What to do with mortgage free property?

24 Replies

Our family home is currently rented out and mortgage free. There are no plans on going back to occupy the home. The goal is the grow into real estate portfolio.

It earns positive cash flow but does a SFH carry more risk depending on a single tenant?

What are the upsides of selling and 1031 exchange into a multi-family investment property?

OR keep property and tap into HELOC and purchase investment property with those funds?

Thanks

Who are the owners?  Does each owner have the same goal?  Make sure everyone is on the same page.  If it has positive cash flow, I would continue renting it out.   

@Aaron Wade

The current owner is my mother, she is going to add me to the title due to my father passing. That’s why I’m trying to figure out our next move for the property.

Thanks

Hi @Ronald Mejia I believe owning multifamily is lower risk and the reward is higher.   In my opinion, the advantage of selling the house with a 1031 exchange would allow your mother to leverage the funds for a down payment to maybe buy two different fourplexes or 5+ unit apartment.  If your mother bought two five-unit apartments, your mother should be receiving more income for the apartments than the single-family. 

Also if the single-family is vacant for any length of time, as you know, you do not receive income but have expenses for the upkeep.  With multifamily, if a tenant moves out, you should still be able to have positive cash flow on the multifamily. 

I also would suggest putting each multifamily into separate LLC holding companies. If someone sues, it will be the holding company they are going after and not your mother personally. Talk with your Real Estate Attorney to see if this would be the best avenue for you.

I am sure BiggerPocket has 1031 specialist that can guide you through the process. Always make sure the numbers work when you are purchasing an investment property and run it like a business because it is a business.

Lastly, in my opinion, if your mother wants a truly passive investment without the hassle of managing tenants, repairs etc., maybe she should consider rolling the 1031 exchange funds into a Delaware statutory trust. She could receive checks on a regular basis from the DST and make around 6% a year in income without all the hassle. I am sure you could find a financial advisor in BiggerPockets that could advise you or you can look up the benefits and risk of a Delaware Statutory Trust in Wikipedia.

Good Luck

@Ronald Mejia I'll give you an alternate opinion you'll only here from 1% of investors, but free-and-clear is a beautiful thing...it's what we all should aspire to achieve. A lot of folks think real estate investing is all about scaling...like owning a bunch of property is a good thing. It's really quite shallow. Your free-and-clear property will cash flow more than the next 5 you buy...combined.

Think about alternatives before voluntarily assigning debt to your properties...

Best of luck. 

@Ronald Mejia First thing to remember, your leveraged returns will always be higher than unleveraged returns. Meaning, your ROI would be higher if you had a mortgage on the property.

Second, if you lived in that home for 2 of the last 5 years you can sell and up to $500,000 of the profit will be tax-free. No need to 1031.

Look up and learn the formula: Return/Yield on Equity. Learn the pros/cons of a HELOC vs a new 1st Mortgage. Lastly, get better understanding on using current tax environment to cover over capital gains with new losses in large mfam deals.

Happy Educating!

Here is the way I think about this. Is this an easy rental in a good area? Does the location have a future? Is there appreciation potential? If the answer is yes, I'm going to hold this property. I sold 2 properties recently because they attracted difficult tenants. They attracted difficult tenants because the properties were not in areas that were developing in the right direction. I sold them and redeployed capital into other investments. So that's where you begin. Ask yourself if you want to own and manage this property. Next, I'm NOT going to have a property paid off. And some of this is personal so take this through your own filter. As a business person, my goal is to grow. For that I need to acquire assets. I'm going to refinance my property to 70% LTV and use the equity to buy another similar property. Now I have two assets that are growing, leverage by a currency that is being devalued by the Treasury by the year. Get assets when you're young and hold on.

@Ronald Mejia

I see two options with several variables playing into each. This is exactly the situation I specialize in but taking whole portfolios into account.

1. Favorable rates allow you to put debt on the property. Cash out refi and use the cash to put into another property. Measure the combined projected returns of the two together to see if it beats your after-tax cash flow. I bet it doubles. Your after-tax and pay down on principle will double with ease considering you currently have no paydown...

