Why not snowball the debt on real estate investments?
Lexington, KY · Member since 2017 · 18 posts · 19 votes
Why not snowball the debt on real estate investments?
Most Popular Reply
The reason not to pay down a income property mortgage is due to the high opportunity value of cash to investors.
Investors must understand that every property actually has two separate income generating streams. First is the property, second is the equity in the property. Novice investors believe that paying down a property increases cash flow. In fact equity has the opposite effect it actually decreases cash flow to the point that the property itself becomes a liability as opposed to a asset. The property generates no actual income of it's own and becomes a expensive money pit.
Here is why.... For every 100K in equity, valued at 10% opportunity, it is generating $833 of the properties monthly income. When you deduct that amount every month from the rental income you see how the property quickly becomes negative cash flow producing to the point of liability. If the 100K is spread around multiple investment properties, with minimum down, the return on the 100K is increased allowing all investment properties to generate positive cash flow.
Equity in a property is dead cash that has been retired and is no longer earning it's keep. It would be financially beneficial for a investor, with free and clear properties, to sell everything and place all the money in mutual funds. The end result would be higher returns with no work.
Equity kills cash flow and disrespects the value of cash. Cash buyers are the quintessential conservative investors and receive the lowest possible returns of all real estate investors.
66 Replies
- 9yPeter MckernanBusiness MemberResidential Real Estate Agent · Irvine, CA · Member since 2013 · 2k+ posts · 1k+ votes
Hello @Robbie Taylor
I believe it is all personal believe and comfortability in the debt verse cashflow realm. A lot of investors on this site see the debt and mortgage as good debt especially if that debt is getting cashflow on that property. The main reason people do not pay down their properties as quickly as you would think is because they want more money for that next deal that will get them more cashflow.
There are some on the site that do believe in paying down debt, or paying off homes to gain more ability to cashflow and leverage more. It's more a thought process and the more the better. If there are more properties there is more cash flow, but that can be twofold. If there is more paid off on one property there is more cashflow once that investor REFIs.
The McKernan Group4.957 Reviews - Real Estate Agent · Naperville, IL · Member since 2013 · 402 posts · 177 votes9y
@Robbie Taylor I would recommend having a mix of some free and clear and some leveraged. If a property is paid off, there is no interest to write off at year's end, just something to think about. Also, if you do have free and clear properties, make sure to have the proper umbrella insurance and/or LLC set up to protect your assets.
- Investor · Pittsburgh, PA · Member since 2015 · 1k+ posts · 1k+ votes9y
@Robbie Taylor @Josh Mitchell @Peter Mckernan Robbie I agree with you 100%. That's the best way to build wealth the safe way and there is absolutely nothing wrong with that. If you want to grow your portfolio at a faster clip then you have to leverage. Its that simple. Josh and Peter have very good points. Its all really up to you the investor which strategy you want to run with and your comfort level.
Good luck with your ventures
The reason not to pay down a income property mortgage is due to the high opportunity value of cash to investors.
Investors must understand that every property actually has two separate income generating streams. First is the property, second is the equity in the property. Novice investors believe that paying down a property increases cash flow. In fact equity has the opposite effect it actually decreases cash flow to the point that the property itself becomes a liability as opposed to a asset. The property generates no actual income of it's own and becomes a expensive money pit.
Here is why.... For every 100K in equity, valued at 10% opportunity, it is generating $833 of the properties monthly income. When you deduct that amount every month from the rental income you see how the property quickly becomes negative cash flow producing to the point of liability. If the 100K is spread around multiple investment properties, with minimum down, the return on the 100K is increased allowing all investment properties to generate positive cash flow.
Equity in a property is dead cash that has been retired and is no longer earning it's keep. It would be financially beneficial for a investor, with free and clear properties, to sell everything and place all the money in mutual funds. The end result would be higher returns with no work.
Equity kills cash flow and disrespects the value of cash. Cash buyers are the quintessential conservative investors and receive the lowest possible returns of all real estate investors.
@Robbie Taylor As @Peter Mckernan has basically said, there is more than one way leading to Rome. As with pretty much everything, there are various opinions, beliefs and therefore approaches. I'm a firm believer that - within the "reasonable parameters" - there is no wrong or right, just variations of things of which some will suit person A and other(s) will suit person B.
