Landlording & Rental Properties

Case Study: How to Replace a $70,000 Job Income Using Rentals (for the Math-Averse!)

Expertise: Personal Finance, Landlording & Rental Properties, Personal Development, Real Estate Investing Basics
38 Articles Written
replace-salary-rentals

The first step to properly answer an important question is to challenge its premise. In this case, the premise is that since you’re currently earning $70,000 per year in your job, you would need to replace that entire amount if you needed to maintain the same standard of living in retirement. But is that really true?

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Take a look at how your current income is utilized. The majority of your current income goes to covering living expenses like mortgage, food, utilities, debt payments, etc. But some of it usually goes to fund retirement investment accounts. Some of it may go to fund education accounts for your children. Lastly, if you’re living below your means, some of it would go to savings. When you retire, the passive income you will rely upon must cover your living expenses. But you will not need to keep saving for retirement, and your children will probably be out of college so you won’t need to fund any education accounts.

I get why most long-term investors pick their current job income as the target for their retirement income. By our very nature, we don’t like change — especially when it comes to our finances and especially when we view our current position as comfortable. So, to set a goal of simply changing the source of the income (from active to passive) but not its quantity makes sense. However, I see many investors who postpone their retirement indefinitely because they can’t reach a certain level of income, which, upon closer inspection, isn’t necessary for them to retire in the first place.

Perform an Audit

My advice to you is to do a quick audit of your personal income and expense statement to figure out exactly what your necessary living expenses are for the lifestyle you want to lead in retirement. That amount is the minimum required for your retirement. Then, if you’d like to cushion that amount to allow for fun, discretionary items like travel, extra spending money, etc., that’s perfectly fine.

Having questioned that premise to death, now let’s assume that $70,000 is the right income amount you need to create through your real estate portfolio.

How many rentals will it take for you to reach that goal?

The answer will depend on two main things: the investing model to follow and the type of investment property you target.

real-estate-negotiation

Related: 6 Powerful Benefits of Quitting Your Job and Becoming an Entrepreneur

Real Estate Investing Models

There are countless permutations of real estate investing strategies that you can follow in pursuit of your goal. But if we zoom out and take a look at the big picture, there are two primary investing models or schools of thought. Neither of them is wrong or right in and of itself. You have to figure out which one is a better fit for your investing style and aversion to risk.

First, let’s go over some fundamentals. Income (or cash flow) is the yield on capital. Think of it as a dividend on your money invested. If you had enough capital lying around, you could create whatever income stream you wanted by simply purchasing the required amount of real estate. For example, let’s say you had a cool million dollars in your glove compartment doing nothing. You could purchase $1M worth of real estate that yields 7% per year and create an income stream of $70,000 per year without breaking a sweat.

Of course, the problem is most of us don’t have a cool million dollars just lying around, so the fundamental problem we need to solve is how do we acquire enough real estate using the capital we do have to achieve our goal.

Now, the amount of real estate you need to own will depend on the long-term real estate investing model you follow.

The Perpetual Leverage Model

The first real estate investing model was popularized by Robert Kiyosaki and his bestselling book Rich Dad Poor Dad. The idea itself far pre-dates Mr. Kiyosaki, but his successful book certainly popularized the model. Let’s call that school of thought the “perpetual leverage” model. The idea is simple and it focuses squarely on cash flow.

Suppose you purchase an investment property for $100k, putting down $20k of your capital and borrowing $80k for 30 years at 5%. After the purchase, you turn around and lease the property for $1,000 per month, and your operating expenses are $400 per month, leaving you will $600 per month to service the debt and make a profit. The mortgage payment is $430 per month, so your positive cash flow is $170 per month.

The perpetual leverage model assumes that the property will remain leveraged for the entire term of the loan (hence the name "perpetual") and you will make mortgage payments according to the schedule the lender set when they made the loan. In essence, the property is a leveraged ATM machine that throws off $170 each month.

So back to your goal: You want to replace $70,000 a year in job income with passive real estate income. That means your real estate portfolio must produce $5,833 per month in income. If we assume that each property you own will produce a leveraged cash flow of $170 per month, you would need to own 34-35 such properties to achieve your goal under the perpetual leverage model ($5,833/$170).

The Smart Leverage Model

The second long-term real estate investing model is the “smart leverage” model. It recognizes the fact that leverage is necessary to bridge the gap between the capital we have and the real estate we must acquire to achieve our income goals. But it simply uses leverage as a tool in the acquisition of a larger asset value, not a support column to hold the weight of your entire portfolio. The basic idea is that an investment property produces the maximum amount of nominal cash flow with the minimum amount of risk and management when the investment property is free and clear. Second, under this model, cash flow is very important, but its timing is more important.

In the end, we’re all after cash flow. The crucial question is, when will you need this cash flow? Every investor I have spoken to over the last decade has told me they’re after creating cash flow. When I ask the question of when they need the cash flow, a puzzled look comes over their face and they ask me to clarify what I mean. My point becomes crystal clear when I ask them if they’re planning to use current cash flow to pay that month’s light bill or buy groceries. What most real estate investors are really after is cash flow at retirement.

Related: 10 Challenges to Seriously Consider BEFORE Quitting Your Day Job

If that’s true for you, doesn’t it make more sense to use current cash flow (which you don’t need to cover current expenses) to grow your asset value through paying off the mortgages that encumber them? In other words, under this model, we will NOT pay off the mortgages according to the schedule your bank set. Which brings up an interesting question: When the bank set that schedule, do you think they did it because it was good for them or because it was good for you? I rest my case.

Back to the case study. That same investment property that produced $170 per month in leveraged cash flow would produce $600 per month in cash flow if it were free and clear ($1,000 rent less $400 operating costs). Therefore, you could achieve the same $5,833 per month in income by owning 9-10 free and clear properties (instead of 34-35).

