Loan term and negative cash flow - Struggling with the concept...

Buying & Selling Real Estate
11yFollow

Loan term and negative cash flow - Struggling with the concept...

Nicholas B.
Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes

Regarding small scale rental properties or I believe "buy and hold" is the term used around here (sorry, I'm new to all this).

I notice that a lot of investors mortgage properties for 10, 20, even 30 years - whatever it takes to produce a (sometimes barely) positive cash flow. It seems that a lot of them end up in a "one day, I'll be rich" scenario of waiting out the mortgage before they really have solid usable income from the rent checks. Maybe they put a couple bucks in their pocket, but in the mean time, they're paying thousands in interest and often run into difficult DTI problems when they go to finance something in their name.

Do people who have the disposable income ever intentionally enter a negative cash flow deal in order to get to the "I keep the rent $" phase sooner and save the interest? Or more importantly, why not?

I'll add an example in case I'm not really clear:
Let's assume an initial loan amount of $60,000, $3000 / year of taxes and insurance, and a rental income of $1200 / month analyzed over ten years. Assuming that repairs and maintenance will be paid out of pocket. Total income would be $144,000 minus the out of pocket expenses. Please bare with me for simplifying all of this to get to the point. 

  • If I take a 5 year HEL at 4.115%, P&I = $1108 + $250(T&I) = $1358 x 60 months is $81,480. Then another 5 years of tax & ins totaling $15,000. Total investment is 96,480, leaving an income of 47,520. For the first 5 years, I'll have to float $158 / month totaling $9,480, but the next 5 years, I'll have $950 of additional income totaling $57,000.
  • If I take a 10 year HEL at 5.365%, P&I = $647 + $250 = $897 x 120 mo is $107,640 total, leaving an income of $36,360. Each month, I'll have a positive income of $303, totaling the $36k.

Maybe I'm missing something. I guess I just wonder why I read so much about making "positive cash flow" leveraged deals, but nobody ever talks about just getting the thing paid off and then enjoying the income. This is something that I'm actually considering doing in the future, so feel free to save me from myself. Thanks!

0Reply
154 views

Most Popular Reply

Bryan O.
Specialist · Lakewood, CO · Member since 2014 · 1k+ posts · 1k+ votes
11y

You are talking about 2 different strategies and preferences:

1) Get the property paid down as fast as possible. Use any extra income to shovel into paying down the debt, then having greater cash flow later and the comfort of knowing that the property can lose value in a crash, but that they will never be underwater. They sacrifice that cash flow now for higher cash flow later

2) Get as long of a loan as possible and use as much leverage as you can. This maximizes your cash flow at the start and leverage is a very large value add when property appreciates, but if the property value goes down you may not be able to sell it to get free.

Both strategies work, but they are both different risk profiles and mindsets. They accomplish different things at different times with the same ultimate goals. Do you care how much interest is paid when you aren't paying it? I am young(ish) and in expansion mode, so I prefer strategy 2 right now. As my risk tolerance goes down I will transfer to strategy 1 so I can "retire". Once they are paid down more, maybe I'll just hold the notes...

So tell me, do you like Apple pie, or Pecan? Because that is our discussion.  ;)

3Reply
See this reply in the discussion

35 Replies

Jump to latestLatest
  • Jim Walker
    Real Estate Agent · Carmichael, CA · Member since 2011 · 17 posts · 20 votes
    11y

    Hi Nicholas.   

    It is different strokes for different folks. Usually at polar opposites.  There are some investors who want maximum leverage, even to the point where they are risking their investment in case of adverse conditions.  Lehman Brothers was leveraged 50 to 1 and that company lost everything while sparking the 2008 global economic meltdown. (not saying it was all Lehman's fault, it was just the spark - the room was already full of flammable gas!)