As a very general approach I would say that if you plan on building up a cash-flow generating "empire" you probably want to leverage as much as reasonably possible so as to rather quickly increase the numbers of units you own. At a magical percentage (depends on you!) you may want to start using some of the cash to pay off (some) of the properties. This will actually - obviously - increase your cash flow but will also, initially, for a certain period of time reduce the available cash you can then accumulate to use as down payments for more units. I hope this makes sense.
Those people who paid for 1 unit all cash and then then wait forever to use that cash coming in until they can afford to buy another unit all cash (making it a whopping 2 units...) will miss out a lot during that time phrase, simply because of market action (price increase!) and inflation. To circle around to my point at the beginning of this post: that's my opinion. But I'm definitely not alone. ;-)
- Real Estate Investor · Encinitas, CA · Member since 2016 · 3k+ posts · 3k+ votes9yRobbie Taylor You do make a valid point in term of balancing ease of management versus adding doors as nauseam. I think if you're adding doors and debt because you want to "reach a goal of _____ doors" it makes no sense. You shouldn't invest so you can hit an arbitrary plateau. But, here are some reasons to add doors: 1.) Diversification: It good be type of property, geography, etc. but "more" is also (generally) more diversified. 2.) Planning: I don't know the specific number but I'd say at about 24 units you can pretty plan for something going wrong every month. Some vacancy, some appliance repair, etc. The bumps get evened out so it actually gets easier to service debt because there's no false confidence from a randomly good cash-flow quarter. 3.) TAXES, TAXES, TAXES: It makes some difference at $10K a month but makes a huge difference at $20K a month. You want deprecation and mortgage interest to use against the income of the property. It's worse in high income tax states like California. And cash-flow from real estate is taxed as ordinary income so anything I get, well, I pay ~45% to the government. If tenant income (through me) is paying down a loan I get equity built (no tax until I sell, even then I can 1031) and mortgage interest is getting paid (tax benefits) it's the best situation. Personally, tax implications are the primary reason I carry as much debt as I do. I don't want to "add more units" for a glamour stat line but it's a better option than paying the government. When I "retire" and use real estate as a primary source or income my strategy will change --- along with my marginal tax bracket!
- Lexington, KY · Member since 2017 · 18 posts · 19 votes9y
Thanks @Peter Mckernan. For me I think it is mindset. I love my job so I'm not looking for a way out and my wife is an agent. We have a blast with it. Lexington KY, isn't a super expensive market but it moves extremely fast. Most good deals are pending within 24-36 hours. To build a large portfolio you need to be constantly watching the market and be ready to pounce. For our lifestyle (2 daughters who are involved in everything, and a new puppy!) slow and steady is just going to have to win the race for us.
I was wanting to make sure I wasn't missing some major tax implication or something.
- Lexington, KY · Member since 2017 · 18 posts · 19 votes9y
Thanks @Andrew Johnson
- 9yPeter MckernanBusiness MemberResidential Real Estate Agent · Irvine, CA · Member since 2013 · 2k+ posts · 1k+ votes
@Robbie Taylor Nope, you were not missing anything. It's comfortability and thought process. The market is hot and it's hot everywhere. Just throw your hat into a deal as soon as you can calculate all the numbers and feel good to go. It may cause you to stay up late on some nights, but it is worth it for that needle in the hay stack you find.
The McKernan Group4.957 Reviews - Rental Property Investor · Rockford, IL · Member since 2014 · 4k+ posts · 2k+ votes9y
In a proper business entity structure, you wouldn't have one business (LLC) paying another business's bills, unless it's your S-Corp (operating company) handling payments for the LLCs.
Remember that if you're holding property in your own name, you're one lawsuit away from potential homelessness. The plaintiff in the lawsuit may settle for what the insurance company offers(, and maybe not!). Court proceedings, however, are public records. Once your holdings become public record, your ENTIRE ESTATE is exposed and at risk. Some people make their living by taking it away from others.
- Investor · Malakoff, TX · Member since 2017 · 2k+ posts · 2k+ votes9y
A follow up question on this topic: when one IS ready to start more aggressively paying down RE debt, could it be better to choose a single property to pay off, rather than spreading the additional payments across multiple properties? I'm thinking it would be advantageous to eliminate a mortgage payment, which would take longer if you spread the payments across more properties. What do you think?
- 9yJoe VilleneuvePro MemberPlymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
Originally posted by @Thomas S.:
The reason not to pay down a income property mortgage is due to the high opportunity value of cash to investors.
Investors must understand that every property actually has two separate income generating streams. First is the property, second is the equity in the property. Novice investors believe that paying down a property increases cash flow. In fact equity has the opposite effect it actually decreases cash flow to the point that the property itself becomes a liability as opposed to a asset. The property generates no actual income of it's own and becomes a expensive money pit.