Putting aside the question of how you could reach the point where you own 10 free and clear properties for a moment, which investor would you rather be? Would you prefer owning and managing 35 properties all the while carrying a multi-million dollar mortgage balance or would you rather own 10 free and clear properties if both methods produced the same passive income? Lastly, do you think one method leads to an inherently riskier portfolio, and how does that factor affect your decision?

The answers to these questions will indicate which model works best for you and your investing style.

Property Types

The second factor that determines how many properties you need to acquire is the type of investment property that is available. In the case study above, we used a $100,000 single family property (because it’s a nice round number that makes it easier to calculate). But in your specific situation, the numbers will likely be very different, as will the types of available property at your disposal. As an example, in your market, there might be an available supply of small multifamily properties (2-4 units) that fit your property criteria. The numbers on these properties would vary quite a bit from the simplistic example I provided above.

But the principle remains unchanged.

  1. First, determine which model you want to pursue.
  2. Then, get clear on the basic numbers of an “average” investment property in your target market (price, rent, operating expenses, net operating income, debt service, and cash flow).
  3. Depending on the model, you can divide either the monthly cash flow (perpetual leverage) or monthly net operating income (smart leverage) into the monthly passive income goal to determine the number of properties you need to acquire.

[Editor’s Note: We are republishing this article to help out our newer readers.]

Which model do you (or would you) use to determine what you need to replace your income? Where are you in this process?

Let’s talk in the comments section below!

Erion Shehaj helps successful professionals achieve financial independence using the Blueprint Real Estate Investing™ strategy. By combining the principles of robust financial planning with quality real estate investments, Erion shows ordinary people how to replace their salary with passive income and retire early to live life on their terms. Over his real estate career of 13+ years, Erion has helped his investor clients purchase $90M+ in real estate assets to build robust real estate portfolios and streams of passive income. In addition, Erion has been involved in successfully rolling out small multifamily new construction projects across Texas. Erion has written extensively about long term real estate investing and business in several publications like BiggerPockets (since 2013), Investing Architect, American Genius, Geek Estate and more.