    On a micro level, the scenario you laid out is fine. Provided that you have plenty of funds left for "rainy days both in your personal life and for the investments you take on. Once you have a healthy rainy day fund and a good credit score and credit line to draw on above that, then it is smart, if you have no higher paying investment opportunities to retire some debt early.  Here is how I do it. The average return on my highest earning assets available to me is about 8%  {That is $100K houses rented for 1k per month with $4000 in annual expense.) Debt Service is purposely left out of this equation because it is The return on asset - not return on investment. 

    If I have money to invest, it theoretically makes more sense to pay down any debt that is over 8% APR and make the just the required payments on any debt that is below 7.9%APR and invest more money at 8%. In reality, I strive to pay off any debt over 5%APR because acquiring property, renovating, then getting and retaining tenants is harder work than writing a check to JPMorgan Chase.

    I simplified my answer of necessity. There are so many other factors.  To scratch the surface. What are the investment opportunities readily available for the investors available funds? How does the investor feel about the locations, and quality of those investments? Most of my investors won't touch $100K houses because of the neighborhoods. What is the return then on $300,000 houses?  I can tell ya. It ain't 8%! But the $300,000 house will have higher resale value at disposition time than 3 $100K houses. So much to consider. 

    2Reply
  • Logan Hicks
    Business Owner/Investor · Millersville, MD · Member since 2015 · 191 posts · 71 votes
    11y

    "I'll add an example in case I'm not really clear:
    Let's assume an initial loan amount of $60,000, $3000 / year of taxes and insurance, and a rental income of $1200 / month analyzed over ten years. Assuming that repairs and maintenance will be paid out of pocket. Total income would be $144,000 minus the out of pocket expenses. Please bare with me for simplifying all of this to get to the point."

    There in lies the answer to your own question and problem.

    Notice how you did your math with a 10 year piece, based on a 10 year mortgage, and standard repairs.

    What you arent accounting for is a dead water heater, every 5-10 years. A new roof, every 15-30 (almost no real estate rental is going to be built brand new unless its from a builder.)

    A generic roofing job will run you anywhere from 9k upwards to 20-30k depending on the size of the property, type, and slant.

    Thats anywhere from 10% to 18% of your income gone, and to a single repair that MUST occur, and that will most likely occur during the note duration.

    Always calculate for one roofing job, for 2 water heaters, and for at least 3 10k repairs in addition to your normal math.

    Thats why I always say simply keep 8% in reserves of the property value in cash for repairs only.


    0Reply
  • David Nolan
    Professional Property Investor · Brisbane, Queensland · Member since 2015 · 165 posts · 160 votes
    11y

    @Nicholas B. Hi Nicholas

    I appreciate you may have got the answer you were looking for which is great. In regards to why people take negative cash flow properties and hold for the long term. In many cases the investor would be looking for some form of increase in value over time that is greater than the increase in the cost of living. However, there is one other very important fact to consider and one that might help you find a happy medium of how many properties to buy with your resources and that is the proposed investment's Internal Rate of Return (IRR).

    Assume you have three possible scenarios and you want to know which is the best one to invest in. By calculating the Internal Rate of Return (IRR) on each investment you will see the different IRR's that the series of cash flows produce. Investors would normally invest in the investment that produces the greatest IRR. Your accountant should be able to help you produce an IRR for each scenario you are considering if you give them the cash flows and assumptions that you are working on. For example what do you think the rate of inflation or cost of living is likely to be, what will your annual rental increases be, what do you think the capital expenditures will be and when do you think you might make them? You also need to let the accountant know how much equity you are investing.

    By doing these types of calculations you will be able to identify if paying off the mortgage sooner rather than later on any individual investment makes the most sense. It is not a guessing game, it is more of making educated assumptions and adjusting your strategy to suit the prevailing market conditions.

    There is more to this property investing business than meets the eye at first and obtaining a good understanding of investment fundamentals first, before investing in anything, is of vital importance. So, I would suggest most humbly to seek professional advice before acting. Your accountant should be able to help you make sense of this. If not, then seek out a local accountant who understands property investing to help you make these important decisions.

    In property investing you make money when you buy and that means having a clear understanding of how your property is going to increase your wealth, not decrease it.

