Best use of cash - pay down debt or buy new property?

Question

Hi fellow investors,

I am trying to decide between paying down debt on my existing rental property or acquiring new rental property with the cash I have. Conventional wisdom says it is better to use leverage and acquire new property, and I have read articles on bigger pockets as well as heard this on podcast episodes. However, when I do the math, paying down debt looks quite appealing in my case. Here are the details.

Option 1 - pay down $211,000 debt on my rental property. At 3.875% rate, my monthly P+I is $1192. If I pay it off, I would save $14,304 per year. That is 6.77% cash on cash return!

Optio 2 - use this as a down payment (30%) on a new home purchase worth around 704k. Unfortunately, in my area (San Diego), even with 30% down you are barely cash flow neutral so there is no cash on cash return. If you consider principal reduction due to mortgage payments, you would get about 8k per year assuming 4.5% rate. This is an indirect cash on cash return of 3.8%.

Considering the higher cash on cash return, option 1 seems more appealing, so why would anyone choose to go with option 2? If I put down more for the purchase, I can improve the return on option 2 somewhat, but it still is lower than option 1. But you get less leverage by putting down more.

Am I missing something? I am fairly new to real estate investment, so hoping experienced investors can share their insights. Thanks!

Thomas S. · Answer

In your area it is 6 to 1, 1/2 dozen to the other. For most investors paying down a 3.8% mortgage would be crazy. Cash easily earns a 10% or greater return when invested in a good market there for paying down a 3.8% loan is losing 6.2% return.

If throwing cash at a rental is the only way to make money it isn't really investing.

Having equity in a rental kills cash flow but if you have no cash flow to begin with there is very little reason to even own the property. It is not investing it is simply speculating on appreciation. You might as well be playing the stock market.

Account Closed · Answer

@Kris Biz  Only investing in California is costing you a fortune.  I would suggest you start educating yourself immediately about places where real estate is not over priced.

Long term, it is a very bad sign that the properties will not cash flow.  What is going to happen when rates increase?  It will get worse.

I wonder how many loans in California have loans that end with balloons?

Tushar Radke · Answer

You could do flips in the San Diego market and have a significantly higher return until you find that multi-plex from a motivated seller that does cash flow. There are probably apartment complexes in Escondido that might Cash Flow with that sort of money put into a commercial loan. You could also consider investing in Mobile homes if you care primarily about Cash on Cash return vs Equity. Finally, you are not considering the tax write off for Depreciation which could be depending on your tax bracket, an additional 3k. Also while you are saving 14304 in payments, the interest part of the payment is really what you are saving annualized and that is probably closer to 8100? The rest was building equity for you anyway. So for me, you are effectively saving Interest payments of 8100/yr by paying it off for an actual Cash on Cash return of 3.8% going down every year. Even if you buy a Cash Flow Neutral Property with your downpayment of 211k, you have Principal Reduction of about 8k in first year plus a 3k tax benefit from depreciation and if the property appreciates 1-2% as projected in most areas, that is effectively an additional 3-6% ROI for a total of 8-10% ROI. The only reason to deleverage is an anticipation of correction in the market assuming you are unable to hold through the correction cycle. In several parts of San Diego, a correction seems plausible sometime in the next couple of years but there are other parts where fundamental indicators are still very strong.

Shawn Couch · Answer

Appreciation due to inflation/money printing. Real estate is a hard asset.  Regardless of the actual stated price, there is always a value for real estate that will be proportional to other costs in life.  Also, Interest rates are still at historic lows and although these low rates are likely causing inflated pricing in hard assets, a long term horizon should shelter you from any corrections.

Consider a 2 or 3 unit property for a higher cash on cash potential. There are a few decent deals to be had in this catogory.  PM me if you would like to see some numbers on a few deals.

Good luck, and prosperous investing.

Best use of cash - pay down debt or buy new property?

Most Popular Reply