    Deryk Harper Residential Real Estate Broker from Alpharetta, Georgia
    Replied over 2 years ago
    Thanks for sharing Erion. That was very well written. My wife has always been pro cash investments and I have always been a little more towards the leveraged side. We have compromised and decided to use half the extra cashflow we have to pay down more investment mortgages, and half to continue to invest in more units, until we reach our goal. We are getting up in years so our timeline differs from from younger investors. But, as you said, the principle remains the same. Thanks again for taking the time to share your knowledge and experience.
    Aaron Franz from Madison, AL
    Replied over 2 years ago
    Sounds like a sound compromise to me! My wife and I will be doing the same when we get a couple more properties under our belt.
    Jerry W. Investor from Thermopolis, Wyoming
    Replied over 2 years ago
    Erion, thank you for your article. The biggest single factor for me in picking a retirement number is health insurance. What my salary is can be very important, but if my health insurance is $2,500 per month with a $5,000 deductible, then I need to rewrite my retirement number. One of the reasons that starting your investing career early is important is you can pay your properties off over time and have them free and clear many years later. While I have invested in real estate for over 20 years, it was only in the last 3 years I got aggressive. I have used 15 year loans in order to pay down my properties quickly. It is more of a challenge to get properties to cash flow or break even on 15 year notes, but they build equity quickly. I have just recently started using some 20 year mortgages in order to up the cash flow as I know I will not have them paid off by the time I retire. Since I do not need the income to live on I hope that I can use the extra cash to pay off other mortgages early. While I would like to retire in 2 years, I realize my investments do not cash flow enough to do that, and the earliest I can began getting any retirement is 4 years away. It is nearly 10 years before I could draw maximum social security, and I sure hope I am not working full time at that time.
    Chris Ayers Rental Property Investor from Warrenton, VA
    Replied about 1 year ago
    I agree health care is a worry to all of us. That might be the reason instead of full out retiring really early I might switch to a Tues-Thurs 30 hour week for awhile.
    Larry Tam Investor from Hayward, California
    Replied over 2 years ago
    Jerry, I always go for the longest term available to me, be it 30 year or even 40 years. I can then choose to make larger payments as though it was a 20 year or 15 year loan to pay it down faster. However, it gives me the flexibility to go back to the lower 30 year payment amount if times get tough financially. The other advantage to making the larger payments than necessary on a 30 or 40 yr loan is that it effectively lowers the interest rate I am paying the lender, as if I had closed on the shorter term loan. But even if it is a little more interest, I think it is worth the extra cost to buy more financial flexibility.
    Kevin Jorgensen from Beaverton, Oregon
    Replied over 2 years ago
    This is the path I would follow. Picked up the advice from Edelman.
    Christopher Neeson Investor from Alaska
    Replied over 2 years ago
    The real question behind this is what will that $70,000 a year or even double that $140,000 a year be worth in 30 years. We have already seen inflation take its toll sending cars from $4000 new to $40,000 new. Yes real estate tends to keep up with inflation better via rents, but you know what else does. Repair costs….. I am not aiming to replace mine and my wife’s income, I’m looking to triple it. Based on health care rates, inflation, and the cost of repairs as well as any other unexpecteds. I am planning to Triple our household income with real estate investing. Within 3 years we have already acquired enough to replace our incomes when loans are paid off. This includes 5 year 6 year ballons on 16 units and 30 year loans on 6 units. Once you have found true high ROI, high Cashflow properties you will never look at an average market again. I say anyone in 2040s retiring will probably need at minimum a $100,000 income just to survive. My prediction based on prior 50 years inflation
    Jeff
    Replied over 2 years ago
    The first method is actually the “smarter” method. You can capture more equity by buying more properties (below market value hopefully), you are better diversified, and most importantly your return on equity is higher, thus a more efficient use of capital. It’s just numbers and the numbers should dictate your decisions.
    Colin March Rental Property Investor from Portland, ME
    Replied over 2 years ago
    Jeff, I totally agree with you. Not sure why so many people are missing the analytical part of this.
    Erin L. Investor from Venice, CA
    Replied over 2 years ago
    Yes – ROE Return on Equity starts decreasing as the loan gets paid off – so your return on your available money is less as years go by, hence better to pull that money off after reaching a certain amount of equity and find a higher ROI.
    Nathan Mansur Investor from Buffalo, New York
    Replied over 2 years ago
    I love the thought process posted here, especially what Erin said about Return on Equity decreasing over time. This is very important in the analytics to accomplish our goals long term. Finding that balance of cash flow and stopping diminishing returns to find higher ROI is key in the EARLY stages of your investing career, such is my situation. Once a predetermined amount of properties is obtained, then you can accelerate payments and thus gain financial freedom.
    Felicia Benson
    Replied over 2 years ago
    Agreed. The key is to keep your cash moving through your assets… Think of it as having an infrastructure of cash flowing pipelines. Don’t let your cash ? sit! I tell people I don’t care if I ever pay my mortgages, but if I do then awesome. My planning is on the current ROI… Not what it would be in thirty years. Conservative approach always. No fluffing.
    Kenneth Freire from Minneapolis, Minnesota
    Replied over 2 years ago
    Hey Erin. I’m new to bigger pockets and I’m just getting started with educating myself with Real Estate Investing. I’m not sure what you mean by ROE. Can you expand on this concept or direct me to another blog that explains this. Thanks!
    Patrick Kim from Sunnyvale, California
    Replied over 2 years ago
    I’m a lil slow on this ROE concept as well :/
    Jeff Bader Investor from Portland, OR
    Replied about 2 years ago
    I believe what Erin means by ROE is that, while the rate of increase of the portion of the mortgage payment that is going towards principal pay-down (equity growth) is fixed (let’s say it’s increasing at 0.3% per month), the rate of increase of the overall equity will be decreasing every month. Let’s say equity growth starts at 0.5% at the first month, but after about 4 years, the month-over-month equity growth will have decreased to 0.45%. The exact numbers will vary widely based on the terms of the loan and how much was put down. But the idea is that the equity’s rate of growth is always continually decreasing, so the argument is that a growth-focused strategy would require the investor to periodically re-leverage in order to make the best use of their capital. Whether it’s 1031 exchanging up or refinancing, maintaining leverage is required for equity growth. When there is no leverage, cash flow may be maximized, but growth is minimized.