Here is why.... For every 100K in equity, valued at 10% opportunity, it is generating $833 of the properties monthly income. When you deduct that amount every month from the rental income you see how the property quickly becomes negative cash flow producing to the point of liability. If the 100K is spread around multiple investment properties, with minimum down, the return on the 100K is increased allowing all investment properties to generate positive cash flow.
Equity in a property is dead cash that has been retired and is no longer earning it's keep. It would be financially beneficial for a investor, with free and clear properties, to sell everything and place all the money in mutual funds. The end result would be higher returns with no work.
Equity kills cash flow and disrespects the value of cash. Cash buyers are the quintessential conservative investors and receive the lowest possible returns of all real estate investors.
If I had my wish, I would have voted for this post 100 times. This is going to go down as one of my favorite answers to a question.
@Eric James If one was indeed at a point to pay down a mortgage then - from a risk point of view - it would make most sense to pay down 1 property rather than spreading the "invested" (I hear Thomas S. cringe ;-) ) money over 1+ properties.
Basically: one bird in the hand rather than two in the bush. That way you own at least 1 property free and clear rather than having to still share all - albeit at to a lesser degree - with the bank(s). Who will take them away from you if push comes to shove.
@Thomas S. again gets very little praise/feedback on his - repeated - input re opportunity cost of cash/equity. It seems very few people understand what he is actually saying. I guess when trying to simplify it one could say that the logical deduction from the often voiced mantra "use other's people money" is "hell, even more so use your own money where available! (to add more other's people money)".
Albeit I do concur very much with his statement "Cash buyers are the quintessential conservative investors and receive the lowest possible returns of all real estate investors" one should also realize that - again - person A likes this and person B likes that and that the vast majority of "investors" is extremely conservative. Not pulling out equity to reinvest into whatever is extremely conservative and perfectly in line with probably 95% of all people doing some sort of investing. Is it wrong to do so? I'm not to judge. Dpeends on their risk appetite which all of us here cannot judge. Then again, spyicing things up a tad typically would'n hurt those 95%...
On the other hand, the less cash these people pull out, the less cash they have to invest, leaving more properties out there for me to scoop up! Ha! There you have it.
- Spring, TX · Member since 2017 · 3 posts · 10 votes9y
I agree with Peter. It's hard to get rich paying down the debt, but there's certainly an element of comfort there.
Imagine you have $100,000 to spend. You can buy 1 100k house, and say you rent it for $1k a month. After taxes, etc... you have $750. Not bad. But say you take that 100k and buy 5 mortgaged houses. Maybe you're only making $400 per property, but with 5 properties you're making $2,000 a month. And in 10 months you can buy another property, so you're making $2,400 a month. And in 9 more months, another property so you're making $2,800 a month, all the while you're building equity in those (now 7) properties.
Now look back at buying outright: if you're saving up to buy another house outright, it will take 11 years to get another stream of income of $750 (or whatever it might be in 11 years). In 11 years how many properties could you have if you leveraged?
So it's really about growing your investment and cash flow, rather than what the cash flow might be now.
I was reading a similar thread here:
To restate what others have said, you can build wealth faster with leverage (if you can tolerate the risk/reward of the debt). Build a quick spreadsheet with a 10yr or 30yr projection, and see what your equity and cash flow grows to with $200,000 (for example) cash available in the beginning:
- Buy 1 rental for $200k, all cash (you have $200k equity in $200k value of real estate)
- Buy 4 rentals with $50k down on each (25%)....with 75% LTV mortgages. (You have $200k equity in $800k of real estate)
- use the monthly cash flow to pay down mortgages, or
- save the cash flow, until you get $50k....then go buy your 5th rental, and so on.
- Buy 4 rentals in the BRRRR method, the possibility of having 100% leverage, 100% LTV mortgages:
- Initially put $50k down on each of 4 rentals...but they are fixer-uppers that you get for 75% of ARV. Your acquisition and repairs are $200k, but the new appraisals are $267k per house. You initially have $200k equity in $800k of real estate (at your cost). Then you get the new appraisal for the refi, you take a new 75% LTV loan....you take $200k "cash out" with the refi. After the refi, you have $267k equity in $1,068,000 of real estate value and you have your original $200k cash in hand.....you have $467k (cash+equity).