2. Sell or exchange into a moderately leveraged investment. If you had 60% loan-to-value on a small multifamily investment you often find improved cash flow from current and add the pay down your returns could double.

These are what I measure:

(1) Pre-tax cashflow

(2) After-tax cashflow: based on investors effective tax rate, of its owner occupied, your not taxed on income.

(3) After-tax + pay down on principle: measuring your pay down on the loan as a return, as you are increasing your equity position

(4) Total return (after-tax plus pay down plus appreciation) : I use 3% for appreciation to remain conservative in my expensive northwest market.

If you figure those to your current situation and run the numbers for your projected strategy, pick the one that has a combination of the best returns and aligns with your goals and time horizons. If you are willing to lessen cash flow for more pay down considering the current rates, do that. Otherwise you could meet in the middle and have less leverage.

@Ronald Mejia i would agree with some of the others and say that you should leverage the property by pulling money out with either a HELOC or other loan to purchase more rentals. Besides the power of leverage you also have to think about liability. Someone who is thinking of suing you and your assets is probably less likely to do so if you have less equity in a property. You are kind of leaving your self own for a lawsuit right now. For example if you own a property worth $100,000 and have $20k of equity they may not go after it because it s not worth their time as opposed to 100k worth of equity for the taking.

@Ronald Mejia in my opinion sfr has more risk. Once it goes vacant, well there goes your income. If you're into building a steady stream of cash flow, you should think about multifamily even if it's a small duplex, triplex or quad. If one one unit goes vacant, then at least you still have income coming in. I think the HELOC suggestion may be a good idea to invest in more doors. The more doors you have, the less risk you have. An FHA loan product may work for you, if you currently have a W2 income.

Thank you for all the insight. HELOCS work based on the amount of equity owned in a property...if you own it out 100% then you could get 70% of the value of the house?

So if house is worth $100,000

HELOC could be $70,000?

@Ronald Mejia

70-90%. A HELOC would allow you to borrow money as you need it and only pay interest on that amount.

It might be a 5-10 year draw period with a 10-15 year repayment period. During the draw period you can borrow money and can make interest-only payments. During the repayment period you can no longer borrow money and the payments are principle + interest. Interest rates might be fixed or variable depending on the lender. You can punch numbers into an online HELOC calculator to see how the numbers pan out. Have a lender show you the difference between a cash out refinance vs a HELOC.

@Ronald Mejia - The house is free and clear of a mortgage and you cant ask for better than that.   

IE: An investor with 5 rentals is "cashflowing" $150-$200/per month on each rental property and each property has an outstanding mortgage or maybe two. If they are lucky, they are clearing $600-$800 per month total on 5 rentals provided there is no capex issue, vacancy, eviction, etc.. With your free and clear one property, you are doing better than them with 4x less headaches. All it takes is an eviction, vacancy or Capex and that cashflowing rental property will be cashflowing Zero for 5+ years.

If you want to buy a rental property put a downpayment from your own funds and apply for a mortgage.  The home that is free and clear puts real money in your pocket.

@Ronald Mejia I agree with the above a free and clear property will put a lot more cash in your pocket monthly. And area/appreciation are valid points as well.

This is a perfect situation to get your feet wet as an investor/landlord/owner. I would do two things:

1. Rent it out for a year and see if you enjoy it, make money, learn, etc. A free and clear property doesn't come along too often for beginners, and the additional cash flow versus a rental with a loan will allow you to have some bumps in the road and still make some money.

2. Take out a HELOC while the market is up and banks are lending. All it takes is a market swing, and it will be much harder to secure one. I always advise to go ahead and get the HELOC, even if you don't end up using it right away. You never know what new deal may fall in your lap, and it is best to secure the capital now while banks are loose.

Best of luck!

I ended up getting a HELOC at 5.5 APR no closing cost or appraisal cost. I also got 95 percent which is about 69 or 70,000. Check with your local credit union. Good luck to you. What a blessing!