    Dante Pirouz Rental Property Investor from Fort Gratiot, MI
    Replied over 2 years ago
    Great article! It seems so difficult to get to 30-35 units in a short period of time but the free and clear ownership model makes a lot of sense.
    Nicholas Lohr Investor from San Francisco, CA
    Replied over 2 years ago
    Hi Diante, I feel the same way, totally makes sense in a perfect world. I just can’t get past the HOW part? any thoughts?
    Liisa
    Replied over 2 years ago
    I’ve been thinking a lot about this lately. I have about a dozen units already with decent cash flow but want to start directing the extra cash towards paying the mortgages off early. Does anyone know if there is an app to calculate different scenarios with regard to which property to payoff first, and then the second, etc????
    Andy H. Investor from Stockdale , Texas
    Replied over 2 years ago
    Lisa: Try googling “cash flow index”. I have heard a couple of people talk about using this formula to determine which mortgage to payoff first, and it seems to make sense.
    bob B
    Replied over 2 years ago
    the answer is simple. the smallest on so you can have a free and clear house faster
    Chris Billington Investor from Wheat Ridge, Colorado
    Replied over 2 years ago
    I incorporate this strategy to a degree and would have to say the answer depends. The way I look at it is why not pay the highest interest rate property off first. Why pay the smallest if it’s the lowest rate. Too many factors to find the right answer.
    Chris Billington Investor from Wheat Ridge, Colorado
    Replied over 2 years ago
    shoot how about highest rate/longest term left…..
    bob B
    Replied over 2 years ago
    the answer is simple. the smallest on so you can have a free and clear house faster Reply Report comment
    Robert Burge Investor from Rio Linda, California
    Replied over 2 years ago
    At the time of this posting, we have 5 rental mortgages, we are paying them off, smallest to largest, regardless of interest rate. I found a extra mortgage payment spreadsheet on Google and have used that to develop our plan.
    Nathan G. from Cody, WY
    Replied over 2 years ago
    I see a lot of investors trying to build a portfolio of homes cash-flowing $100 – $200 with the intent of living off cash-flow while maintaining leverage. This is a risky method and I expect we’ll see a lot of people lose their shirts in the next few years. Why? The market could disappear in their area, driving rents down or depleting the inventory of renters. There are unforeseen maintenance costs. They could lose their primary job, forcing them to rely on the cash-flow to make ends meet and start losing properties. When heavily leveraged, one domino can topple the entire plan. If you’ve ever listened to Dave Ramsey, he is a great example of a hot-shot real estate investor worth millions but it came crashing down because he was highly leveraged and the market turned. Investors are wise to prepare for things to go bad. If you have ten properties cash-flowing $100 and haven’t set money aside, what will you do when two of the houses go vacant, you lose your job, and you have a $5,000 repair bill? Many investors are cash-flowing $100 – $200 a month when we are experiencing peak rent rates. What happens when the rental market slows and you have to drop your rates to keep the property filled? With that kind of leverage and low cash-flow, it doesn’t take much to put you in the negative pretty quick and suddenly the properties are costing you money. The wiser choice is to save more and buy fewer properties with less leverage. Each property should stand on its own, meaning it produces enough cash-flow to cover the mortgage, vacancies, and major repairs. Set aside an emergency fund for each property. Once the fund is established, use the extra cash-flow to pay the property off faster. I’ve been trying to decide on a strategy and was stuck on the idea that I needed dozens of rentals because everyone else seems to be going for quantity. But the more I think about it, the more I’ve come to realize that it’s a high-risk strategy. A smarter strategy is to slowly purchase a small number of quality properties with no less than 30% equity. Cash-flow from each property will be set aside to create an emergency fund. Once the emergency fund is built for a property, I will use the cash-flow towards accelerated payment on the smallest mortgage. Whether I have three properties or 10, I will apply the cash-flow towards paying off the mortgages until they are paid off. In less than ten years I should have ten properties fully paid for, cash-flowing over $10,000 a month, a net worth in the millions, and only a few properties to manage which will greatly reduce the demands on my personal time.
    Michael Greenberg Investor from Denver, CO
    Replied over 2 years ago
    Great stuff Nathan! I have recently invested in a couple of vacation rental properties and are using the cash to pay them down as quickly as possible and I track each property with their own P&L. Fascinating results and not what I expected. I plan to grow this portfolio slowly and as each P&L allows and until I reach my cash flow goals – which will protect my personal lifestyle as you indicated as well. Cheers, Mike
    Jonathan Pezzoli Real Estate Agent from Wilmington, North Carolina
    Replied over 2 years ago
    I like the lesser risk strategy you suggest. When do you look for another property to purchase? Do you have a max number of Mortgages you’ll take on? At some point there is leverage happening if you’re acquiring 10 properties in 10 years.
    Nathan S. Rental Property Investor from Minneapolis, Minnesota
    Replied over 2 years ago
    Nathan G, what do YOU usually save as a flat dollar amount or percentage for a reserve or emergency account?
    Terry Koepp Investor from Marion, Iowa
    Replied over 2 years ago
    I totally agree with your logic and strategy! I too will be using this model to get 5 to 10 properties free and clear in 10 years or less!!!
    bob B
    Replied over 2 years ago
    you are right. in a recession expect a 20% decrease in rent and you could lose your job for a year. plan for it. 30%+ is where the commercial (smart money) starts to feel safe.
    Colin March Rental Property Investor from Portland, ME
    Replied over 2 years ago
    Bob, where does this “20% decrease in rent” come from? 2008/09 was a pretty good stress test and rents didn’t really fall owing to the switch from owning to renting (ie, if you can’t buy a house, you need to rent, thus rental demand increases). You have a good link you can send me on regional rents in the US? I’ve heard of 20% decreases when population decreases. I’m not talking about Class A properties here, clearly.
    Alex Cordero from Las Vegas, Nevada
    Replied over 2 years ago