- Now the "repeat" step of the BRRRR , take your $200k cash and buy 4 more rentals with $50k each. After refi....you'd have $534k equity in $2,136,000 of real estate....and your $200k cash back in hand.....then repeat for cycle 3,4,5....
- Other posts have emphasized the leverage is helping you grow faster, and there are taxable income differences if you have deductible loan interest.
- Now, what if your local market experiences a few percent of appreciation per year? Portfolios' 1, 2, and 3 above, have dramatically different wealth growth due to appreciation. Your percentage gain would apply to $200k or $800k or $1 to $5 million....
- And admittedly, if real estate dropped by much.....you'd suffer that percentage on small, medium or large portfolio.
So.....risk versus reward of using debt/leverage. Different strokes for different folks.
@Thomas S. Cash buyers also get the lowest possible sleep deprivation.
I'm not opposed to some level of debt but the biggest factor in the return I get is what I paid for the property, not whether or not I leveraged it.
- Lexington, KY · Member since 2017 · 18 posts · 19 votes9y
@Robert Grant McEwen @Andy D. I agree with you 100%. I don't think anyone here suggested paying cash for a property and using solely that cash flow to save for the next 11 years later is a good idea.
I love the concept of BRRRR or other methods to build the portfolio to the point that you attain what you want to manage. There is a point there where people who don't want investing as a full time gig want to stop and enjoy the passive income. I'll still have a very substantial 403b from the University I work for and a wife who will be getting her brokers license as soon as she's eligible. I'm not necessarily as risk averse as you say the 95% are. I'm just not out to get a high of the next big deal. I like to take the necessary risk to accomplish my long term goals (like diversified sources of income, a nest egg for my kids to get started with etc.) I'll never feel like I'm losing anything by having other investors "scoop" up properties when that is the thing they do and depend on as their job.
As a dentist, this will never be my full time gig, nor would I want to be dependent on it. My expertise is elsewhere. I'd admit though this is a lot of fun and I'm sometimes jealous of my wife's job ;)
- 9yJoe VilleneuvePro MemberPlymouth, MI · Member since 2013 · 13k+ posts · 19k+ votes
@Thomas S. You are one of the few that really get it...unfortunately. Too many REI have no clue how money works. One of the great lies most believe is their own home, if paid orr or not, is their greatest investment..and that couldn't be further from the truth. This same "homeowner" mentality is then carried over to REI, and they lose...but don't know it.
Money, your own money, or your seed money (wherever it came from) is a verb. When it becomes a noun, you lose.
Stick to your guns Steve. You are 100% correct...but you knew that already.
I think it comes down to your goals. If your goal is to get to a certain $ amount per month and stop, then yes, I think paying the mortgages off can be a good strategy. If your goal is to amass a lot of properties or build an "empire", you really can't do that by paying off mortgages. I keep myself leveraged to a certain point and if it gets too low, I cash out refi and buy more properties. For me, I'm trying to build a business, not just cover my expenses (plus some) and stop, so paying off mortgages is the last thing on my mind.
- Rental Property Investor · East Wenatchee, WA · Member since 2014 · 10k+ posts · 16k+ votes9y
Not all RE debt is the same. I have a mix of paid off (or getting there) higher risk and higher PITA commercial loans with annual reporting requirements, balloons, adjustable rates, etc. Those are going bye-bye, 'opportunity cost' or not.
Some of us also have older resi's with 6+% rates and I'm satisfying a couple of those as well until things cool off in my market.
But if you are talking about long-term fixed rates in the 3s and 4s, no. Not even I rush to pay those off. A 5th grader could beat those returns passively in their sleep. What rate and term of loans are you talking about @Robbie Taylor?
Originally posted by @Robbie Taylor:
I love the forums and the podcasts, but one constant I see is that people are looking to add more properties or refinance properties for cash to buy more properties etc.
Why don't more people start snowballing down the debt on their first properties with the cash flow from the 2nd and 3rd purchases and so on? Is there a downside to owning free and clear? If I look 10 years in my future I think I'd rather have $10,000+ a month in cash flow while managing a portfolio of 7-12 free and clear units (depends on your area) than managing a 40 unit portfolio with debt, responsibility, and moving parts. Is it just all about personal goals or am I missing something big here?
I think the only thing you're missing here (and you aren't necessarily missing it) is leverage. Now, please don't think that I'm arguing for or against leverage. That's a classic risk versus reward argument, and there are arguments in favor of either technique.