    Good luck on your journey and happy investing!

    1Reply
  • Steve Vaughan
    Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes
    11y

    Thank you for starting this discussion @Nicholas B. I don't like paying interest or over-leveraging for skinny CF, either.

    Over time I have become more comfortable with paying my portfolio off. I used to run around trying to maximize every ROI possible. It's exhausting, frankly.

    I haven't borrowed from a bank or lender in any way in over 3 years (No CCs, car payments, student loans, nothing).  I reduced 3 of my mortgages to a 15-yr am in 2012.  The rate was 27% lower for the 15 vs 30,  On one house alone the interest savings will be $193,000 over what was the 24-yr remaining term. The payment increase is only $163/mo. Try arguing with that Mr High Leverage!

    As a fellow finance guy, I completely agree that having a mortgage for the 'interest deduction' to be the dumbest theory around.  Send me $10k and I'll return $3k any day of the week.   Maybe I'm not sophisticated enough, either?

    With such historically low mortgage rates, it's easy to see how folks want to borrow all they can, but having paid for rentals is worth the (opportunity) cost. Peace and serenity? Priceless!  

    My first paid-off piece of RE in line is a 10 unit mixed-use commercial bld.  Putting that payment into my snowball of debt reduction will forever change my family and the way I live and give.  The next house will be 9 months later.  2 more houses the following year, etc.  Cheers!  

    2Reply
  • Perry Ivy
    Investor · Jonesboro, AR · Member since 2015 · 241 posts · 132 votes
    11y
    Nicholas B. Steve Vaughan I too am pouring all of my money back into my rentals, congrats to you guys on going against the crowd. An old real estate investor once told me that the crowd is always wrong. Warren Buffett says, "when the tide goes out, you'll discover who's been skinny dipping", 2008 was that time. My paid off real estate gives me peace of mind, sure I don't have the cash to buy things that I want, but I have plenty to meet my needs. The most valued possession in life is time and mine is to precious to spend chasing the next deal, strategy and robbing Peter to pay Paul. I'm rambling, but once again congrats. When the next downturn happens you guys will be the Heros :)
    2Reply
  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    11y

    Wow! There have been some really great posts since I last checked in. I feel bad for not thanking each individually, but I did read every post in it's entirety. Thank you all. 

    I'm considering this as confirmed that the factor of contradiction is scale. I'm not judging anybody for using an aggressive strategy involving leverage. It's just not something I'm interested in right now. I just hope that people understand that it's that scale that makes it work. 

    My point is that people get it confused and seeing it in action confused me ("Why are people doing this to themselves?"). I guess it's not a terrible thing to stretch out a few properties that are "paying for themselves", knowing that 10-30 years later, you'll have acquired the asset "free of charge". Well, at least until they go to take out a loan and realize that in a personal credit transaction, lenders will add the rental income and mortgage payments directly to your DTI and still expect 40%...

    2Reply
  • Cheryl Packham
    Rental Property Investor · Surprise, AZ · Member since 2014 · 196 posts · 86 votes
    10y
    Originally posted by @Nicholas B.:

    Wow! There have been some really great posts since I last checked in. I feel bad for not thanking each individually, but I did read every post in it's entirety. Thank you all. 

    I'm considering this as confirmed that the factor of contradiction is scale. I'm not judging anybody for using an aggressive strategy involving leverage. It's just not something I'm interested in right now. I just hope that people understand that it's that scale that makes it work. 

    My point is that people get it confused and seeing it in action confused me ("Why are people doing this to themselves?"). I guess it's not a terrible thing to stretch out a few properties that are "paying for themselves", knowing that 10-30 years later, you'll have acquired the asset "free of charge". Well, at least until they go to take out a loan and realize that in a personal credit transaction, lenders will add the rental income and mortgage payments directly to your DTI and still expect 40%...