    This was part of my thought process from the very beginning. I’ve had trouble pinpointing exactly which REI strategy would not allow me to place all my eggs in one basket. I DO NOT want to be over-leveraged, yet I do want to build and have a great list of properties that are cash flow positive. Therein lies my predicament. I thoroughly enjoy your thought process of planning ahead if the market were to take an unprecedented turn. Fewer properties (less leverage), each property can survive on its own, then pay down the property w/ the lowest balance w/ returns! Thanks for the insight Nathan.
    Anna M. Investor from Denver, Colorado
    Replied over 1 year ago
    This is such a great strategy even a year letter of your comment. I have thought long and hard about what strategy I want to use and for someone that self-manages I know that I want my cashflow quicker, with less work, i.e. fewer properties to manage. I also add value to my properties so as to attract quality tenants and be able to command a higher rent (as high as the market will allow, but also not being the highest either), enough to further increase my cashflow. Then work on getting to free and clear quicker, all while keeping my 30Year to allow for flexibility should I need a longer term, but just paying it down like a 15, 10 or 5. Thank you Nathan. You always have such great insight and I was particularly excited to read your comment on this one as it is in line with the strategy I have been thinking up. Thank you to you and all those that commented as well as Erion Shehaj for this post. 🙂
    Nathan Smith from Austin, Texas
    Replied over 2 years ago
    I agree with Nathan G. Strategy. You can leverage more and buy more properties however depending on your market that can be risky. Get caught in a down market with 20 properties that are barely cash flowing you might suffer a loss. If leveraging you need to make sure you buy “right”….. meaning cash flow more than $100-$200 per month.
    Grace
    Replied over 2 years ago
    Well said. I was going to make a very similar response to yours but you said it all. Over the last 10 years i have acquired 22 rentals. Mainly town homes and condos with a few single family thrown in. All but one are free and clear of debt. When I started I saved up the passive income till I had enough to buy the next unit. I also utilized a line of credit I had so if something came on the market that I did not want to miss I could grab it. But I concentrated on paying that line down with the rentals passive income ASAP. I am a Dave Ramsey fan as well as an ELP for him. In the last real estate market crash I saw a ton of investors including Real Estate agents lose everything due to over leveraging. So use caution when investing. Right now I have put a hold on purchasing in my market areas as the cash flow and return is not there for rentals. But when the market cycles through again I will be ready to buy again.
    Anudeep Yapala Rental Property Investor from Chandler, AZ
    Replied over 1 year ago
    Hi Nathan, Good view. I am some what similar thinker as your post. Anudeep
    Nicholas Lohr Investor from San Francisco, CA
    Replied over 2 years ago
    Erion, To me the tone of your article implies that the 2nd model is the superior one. You even used the term “smart” there in the title of it. And the questions you posed at the end of that section seemed rhetorical. I’m confused though. How can an we just “put aside” the HOW part? That’s the sixty-four thousand dollar question is it not? Focus all energy/ money on paying off each property as fast as possible, faster than the bank wants? Sure sounds great, but to me the HOW part of where that money comes from is the biggest part! It’s like telling someone who has saved up $30-50k, which I’d guess 99% of the people reading this, including myself, is the best we can reasonably do after a pretty long period of saving, to just go out and “get” 10 free and clear properties. After reading this I had a feeling of, “unless I can find 2 million bucks somewhere to buy 10 properties or I want to work at the “other” job for the rest of my life slaving to pay them off one by one, there is no choice, it’s leverage.”
    Mark Otto from Saint Paul, Minnesota
    Replied over 2 years ago
    Hi Erion, this is first time I have posted on BiggerPockets. I’ve seen a couple of your questions and thought I would share my two cents. For starters I own 16 single family homes in a college town with two business partners (more on that some other time). The how part was not easy for me, our group started saving $100/mnth 15 years ago, took that money invested in the stock market, then 9 years ago right before the crash of 2008 we pulled all of the money out of the market and bought two houses (yes are timing was purely luck). From their we took the cash flow and every time we saved up 30-40K we bought another house, we also got a line of credit from our bank for those can’t walk away from opportunities. And now here I am having bought houses for 9 years have 16 and we are starting to take an income/draw for the first time. So the question becomes money now or money later, paying down hurts your money now, but increases your money later. I’m 38 we have 10 – 30 year mortgages, 1 – 15 year, 1 – 25 year and 4 – 5/1 ARMS. So the answer is time it takes time and in our case we also used some private money from family that we pay a good rate on, good deal for them good deal for us. Good Luck buying rentals has been the best financial decision I have ever made.
    Felicia Benson
    Replied over 2 years ago
    You gotta milk the cows…. Not slaughter them. Totally agree with you 100%.
    Veronica cabrera
    Replied over 2 years ago
    Do you teach workshops? We would love to learn more! Is it possible for a family like ours to achieve something like this?
    Gautam S. Real Estate Investor from Eola, IL
    Replied over 2 years ago
    Very good point, @Nathan Gesner. I am also for paying off mortgage from 7-10 yrs time frame. The you will have a peace of mind as well as a solid cashflow of your portfolio. I eve suggest to buy few extra properties and keep them cashflowing for say 5 years and sell them to pay off your lowest balance mortgage. a good number is 5:1 ratio. Every 5 SF rental Add one SF that will be sold after 5 years with some healthy profit taking with the equity that you build over the years! Good article & thread!
    Dave B. Lender from Denver, CO
    Replied over 2 years ago
    Not a bad strategy, it’s too bad a 1031 won’t let you pay down the mortgage on a previously owned property. Otherwise, this would be ideal.
    Gary
    Replied over 2 years ago
    I prefer the second model. It would drive me crazy to have 35 more mortgages while I was retired.
    Jean Rhem
    Replied 10 months ago
    Lol I agree!
    Mike Dymski Investor from Greenville, SC
    Replied over 2 years ago
    Well written article. There’s another model…partial leverage or leverage until you reach critical mass or near retirement and then scale back. Leverage and taxes are the best aspects of direct ownership in real estate and there are other more passive assets than direct ownership if your goal is single digit returns. Direct REI is too much work to not achieve outpaced returns.
    Doreun Ramalia from Granite Bay, California
    Replied over 2 years ago
    If I own 10 properties and they produces 70K in cash flow, I will pay taxes on that cash flow. If I mortgage 35 properties and they produce 70K in cash flow I will likely pay very little in taxes on the cash flow because of the additional mortgage interest deduction. Therefore, net return on the leveraged portfolio is greater than the owned properties.
