying down the existing properties. I believe this will produce more cash flow overall at retirement, in fifteen years, because I will own more cash flowing properties, even though some will still be leveraged. I must admit, however, that I am not sure I know how to calculate whether the paydown or acquisition strategy is better. As you write your next piece, perhaps you would weigh in on those kinds of considerations.

Neil makes a good point. The congruence of bargain basement mortgage interest rates on investment properties, solid tenant demand, low vacancies and rising rental rates make the current environment perfect for more acquisitions. So then, should you use your cashflow to pay off the mortgage debt or recycle it into liquid capital to acquire more properties instead?

As it’s the case with most good questions, the answer is: It depends.

Timing, Time and Capital

Capital growth through debt pay down and recycling cashflow to fund further acquisitions are not always mutually exclusive.

In fact, in most long term real estate investing strategies you see them both utilized at different stages. It’s a matter of timing. While you’re in the process of acquiring the assets you need to obtain the income you want at retirement, recycling the cashflow as acquisition capital will speed up the process considerably. Then once you are done acquiring, you can start paying down the debt aggressively.

But it’s all dependent on how much time you have at your disposal. A real estate investor that has 20+ years till she wants to retire is in a very different position than the investor that needs to retire in three years. The first has plenty of time to delay paying down the debt and focus on acquiring as many quality assets as possible while the going is good. The second does not have the same luxury. They must focus all their resources (cashflow, savings from job income etc) to pay off their debt.

Last, available capital comes into play in this discussion as well. The “either or” type question assumes that the real estate investor must choose between paying off the debt and acquiring more assets. But it ignores the very real possibility that the investor might have sufficient capital to do both. In other words, an investor that  already has the capital to acquire more assets (or has the capability to save enough from her job income) would be better served to attack both fronts simultaneously.

The Slippery Slope to Perpetual Leverage

I think this calls for an important note of caution. While it might be advisable to temporarily put off the capital growth phase of your strategy in favor of taking advantage of acquisition opportunities, it is never in the long term investor’s interest to eliminate it in favor of a perpetual leverage model. As opposed to the strategy I advocated for in my last post, this model involves an investor that builds the desired cashflow by simply acquiring more and more mortgage assets. As an illustration, Investor A and B share the same goal: They would like to create an income stream of $60,000 per year from their real estate investments so they can retire. Investor A uses a Blueprint real estate strategy that calls for the acquisition of 5 quality properties and the subsequent mortgage payoff to a free and clear portfolio by retirement. Investor B uses a Perpetual Leverage model and needs to acquire 12-13 properties that while leveraged produce that same annual income. Further, Investor B intends to follow his Lender’s payoff schedule and not make any attempt to pay off the debt on her portfolio any faster.

So what’s the problem with Investor B’s strategy? Well there are a couple of major problems actually. First, Investor B’s portfolio carries significantly higher risk. That might seem like a bearish statement given the “flowery fields” environment we find ourselves in currently. But remember two things.  As Mark Cuban once said, everyone’s a genius in a bull market. And most importantly, Murphy’s address book is always up to date and he knows where you and I live. When you commit to invest in real estate long term, you have to assume that somewhere in your investing timeframe, the wind isn’t going to be in your favor. And most importantly, if your strategy doesn’t have the capacity to absorb a soft market because increasingly risky bets, chances are that the unfriendly wind will break down your sails and leave you stranded. Second, when you reach retirement, would you rather manage more or less assets? Don’t answer that.

I’ll leave you with one more piece of advice. Most long term real estate investors go astray when they focus more on return than they do on income and risk. Let me ask you a question: Which is better, a 15% or an 8% return on investment? Here’s the answer: That’s the wrong question. The right question-  What’s the capital base you’re calculating your return on? If you own three leveraged properties that produce $15,000 of income per year on your $100,000 invested capital, is that better or worse than 8% or three paid off properties that produce $40,000 in annual income? At retirement, the only two things that matter are the nominal income your portfolio is producing and the level of risk in it. Everything else is distraction.