    Hi @Nicholas, I know this was posted a few months ago and I wanted to chime in as well because it was something I fought with for a while. I had the same thought process in regards to taxes and interest and really what I want to point out here is what people are alluding to here are "opportunity costs" and "time value of money". Also negative cash flow will hurt the DTI ratio more than having longer term debt.

    First, I will say that I understand your thought process completely that paying interest to save on taxes is counter productive, and you are correct.  

    Next, the most important thing to factor in a deal is what is the rate of return on the money you are putting in out of your own pocket.  Real estate is unique that lending is so readily available to purchase this type of investment, however, leveraging is also a strategy available in the stock market as well.  (I will not get into that here however).  

    So, to simplify, If you take $100 and invest it at 10% return, you will get $10 back each year.  But say you can take that same $100 and buy $500 worth of investments by putting $20 towards each investment and someone else pays the other $80.  You have to pay that other person 5% for their money to use it.  Now, you have $500 worth of investments that still pay 10% return each.  So you get $50 back but half of that goes to the other person so you get $25 for your return on your initial $100 investment.  While you are paying someone else interest for the right to use their money you have increased your return on investment from 10% to 25%.  So you need to look at your opportunity cost for buying that first investment in whole or using that same money to buy several investments using leverage.  You would get $10 on wholly owned investment and $25 on your leverage investments.  So your opportunity cost of paying for the first investment rather than leveraging is $15.  

    Now, time value of money.  As inflation increases our money becomes worth less.  Compounding interest makes a $1 today worth more than $2 next year.  So now that you have that extra return on your leveraged investment, you can reinvest it thus compounding the interest yet again.  

    As with any investment you must determine your risk tolerance based on your situation and determine what amount of risk and leverage is reasonable to you.  

    Another reason for using longer term loans with smaller payments to ensure a positive cash flow is to actually hep your DTI. When you can show full debt and expense coverage of your investment properties they will actually take that into account when looking at future lending scenarios. If you have a shorter term loan with higher payments it will increase your debt to income ratio regardless of the years to maturity.

    I do not have an opinion on which one is better, I will tell you that I have chose to leverage within reason and to be very careful not to over leverage.  

    I hope that helps,

    Cheryl

    1Reply
  • John Thedford
    Real Estate Broker · Naples, FL · Member since 2013 · 9k+ posts · 6k+ votes
    10y

    36 months  to debt free. Six figures gross rents. Soon to be 61 years old.  I see both sides of the argument and either way is good depending upon one's personal preference.  Mine is zero debt  at this stage in my life..

    1Reply
  • Scott Carder
    Investor · Owasso, OK · Member since 2013 · 166 posts · 90 votes
    10y

    I think it boils down to comfort level. I have 2 SFR, one is a 15 year and the other a 7 year. I don't want payments for ever so they will be paid off probably within 10 years.

    0Reply
  • David Nolan
    Professional Property Investor · Brisbane, Queensland · Member since 2015 · 165 posts · 160 votes
    10y

    @Nicholas B. One other way to consider leverage is to consider what you could do with cash if it costs you 4.5% per annum. How much can you earn on the money? Could you earn 6% per annum, 10% per annum, 20% per annum? The way you leverage assets is about being able to borrow as much money as your risk profile will permit you and then use it to make as much money as you can.

    Given the vast number of alternative ways to make money in RE the key becomes how much can I borrow and can I earn more than the cost of the money. If you could earn a solid 10% on a deal, whatever that deal looks like and the money costs you 4.5% then you would, in simple terms, make 5.5% on other people's money. Long term wealth is not made just by holding property for ever and a day. It is by making money work for you, especially if it is other people's money. Why do you think HML's lend money instead of doing their own projects? Because they can buy money for 4.5% or less and put it to work for 10%, 11% or 12% all within a risk profile that suits them. They are not relying on the market growing to make money, they lock it in at the beginning of their deals.

    If you find a good deal then use leverage to optimise your return, but always stay within your personal risk profile to reduce the risk of stress.

    0Reply
Join the conversationCreate a free account to reply, vote on answers and follow this thread.
Log InJoin for Free