    Sylvia B. Rental Property Investor from Douglas County, MO
    Replied over 2 years ago
    Doreun, your math is off. “Cash flow” is what you have left after all expenses are paid, (including mortgage interest) so in either scenario, you will pay tax on $70k. However, if you meant that in the second case you have $70k – mortgage interest, of course you will pay less tax. You have less income! If $30k out of that 70 is going to mortgage interest, then you will have $40k to put in your pocket. Uncle Sam wants 30%, so you get $28k. But if you don’t have a mortgage to pay, all of that $70k is yours. This time Uncle Sam takes $21k, leaving you with only $49k. So you tell me, which is the better net return, $28k or $49k?
    John Crouch from Nashville, Tennessee
    Replied over 2 years ago
    You aren’t considering the tax effect of mortgage interest. Cash flow, at least around BP, typically means cash flow before income tax. If you get to deduct mortgage interest, which you typically do, when calculating your taxable income, then you will most certainly pay less tax on higher leveraged property that is producing the same income and expense. When comparing the two scenarios above (35 with leverage vs. 10 free and clear while keeping income and expense the same), assuming 30% of your mortgage PMT is interest and a tax rate of 35%, your after tax cash flow is quite different. 35 with leverage leaves you with 65K while 10 without leverage leaves you with 47K.
    Sylvia B. Rental Property Investor from Douglas County, MO
    Replied over 2 years ago
    You still aren’t getting it, and yes, of course tax flow is before tax, but it is NOT before expenses. Mortgage interest is a business expense. It is subtracted from gross receipts just like other expenses. If the leveraged properties have $70k in NET income, the mortgage interest was already counted as an expense and cannot be used again as an additional deduction on the 1040. In that case, the tax bills would be identical. If that $70k “cash flow” did NOT include the interest expense, it is not a true reflection of what you put in your pocket. Your 65k after taxes is not correct, because you didn’t subtract what was paid to the bank.
    John Crouch from Nashville, Tennessee
    Replied over 2 years ago
    Ok, good point. I’m still thinking in terms of a W2 wage earner with primary mortgage interest. So, in reality, you would actually have a higher taxable income with the leveraged property because the principle portion wouldn’t be treated as a tax deduction, right?
    Sylvia B. Rental Property Investor from Douglas County, MO
    Replied over 2 years ago
    Right.
    Douglas Dieckgraefe from St. Louis, Missouri
    Replied over 1 year ago
    Forget the mortgage interest. Yes, it is already treated as an expense before taxes. So after that and other expenses you would be left with 70k cashflow either way and at first glance deal with the same tax burden, but there is one thing both of you have forgotten. Depreciation as a phantom expense reducing your tax burden on the leveraged properties. With 10 properties producing 70k you have less to depreciate, but with 35 properties producing 70k (assuming the properties all cost roughly the same) you have 3.5 times the depreciation which could allow you to completely avoid paying tax on that cashflow and even appear as a loss allowing you to write off additional income. Am I missing something here because it seems leverage is better?
    Will Koederitz from Royal Oak, Michigan
    Replied over 1 year ago
    I still think there is a tax advantage. When calculating/estimating cash-flow, it’s typically pre-tax. For example, if I purchase 1 home for $100k cash that generates $600 monthly cash-flow, that’s $7,200 cash-flow annually. Now, I could also purchase 3 homes, $100k each, putting 20% down ($60k total), that generate $200 monthly cash-flow each ($600 for all 3), and I’d also have an annual cash-flow of $7,200. In both scenarios the pre-tax income are identical. When tax-time comes, the 3 leveraged properties have the advantage of deducting the mortgage interest. I’m not accounting for it twice, I’m just paying it for it as an expense during the 12 months that make up the annual cash-flow. And since I paid for it, its deductible during tax time. Also, as Doug mentioned, you get to depreciate 3X now because there are more properties involved. Note that with the 3 homes I only used $60k vs $100k for the 1 home. That means if I had $100k to start, I now have $40k set aside as a large safety net for anything unexpected. Therefore in the leveraged scenario (3 homes), my after-tax income is greater and I have $40k in reserves that would handle just about any situation thrown at 3 single family homes.
    Cory Binsfield Financial Advisor from Duluth, Minnesota
    Replied over 2 years ago
    Since the article implies “no debt” is smarter, I’d like to offer a counterpoint. Lets call it the smartest leverage strategy. If you are employing smart leverage at no more than 70% loan to value where your debt coverage ratio is 1.25 or higher, I would venture to say it is pretty hard to get into trouble. The number one caveat, you better know what you are doing and know how to properly run a rental portfolio or how to manage the property manager AND work with a solid lender. Better yet, replacing $70,000 in income does not require more properties, it requires more units. Quit focusing on properties people! Every unit you purchase becomes a unique piece of cash flow that helps you diversify your income and meet the mortgage payment. Worse, this hypothetical scenario completely ignores the fact that $70,000 in W-2 or 1099 income is actually about $50,000 per year after all taxes including FICA and Medicare. So let’s reframe this scenario to requiring $50,000 a year in passive tax free income or $4,166 per month. You could easily cover this by focusing on small multi family deals in the 4-12 unit range where each unit provides $150 a month. Now, all you need is 27 units. In most cases, you will be buying 5+ unit properties with commercial loans that amortize over 20 years and the interest rate is fixed for 5 years. This not only protects the bank, it protects you. Mr. Bank loans you money on the property and the cash flow first. Afterwards, he looks at you and your balance sheet, income and credit. If the deal does not make sense you won’t get it and you will be forced to find the right deal that fits the banks parameters. This helps you and the bank avoid the leverage problem. Once you have replaced your income with all these units using the smartest leverage strategy, guess what? Your loans balances are paid down considerably. Remember those 20 year commercial loans? The balances have easily dropped by 40%. You could refinance those loans for even a lower payment due to the reduction in principal and give yourself a nice raise for all the trouble. The smartest leverage strategy is not for everyone. Yet, it sure works for me.
    Cynthia Torrecillas from San Jose, California
    Replied over 2 years ago
    If I write something I can come back to this page right? Need a way to save this comment to review later… just getting started here!! 🙂
    Jennifer Sjoblom Residential Real Estate Broker from Homewood, Illinois
    Replied over 2 years ago