@Ronald Mejia

How much is it worth. I took 1 house in LA (1031) and turned it into 22 units in Toledo. I also screwed up and bought a building with a boiler problem and lost $100,000 in a panick sale. The last year I have not been the same, but had I not sold and not screwed up my portfolio would of been cash flowing $5-7k a month. I have another LA duplex and I am thinking about doing it again. I learned a lot of lessons, I hope.

I really hope if you 1031 you check your numbers, negotiate price and GET AN INSPECTION, or three! Also, research property management before hand.

@Ronald Mejia

One more thing man... I think these people do NOT understand how strong the rent control laws are in LA. The city has already tried to apply rent control to single family homes, and it is only a matter of time until they succeed. Be aware if that happens and you want to move in later you will have to pay the tenant off up to $21,000, also you will not be able to rent it out for two to five years.

Originally posted by @Gus Muller :

@Ronald Mejia I agree with the above a free and clear property will put a lot more cash in your pocket monthly. And area/appreciation are valid points as well.

This is a perfect situation to get your feet wet as an investor/landlord/owner. I would do two things:

1. Rent it out for a year and see if you enjoy it, make money, learn, etc. A free and clear property doesn't come along too often for beginners, and the additional cash flow versus a rental with a loan will allow you to have some bumps in the road and still make some money.

2. Take out a HELOC while the market is up and banks are lending. All it takes is a market swing, and it will be much harder to secure one. I always advise to go ahead and get the HELOC, even if you don't end up using it right away. You never know what new deal may fall in your lap, and it is best to secure the capital now while banks are loose.

Best of luck!

This is the best advice imo. Especially for someone starting out. 

@Anthony Rosa

Of course it just depends how much debt someone is comfortable with, but I disagree with you about your cash flow example.

With 1 free and clear property the cash on cash return is going to be the same as the cap rate since there is no debt service involved.

I.e. you have a 100,000 house and your NOI is 10,000. You are getting a 10% return (cap rate). You're cash on cash is 10% as well since there is no mortgage.

Now say you leverage this 100,000 into 5 properties all 100,000 each putting 20% down on each property. And say each deal is identical.

Your NOI is still $10,000 for each property. So a 10% cap rate, but your cash-on-cash will be different because there is much less cash in each deal (20,000) and now there is a mortgage.

The debt service on 80,000 at 5% for 30 years will be around $430/mo which is $5,160 per year.

Each property then cash flows $4,840 per year (NOI - Debt Service). The cash-on-cash return is $4,840/$20,000 = 24.2%.

That is $24,200 per year on $100,000 cash. A lot more than $10,000 of the one property.

When you’re leveraging you are going to get more cash flow, that’s why you leverage. Yes more headaches, more risk, etc so it isn’t for everybody, but just saying that you are putting your capital to work when you leverage.

@Timothy VanWingerden -  10K on a mortgage free home is a lot better than 10K on a home with mortgage debt. The mortgage free home can also take the hit a lot better with unexpected repairs, vacancies and turnovers then a mortgaged home and not have to put aside as much for variable costs. One non-payment followed by an eviction & turnover on that $800-$850 rent and the landlord is behind for 1 year.

If you are just looking at the numbers they are great, no doubt, but i'm also thinking of the times when things don't go so great and it is common on these 75K-100K "cashflowing" properties.  Age of home is likely around 80+, constantly in need of repairs, Appreciation is non-existent, evictions and vacancies are higher than normal and the tenant class isn't the best. 

I'm on the appreciation side. I have nothing against the cashflowing side except that I don't see it worth it to clear $400/month ($400/month provided a major expense didn't occur) on a 100K home that will never increase in value.  

@Ronald Mejia

Lots of options for this one. There's no right answer; it just depends on what you want to so.

I would make sure you both understand the implications of her adding you as an owner of the property. You don't want to lose the eventual step up in basis. Maybe look at doing a POA for real estate instead?

The last thing you should do is hold onto the property and do nothing with it - EXCEPT if your plan is to do this for 6-12 months, build up a reserve, and then do something.

If it were me, I'd hedge - do the HELOC, buy one other property, but still leave yourself cash flowing a good amount on both. You get some leverage but don't risk a nightmare ruining your dream scenario.