I've always been a debt-free kind of guy. I own one property currently, and it's a property that I bought to live in, and later convert to a rental. I ended up becoming a bit scared of the debt during the great recession a few years ago, and aggressively paid on this property, until I eventually paid it off. I then started saving cash for a downpayment on the next place. So, I now sit in a position with one paid off house, and a lot of cash.
The argument for leverage (which in this case simply means buying a place with debt instead of cash) is that you can use other people's money to your advantage. Now, there's no denying that this comes with more risk, but it also comes with more reward.
I'll give a very elementary example of this phenomenon, using completely arbitrary numbers (and totally ignoring all of the other little moving pieces like lender requirements, etc):
Scenario 1: You purchase a single family residence for $100,000, and pay for it in cash. This property is ultimately returning 10% of the purchase price per year for you, or $10,000 on your $100,000 investment. Not bad, right?
Scenario 2: You buy the same home above, and you only put $10,000 cash on the table. You finance the remaining $90,000 with a loan that costs you an arbitrary 5% per year. So, you've now earned $10,000 at the end of the year, minus the financing cost (90,000 X 0.05 = -$4,500). In this instance you've made $10,000 minus your $4,500 in financing costs, for a net return of $5,500.
While scenario #2 gives you less cash in hand at the end of the year, it did so with substantially less cash leaving your pocket in the first place. In the first scenario you paid $100,000 and took home $10,000 in Year #1 (10% return on your cash investment), and in scenario #2 you paid $10,000 and took home $5,500 in year #1 (55% return on cash investment).
If you were able to procure financing that allowed you to buy 10 identical homes to the hypothetical one described in this scenario, each with just $10,000 on the table, you would have ultimately spent the same $100,000 described in scenario #1 at the end of the year. The difference is twofold:
1) By leveraging yourself in the manner described, you would theoretically make $55,000 in profit in year #1 instead of $10,000 profit, using the same outlay of cash.
2) But, by doing this you will have also exposed yourself to $900,000 in debt, that cost you $45,000 to finance in year #1. So, your returns are higher by using leverage, but your financial risk goes up substantially, too.- Investor · Kansas City, MO · Member since 2017 · 791 posts · 1k+ votes9y
Because I reached financial freedom in 7 years with only $150,000 TOTAL of my own money left in deals. (49 properties, 107 rental units)
Originally posted by @Joe Villeneuve:
@Thomas S. You are one of the few that really get it...unfortunately. Too many REI have no clue how money works. One of the great lies most believe is their own home, if paid orr or not, is their greatest investment..and that couldn't be further from the truth. This same "homeowner" mentality is then carried over to REI, and they lose...but don't know it.
Money, your own money, or your seed money (wherever it came from) is a verb. When it becomes a noun, you lose.
Stick to your guns Steve. You are 100% correct...but you knew that already.
I think you're both right. I'm trying to teach myself to stomach the risk more, and make the moves I know I should have made in the past. I look at the post I just wrote, and realize that I wrote an argument in favor of leverage, though I've never done it myself. I have a paid off house, and a pile of cash. Neither are doing any work for me on their own. Sure, the house has almost doubled in value in the ten years I've owned it, but I could have done a lot more by putting that money into other investments at different times along the way.
Still, I held that house through the worst housing recession any of us have probably ever seen, and when you're holding onto a property in the first couple of years and watching its value plummet, it makes you a bit risk averse. On the other hand, I've now been in that property long enough to watch its value nearly double, so there is that side of the market cycle, too.
I've always been very good at saving money, and living well beneath my means. I just need to learn to embrace the idea that spending money on an investment property, and carrying debt that makes me money, is entirely different than financing a new sports car, or putting a vacation on a credit card. I've never been a gambler, but a calculated risk shouldn't be seen as gambling. As soon as I get that idea right in my head, I'll probably be unstoppable :)- Investor · Greenville, SC · Member since 2016 · 5k+ posts · 13k+ votes9y
Thomas covered it very well.
Robbie, another misconception is that investors have to keep buying more and more units. You can leverage however many direct ownership units you want and then invest your remaining capital passively in real estate or other asset classes.
On a final note, some investors just do not actually understand the opportunity cost. Being intentional and knowing that one has a low ROE is one thing but some just don't realize it.
The sweet spot for many investors is modest leverage.
- Investor · Malakoff, TX · Member since 2017 · 2k+ posts · 2k+ votes9y
I'm also in favor of using substantial leverage. A problem I expect to have in a couple years or so is reaching my DTI ratio limit for conventional borrowing
At that point I will need to either pay down debt or find other acceptable means of financing.
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