    I agree with the other commenters. I would love if you did a full post about this strategy.
    Michael Shear Investor from Swansea, Illinois
    Replied over 2 years ago
    @cory binsfield This was a nice comment. I had to read it twice to grasp all the knowledge that you dropped. You should make this a post separate to itself so that it gets more views that it deserves.
    Allison Leung from Denver, CO
    Replied over 2 years ago
    @michael, I agree! I’m reaching out to Cory to see if he’ll write this for us (*fingers crossed*).
    Martyn Lockwood Investor from Sydney, New South Wales
    Replied over 2 years ago
    Nice read and good to hear everyones’ point of view. Different courses for different horses.
    Gary
    Replied over 2 years ago
    If you had $1 million a better option would be to just lend it out at 10% by just moving some paperwork around. Very little hassle.
    Scarlett Mulligan from Clarksville, Tennessee
    Replied over 2 years ago
    Looking forward to rereading all of this information. Thanks for all the wisdom here, folks!
    Nathan S. Rental Property Investor from Minneapolis, Minnesota
    Replied over 2 years ago
    What do you, the average BP user, usually save as a flat dollar amount or percentage for a reserve or emergency account for repairs or unexpected vacancy loss? Lest we only focus on cash flow and forget about down markets and major repairs such as roofing or HVAC.
    Michael Ferry from Wadsworth, Ohio
    Replied over 2 years ago
    I’m planning on putting 28% a month into a reserve to account for that. Do you think that seems about right on a $1,000/month rental?
    Tim Porsche Investor from Denver, Pennsylvania
    Replied over 2 years ago
    What I’ve generally heard is 6 months worth of PITI payments for each property, or 3% of each property’s total value, whichever is greater. That’s what I try to do on all of mine.
    Andrew Syrios Residential Real Estate Investor from Kansas City, Missouri
    Replied over 2 years ago
    Very well written case study!
    Aaron Franz from Madison, AL
    Replied over 2 years ago
    Wow! There is a lot of good information in these comments. It just goes to show that there is no one-size-fits-all method to REI. Do what feels right for you and your situation. Please keep the information and options coming. It feeds the mind and jars the cogs.
    Jake Riordan Real Estate Broker from Overland Park, KS
    Replied over 2 years ago
    The best returns I’ve found are from duplexes. If one side’s vacant, the other still pays for the mortgage plus a little extra. Just need to be patient for the right one. Can still get a 30 yr loan too. Single fam is tough to get good cash flow.
    Tim Porsche Investor from Denver, Pennsylvania
    Replied over 2 years ago
    Another strategy that would let you keep the benefits of leverage and achieving a much higher ROI, is to “trade up” when you reach a certain number of properties and mortgages. So you might start out investing in SFHs and when you reach 10 SFHs in your portfolio, you would sell two of them and use the money to buy a triplex or quadplex that cashflows as much as or better than the two SFHs. You do this until all 10 SFHs are sold and you have 5 multifamily units instead. Then keep buying multifamily until you have 10 of them. Once you have 10 multifamily units, start selling two of them at a time and use the proceeds to buy a small apartment complex. Just keep rinsing and repeating, trading smaller properties for larger ones. This is a very scaleable strategy that will allow you to take advantage of the power of leverage, tax benefits, etc while still keeping the number of properties and mortgages you have under 10.
    Tim Porsche Investor from Denver, Pennsylvania
    Replied over 2 years ago
    Best part is if you use 1031 exchanges for all your sales and new purchases, you won’t pay a dime in taxes when you sell.
    Steve Foster Investor from Beaumont, Texas
    Replied almost 2 years ago
    This is a good strategy in the base case, but the 1031 exchange aspect really brings it home.
    Samantha Klein Investor from Monroe, Wisconsin
    Replied over 2 years ago
    I don’t personally think a $100-200 cashflow per property is ideal at all, $100-200 cashflow should be per unit, and yes if you plan to replace your $70k a year income with SFH, you will probably need 35 or so, but you could buy 2-4 unit + buildings and cut the number of actual properties down, easier to maintain and manage. I like debt because my plan includes owning 30-34 units but only having 9 properties or less to do it, and if I have 1 million in debt, the equity pay down is pretty decent and all of my current units cash flow $250+ a month with 25% down payments, but I buy multi-family only. It all comes down to what your comfortable with, if you’re young, you can take risks with leverage. I certainly don’t think having 25% equity if being highly leveraged but if you borrow 100% somehow then you definitely are depending on the deal.
    Cory Binsfield Financial Advisor from Duluth, Minnesota
    Replied over 2 years ago
    I started with a goal of 10 duplexes. After that, I refinanced the duplexes and focused on 5+unit buildings. The leverage plus tax write offs are amazing once you get classified as a real estate professional. I still own the first 10 duplexes since it doesn’t make sense to sell these cash cows. Frankly, I would never own a property free and clear. It is too risky. There is a reason multi billion dollar REITS always carry debt on the portfolio. It reduces risk while enhancing returns. Billionaire Sam Zell is a good example. On the other end of the spectrum, too much debt is too risky. The key is to achieve balance by always making sure the property cash flows with leverage and taking into consideration vacancy and reserves plus all the other expenses. Structured correctly, you pay no taxes on the net cash flow. This is why you can replace $70,000 in W-2 income with only $50,000 of passive income.
    John Crouch from Nashville, Tennessee
    Replied over 2 years ago
    Thanks, Cory! Any chance you can expand on the “structured correctly” piece?
    bob B
    Replied over 2 years ago
    well written. one thing left out is where we are in the RE cycle. higher leverage at the bottom of the cycle is fine. you will make more in appreciation than cash flow. house here in florida that could be bought for 60k and rented for 800 now sell for 150k and rent for 1200/mo. but I would not finance a keeper now for more than 65% LTV
    Blair C. from Greenville, SC
    Replied about 2 years ago
    I think BOB is bringing up a huge point. This might go without saying, but if you bought a duplex in 2006 with 25% down, in 2009 you were very likely -15% equity in many parts of the country. The 2017 market smells a lot like 2004-2005. Measure your debt carefully. BC
    Corey Staples from Clovis, New Mexico
    Replied over 2 years ago
    Wow. So much learned from this article and the comments. As I eye my first duplex to start my REI journey, I must say thanks for spreading the knowledge, everyone!
    Kendra Gimblet from New York City, NY
    Replied over 2 years ago
    Hello NYC Newbie here, My question is if a person wanted to see substantial income within 5 years of real estate investment what niche should be chosen? I thought being a landlord would be a smart thing to do, but could I begin to see a replacement of income within that amount of time? A friend of mine says I may need to obtain properties and begin to maintain other people’s properties at the same time to reach my goal, any thoughts?