Thank you Neil for the thoughtful question and the fuel for this post. Please keep them coming.
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About Author

Erion Shehaj (G+) is Investing Architect. He helps people craft a Blueprint investing strategy that leads to accelerated capital growth, higher income and lower taxes. Side effects might include: Early retirement, wealth and piece of mind. Follow on Twitter if that's your thing.

18 Comments

  1. Nice work. As for me, I guess I’d be in Neil’s camp.

    I have a question on your last paragraph, you mentioned:

    If you own three leveraged properties that produce $15,000 of income per year on your $100,000 invested capital, is that better or worse than 8% or three paid off properties that produce $40,000 in annual income?

    I guess the answer to this would be what your time horizon is for retirement, right? If you are early in your investing career, IMO your better lock in fix debt at 4-5% over 30 years. If the loans are amortized, you’ll still end up with a free and clear property, right? I guess this all depends on when you start the amortization process. Regardless, you made some interesting points.

    As for me, I’ve been doing everything I can to acquire in this down turn. My market has already shifted in a positive direction (california is a wacky market). Most of our properties have already appreciated 20-30% since the bubble popped. In addition, the inventory in our market went from a 9 month supply to 3 weeks. Our strategy is to keep acquiring until we run out money and can no longer positively cash flow new acquisitions. At that point, we’re looking to exit half of our properties and use the equity to pay down the other half and hold on to a 3rd as rentals, one third as notes and the other 3rd for hard money lending.

    Again, like you mentioned, everything is a risk, so each must make their own choices. I appreciate all the effort you put in your post though. As a fellow blogger, I can appreciate the time and energy it takes to put something like this together.

    Happy Investing!

    AG

    • Erion Shehaj

      Hi Arthur

      I appreciate you taking the time for a thoughtful comment.

      “I have a question on your last paragraph, you mentioned:

      If you own three leveraged properties that produce $15,000 of income per year on your $100,000 invested capital, is that better or worse than 8% or three paid off properties that produce $40,000 in annual income?

      I guess the answer to this would be what your time horizon is for retirement, right? If you are early in your investing career, IMO your better lock in fix debt at 4-5% over 30 years. If the loans are amortized, you’ll still end up with a free and clear property, right? I guess this all depends on when you start the amortization process.”

      The time horizon for the investment is an important factor. But my point was that when a long term investor is getting started she ought to focus on two things: The total income produced by her portfolio and the risk within it. I see so many investors that obsess over their cash on cash return to the detriment of their results. In fact, I know many of them that are earning 15-18% on their money but the nominal income amounts to Starbucks money good enough for three dozen lattes a month. Hence my question – Is it better to make a sizable income while earning 8% or earning 15% while making peanuts?

      Now, about locking in for 30 years at 4-5%. I think you’d be hard pressed to find an investment guy that loves these interest rates more than I do. :-) And we are advising all our clients to lock for 30 years so they have the option but not the obligation to pay down debt. But that said, every investor who has just locked for 30 years has a choice to make and it’s the premise for this post: Do you use that cashflow to pay down debt so your capital base is large enough to meet your income goal or use it to acquire more? And more than anything else it’s a matter of risk tolerance. If all goes well, the properties will be paid off in 30 years anyway so we can just keep buying. Until all doesn’t go well. I don’t have any hard data to quote on this – especially because we almost never hear from investors who fail into the sunset. But do you care to guess how the number of failed real estate investors is split between those who had highly leveraged portfolios and those who opted to pay down their debt? But I agree with you that it’s a choice every investor makes on their own and there’s certainly a spectrum of risk tolerance on which I lean conservative.

      As for me, I’ve been doing everything I can to acquire in this down turn
      Right there with you brother. :-)

  2. Two things about this post:
    1. who in the world can retire on a $60,000 a year income?
    2. your comment about Murphy’s address book made me laugh out loud (no kidding).

    Your early statement was right on, “depends.” Depends where you are in your real estate investing career and with your goals. I started out wanting 5 properties, then 25, then… who knows?? We were leveraged and loved partnerships. Now, years later, we wholesale and flip properties like we’re on fire to pay down mortgages on what we’re holding. Earlier in our investment career, we weren’t ready for payoff.

