Gary West
Hey Gary, good to see you in these parts again!
Regarding paying off the debt versus investing, I did a bit of number crunching.
Scenario 1: Work on paying off debt that is incurring 8% interest. That one is easy. You earn an 8% return in reduced expenses.
Scenario 2: Buy $100K properties that will rent for $1200/month.
a) Buy property with financing, but pay off the debt as quickly as possible before adding more properties.
b) Finance the properties, but don't pay them off right away. Work on adding more properties instead.
To figure out scenario 2, more assumptions are needed. So here are some:
- Financing is at 4.25% over 30 years, with 20% down.
- Closing costs are about $3000.
- Properties need minor cosmetic work. Lets say new paint, carpet, and a smattering of small handyman fixes. Lets call it $4000.
- We need to add in some holding costs while the work is being done, and you search for a tenant. Lets say a month of P&I, taxes, insurance, keeping the utilities turned on and the lawn mowed. Lets call it $1000.
- Lets use the 50% rule for ongoing expenses.
So after you've gone one cycle of option 2a (that is you're done paying the first property off), the numbers look something like this.
Cash Invested: 108000*
Gross Annual Income: 14400
Expenses: 7200
Debt Service: 0
Cash Flow: 7200
* debt service while you're paying it off isn't counted, because the rent covers it.
So, you've got an income of 7200 on 108000 invested, or a 6.67% return. Except now the tax man wants some of it. You do get to deduct depreciation. It's not really a deduction in that you pay the deductions back when you sell, though you can 1031 into another property, and defer it. For the sake of argument, since this is a pretty long term consideration, lets call it a deduction for now. You get to depreciate the structure (not land) over 27.5 years, or 3.6363% per year. Lets say that of the 100K price per property, 80% of it is the structure. That's pretty typical around here for that price range. So you get to deduct $2909 (80K/27.5) for tax purposes, giving you a taxable income of $4291. I don't know your tax bracket, but since you're able to save 4K/month even with the debts, I'll guess 25%. So you'd pay about $1073 in taxes, bringing your after tax return to $6127, or a 5.67% return.
So, 2a is not looking great, to put it mildly. On to 2b:
Cash Invested: 28000 (20K down, plus closing, cosmetic fixup, and holding costs)
Gross Annual Income: 14400
Expenses: 7200
Debt Service: 4723
Cash Flow: 2477
An income of $2477 on $28000 invested gives you a pre-tax return of 8.85%.
The fact that in 2b you leave the mortgage in place introduces another factor – mortgage paydown, which affects both your taxes and long term return.
On an 80K loan with 4.25% interest, the principle is reduced by an average of $112 per month during the first year, or $1349 total for the year. This brings your income up to $3826, or a 13.67% return – not that you get to see that money for a long time. It also increases your taxable income. When it's all factored in, your numbers look like this:
Cash on Cash pre-tax: 2477 (8.85%)
Cash on Cash after-tax: 2248 (8.03%)
Total ROI pre-tax: 3826 (13.67%)
Total ROI after-tax: 3597 (12.85%)
So in terms of pure cash in your pocket, 1 and 2b are a dead tie, with the long term ROI of 2b pushing things in that direction. A couple of other factors:
Inflation: Suppose that over the course of the first year, there is 2% inflation. Your rent goes up 2% but so do your expenses. Given, it's unlikely that it would happen precisely like that, but for the sake of making the point, lets say that it does. So in year two, your rent would be 14688 for the year, and your non-debt service expenses would stay at 50%, and therefore increase to 7344. BUT, your debt service does not increase, and stays at 4723. Your cash flow is now 2621 before tax (9.36%) and 2356 or 8.41%, after tax. That's a 4.7% increase, beating inflation by 2.7%. Meanwhile the 8% you would be making (saving) by going with option 1, is stuck in year 1 dollars, and loses 2% of it's value due to inflation.
Certainty: This one pushes things in favor of option 1. The 8% you save by paying off your debts is a sure thing. The 8.03% after tax COC return for year 1 of 2b is a projection. Maybe you can only get 1150 for rent. Maybe you have a longer than expected vacancy. Maybe the hot water heater needs to be replaced, roof blows off, condenser gets stolen, [insert list as long as my arm!].
Since the returns are fairly similar, at least in the short term, then one idea is to simply alternate. For example, if it takes 7 months to save the 28000 for a property in option 2b, then maybe you could buy a property every 9 months instead, and put two months of savings on the debt. That sounds like it could be a good compromise to make your wife feel more comfortable with the plan, while still making some real progress on the investments. This could be done pretty organically. The market is pretty competitive right now, and it can take a month or two to find a suitable property, not to mention the time between your offer being accepted and closing. Maybe you could use that time to make those 2 payments on the debt.
A couple of other thoughts.
You can do at least a bit better than the 100K/1200 rent combo in our market. For around 85000, you can get something which will command 1150-1200 rent, but the repairs will probably be more in the 7 or 8000 range. That bumps the return a good couple of percent. But you've got to be prepared to spend a fair bit of energy property hunting, and be ready to pounce quickly. There's a fair bit of competition.
Here's one more option - lets call it 2c. Find a distressed property that will eventually rent for 1200, that you can buy for 50K cash. It will have to be cash (or hard money), because a conventional lender will not lend on a property in the condition it will be in for that price. Your closing will be much cheaper – say 1500 – because there's no lender involved. Lets also say that to get it rehabbed and bring it up the 100K market value, your looking at around 25K.
Ok, so with 76.5K invested, you're making the same 7200/year income as 2a. That gives you a 9.41% cash on cash return before tax (about 7.5% after tax).
After the seasoning period (the time that must pass before a lender will look at a new appraisal, typically 6-12 months), you do a cash-out refinance. Closing costs and interest rate will be a little higher due to it being a cash out refinance, and I wouldn't bank on being able to get more than 70% out.
So, say you're able to get 70K out based on a new appraisal of 100K. Your cash left in the property is now only 6.5K. You have to add closing costs for the refi to this. Lets say 4.5K for a total of 11K.
Debt service on 70K at 4.5% is going to be about $4526, giving you a cashflow of $2944, a 26.8% COC return before taxes.
There's definately more risk involved with 2c. More scope for getting the rehab numbers wrong, risk of it not making it to 100K on the after rehab appraisal, and the possibility of difficulties getting a cash out refinance, which is harder than getting a straight up loan for a new purchase. Still, it's food for thought.
Disclaimer – I only have personal experience with options 1, 2a and 2b. I haven't done 2c personally yet, so please don't take everything I'm saying as gospel!
Anyway, I realize I've typed up a storm, so I'll quit now. I hope this is of some help.
-Harry