    Mark Otto from Saint Paul, Minnesota
    Replied over 2 years ago
    Kendra, I think the answer depends on how much cash you have on hand and what you consider substantial income. I’m from the Midwest so I only know that market. Not to be to negative but I think generating substantial income in 5 years seems a little lofty. I used every penny of profit for the last 9 years to buy additional properties I am now just starting to take an income from the business but it is not “substantial”. But if you have 500K in cash that gives 10 – 50K down payments assuming a 200K purchase price, and maybe you can buy in a college town where rent is higher, maybe put $500/mnth per house as profit now you have $60K per year so its possible, just hard to answer with the limited info. Good luck… Real Estate is not traditionally a quick way to get rich, its more a long grind.
    Kendra Gimblet from New York City, NY
    Replied over 2 years ago
    Thank you for your time and response, I will have to look more into how to replace my yearly income and other expenses through real estate. This will assist me in deciding whether or not I will spend time and money dedicating myself to this business. Thank you for the luck! Same to you.
    Gene
    Replied over 2 years ago
    I started real estate investing in my teens. I worked full time in construction and invested on the side. Everything that I bought, was bought with a 15 year mortgage and in a improving area. As rents increased, we paid additional on the lowest balance. Once that first house was free and clear, the additional was put on the next. It did not take long to get 7 houses free and clear, and now we are up to 15 with no debt. We are adding about one a year with all cash. We are now taking some cash out, but will probably stop at 20 and enjoy the income.
    Anna M. Investor from Denver, Colorado
    Replied over 1 year ago
    Wow, congratulations Gene!
    Rob Urquhart
    Replied over 2 years ago
    The leveraged model is hugely risky. The best model, in my opinion is to put 50%. Thus, if rents get clobbered in your market or occupancy rates plummet, you have a built in margin of safety to continue making the mortgage payement (or you could reduce rent to get it occupied). I’m shooting for an annual return of at least 10% (income plus appreciation). Paying all cash makes it very hard to get there, putting 20% down makes it very risk, putting 50% down is a good middle of the road solution. What do you all think? Would you agree?
    Nathan Mansur Investor from Buffalo, New York
    Replied over 2 years ago
    Rob, Do you have any examples of rental markets with occupancy rates , and rent prices dropping significantly? If so, what time frame, where were they, and how much did the rents drop by? I’m just curious so I can factor it into my models, I hear lots about people worrying about people getting “clobbered” but when have you seen it happen?
    Jay Black
    Replied over 2 years ago
    I do all cash, all the time.
    Dan Turkel Rental Property Investor from Hamilton, NJ
    Replied about 2 years ago
    Shume mire! I thought this article was very well written and thought provoking. Thanks for taking the time to write it.
    Claude S. Investor from Savannah, Georgia
    Replied about 2 years ago
    Excellent article. If you are close to retirement paying cash and having maximum monthly cash flow by paying cash makes the most sense. Getting 30 year mortgages at age 60 does not make sense to me with resultant small monthly cash flows. I very likely won’t be alive when these mortgages are finally paid off. It all depends on where you are in life.
    Rachel Luoto Rental Property Investor from Bremerton, WA
    Replied about 2 years ago
    IT ALL DEPENDS ON YOUR MARKET! A lot of naysayers in the comments talk about dropping property values and rental income. In my market rental income has never dropped even in recession. Friends with property in Seattle never even lost value in their property during the recession. BP is a great jump off point, but please connect with experienced, local investors!
    Curtis Mears
    Replied over 1 year ago
    Great article. I left my job 2 years ago and have been investing in SFH. One area investors leaving their 9 to 5 job must consider his a change in their family expenses. For example, I paid $700 per month for decent health care when working 9 to 5. Now, as a single person LLC, I pay $1,800 for much worse care. In the end, I would not change a thing, but be aware some expenses may change drastically.
    Drew Kessler from Harpers Ferry, West Virginia
    Replied over 1 year ago
    Seems to me that paying down properties limits your upside, lowers your ROE, and puts a bigger target on your back for lawsuits. If you buy the property right, where it cash flows and you start with ~30% equity I think you limit your risk significantly. As well as pull cash out of the property to grow your portfolio or even turn some over to move to something bigger.
    Rob Cook Real Estate Entrepreneur & Coach from Powell, Wyoming
    Replied over 1 year ago
    Wow, impressive array and collection of info and points of view. What a good forum like BP is all about! In my experience, I have had the benefit of some great periods of appreciation. I always liked and used leverage highly (Not stupidly but per typical investment type lender constraints and requirements). Obviously, in high appreciation conditions, the more leverage the better (as long as you have staying power via reserves, etc). In the last 10 years, I have bought over 40 rental units. Still, have all of those. But twice in that period, I sold other longer held properties which had huge equity due to appreciation and paid off dozens of the mortgages on the recently acquired properties. SO, best of both worlds enjoyed – lots of leverage during the high appreciation periods, and used leverage to buy a lot more, and then used the accumulated appreciation (via selling, not cash-out refis) to retire a lot of the newer debt. And, all with current devalued dollars! Although a fiat currency like the US dollar is likely to devaluate continuously due to inflation, and manipulation, the future mortgage balances on current loans, are still due and payable in Nominal Dollars. So that is yet another benefit of leverage in real estate investing – paying off debt with much cheaper dollars in the future. Related is the usual experience that the price of real estate assets usually inflates over time, while the nominal balance of the fixed-rate debt, stays the same, nominally. So it is typical, for equity to accumulate as price inflates and debt value if future dollars decreases. Lots of competing, conflicting and offsetting considerations and metrics involved in a plan, strategy or discussion like this. In the final analysis, you only enjoy the benefits of real estate investing, IF and WHEN you actually participate. And I have never lost a dime on any of hundreds of deals in estate investing, in 41 years. And that is thru a lot of cycles and markets and locations. So at least in my experience, it is hard to lose if you perform the requisite due diligence at all times.