    Great post and so well laid out. Thanks, Erion.

    • Karen

      In Texas, $60k a year plus Social Insecurity and a paid off home will get you a very comfortable retirement. And I suspect that’s true in many other parts of the country too.

      I’ve always wondered what contact management software Murphy uses – it’s impeccable :-)

  3. I would like more than 60k per year to retire on, but truthfully, I’d say most areas of the US you could retire fairly comfortably on that. (assuming certain things like paid off mortgage, reasonable tastes etc) I have a family of 3, private catholic school, horseback riding lessons, 2 far away vacations per year plus camping and we get along on 50-60k per year.

    • Your comment is spot on Ken. It’s true that in areas where the cost of living is quite high – see, West Coast and Northeast – $60k doesn’t begin to make a dent. But in most parts of the country, that type of income for a de-leveraged retiree will do the trick quite nicely.

      Now, I’m not opposed to upping that to $90-100k a year so that there could be some traveling involved :-)

  4. A fine post Erion!

    I have been struggling with this for a couple of years now. Early on in my buy and hold investing I would always try to put the least amount down and would never dream of paying down debt. The argument I would make to my spouse and another investor friend was that it was better to own 10 properties with 90% LTV than 1 property free and clear from a cash flow point of view. They agreed with the logic of my argument but couldn’t put their finger on why it didn’t feel right.

    Now its many years later and my perspective has changed. I appreciate the risk aspect of it and also the multiplication of maintenance. Mo’ houses, mo maintenance. So just like Henry Ford, when the situation changes I change my mind. Now I will have my first property paid off early next year and am on a schedule that should allow me to pay the rest off every 1 to 2 years. We are however still acquiring (slowly) new properties when they are desirable. I believe I am fortunate to fall into Erion’s 3rd category:

    “… an investor that already has the capital to acquire more assets (or has the capability to save enough from her job income) would be better served to attack both fronts simultaneously.”

    And that is exactly what I have been doing.

  5. I have a couple of points

    1) having properties with no mortgage is a bad idea both from an investment Point of view and a risk point of view. Having properties paid off is a huge target for lawsuits from tenants if it’s not protected properly. And having all your money sitting there earning nothing isn’t a wise use either.

    2) what about inflation eating away the mortgage.

    • Hi Shawn

      Whether your portfolio is paid off or leveraged up to the nose does not change the liability risk that is inherent in owning investment real estate. If a tenant has a liability claim towards the Landlord, they will sue the Landlord regardless of his LTV. I agree that measures ought to be taken to protect the investor from that risk. But the idea that somehow you are at a higher risk because you opted to pay off your debt on your investment is without merit, in my opinion.

      When your portfolio is free and clear, your money isn’t just “sitting there earning nothing”. It is earning the capitalization rate. That may be 8 or 9% per year which is 2.5 to 3 times the rate of inflation. Your return may be higher than that with debt leverage but your risk is also higher. In fact, your risk adjusted rate of return with mortgages would be lower than your risk adjusted rate of return with a free and clear portfolio.

      Makes sense?

  6. That is a question that has been on my mind for years, my plan is to in 10 years sell the highest appreciating properties and use the equity to pay down the mortgages on the remaining properties.

    • Lear

      When Murphy cooperates, that plan works like a charm. Problems arise when he’s grumpy and there is no appreciation of which to take advantage. The Houston market where I operate is a steady and slow appreciation market so our planning does not count on appreciation to meet goals as appreciation can’t be counted upon. We treat it as a nice bonus. If it happens, we will be happy – if not, no damage done.

  7. Erion,
    Thanks very much for taking on my question so directly. It is funny sometimes when the answers aren’t found in some complicated algebra equation, but on common sense considerations like how many rentals to manage in retirement and minimizing risk in the portfolio. I have calculated how long it will take to paydown the mortgages and how much income the free and clear properties will likely produce in retirement and I am feeling a lot more at ease with simply paying off the existing properties. Thanks for the peace of mind.
    Neil –

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