Actual return on investment various pre payment strategies
Rental Property Investor · Winslow, ME · Member since 2008 · 826 posts · 281 votes
I know conventional wisdom says "if you pre pay a mortgage, your ROI is whatever the interest rate on the mortgage is". but I KNOW there was an article here that I've since lost track of that showed it's NOT the case. For some reason, you can capture a GREATER ROI than the stated interest rate depending on how early your pre payments are and how much. He laid it all out, and like I said, I THINK it was an article on this very website. Does this sound familiar to anyone?
Neither is correct. Stop analyzing RE like the Stock Market. They're not the same thing. When you do, you are missing out on most of the advantages REI has to offer. For instance, in this case, here are the key points:
1 - Profit in rental REI is measured mostly in cash flow...POSITIVE CF.
2 - PCF is the result of the spread between the income (rent) and outgo (expenses)...per month/year.
3 - Profit is a measure of the difference between the positive cash flow, and the amount of cash you put into a deal from out of YOUR pocket.
4 - Since the mortgage (interest and principle) is paid out of the rent, which is paid to you by the tenant, the mortgage is NOT a cost to you...but a cost to the tenant (indirectly). This is a "follow the money" application.
5 - This means, ALL the cash you put in must be recovered before you are making a profit. The more cash you put in, the longer it takes to recover and the longer it takes to the start of your profits.
6 - Therefor, when you add any of your cash to the principle, at any time during the ownership of a positive cash flowing rental property, you are spending money that you need not spend...and getting no real savings to you. It actually costs you more money.
7 - The tenant's job is to pay the mortgage for you. Don't help them. They are doing a great job of it.
Neither is correct. Stop analyzing RE like the Stock Market. They're not the same thing. When you do, you are missing out on most of the advantages REI has to offer. For instance, in this case, here are the key points:
1 - Profit in rental REI is measured mostly in cash flow...POSITIVE CF.
2 - PCF is the result of the spread between the income (rent) and outgo (expenses)...per month/year.
3 - Profit is a measure of the difference between the positive cash flow, and the amount of cash you put into a deal from out of YOUR pocket.
4 - Since the mortgage (interest and principle) is paid out of the rent, which is paid to you by the tenant, the mortgage is NOT a cost to you...but a cost to the tenant (indirectly). This is a "follow the money" application.
5 - This means, ALL the cash you put in must be recovered before you are making a profit. The more cash you put in, the longer it takes to recover and the longer it takes to the start of your profits.
6 - Therefor, when you add any of your cash to the principle, at any time during the ownership of a positive cash flowing rental property, you are spending money that you need not spend...and getting no real savings to you. It actually costs you more money.
7 - The tenant's job is to pay the mortgage for you. Don't help them. They are doing a great job of it.
@Kenneth LaVoie I feel it is good to learn about alternative strategies but the benefits to keeping that debt are really effective. Mortgages on an investment property are a BUSINESS debt. Businesses defer debt very often for great reasons mentioned by @Joe Villeneuve. One other is that it is ALSO a tax write-off. Keeping your cash, so you can buy more properties, is more important than paying off debt. If you can continue to acquire income producing assets that SIGNIFICANTLY outweighs paying off debt.
@Kenneth LaVoie I feel it is good to learn about alternative strategies but the benefits to keeping that debt are really effective. Mortgages on an investment property are a BUSINESS debt. Businesses defer debt very often for great reasons mentioned by @Joe Villeneuve. One other is that it is ALSO a tax write-off. Keeping your cash, so you can buy more properties, is more important than paying off debt. If you can continue to acquire income producing assets that SIGNIFICANTLY outweighs paying off debt.
It's a net/sum "game". As long as your cash cost is less than your cash return, you win. When your cash cost increases, but your cash return doesn't, or the cash return is reduced, then you lose.
The object in REI isn't to own the assets. The object is to control them...and the flow of cash coming and going through those controlled assets. If your tenant buys the property for you, then send them a Christmas card every year with a note of thanks, but don't help them. You would be spending cash for no reason, and working your way backwards...eventually out of the game.
This is good stuff and I don't always remember to think this way. I do consider timing, for example: It's more important that our cash flow be higher for the next 5-8 years because of our teen daughter's education, maybe settling down, and more traditional (expensive) family travel vs. my wife and I "backpacking across Europe" type of travel. Hence, killing off the mortgages on a couple of 7 units that still have 11 years left out of 20 makes sense because it should increase our cash flow MORE for the next 11 years than it would putting it into a stock and bond portfolio.
Despite understanding the "absolutes" (i.e. it's more profitable to put as little down as possible, and have as long and big a mortgage as possible to enhance return on initial equity), we still tend to lean toward expiring mortgages, especially during higher valued stock market. Not saying this is the right way (or even A right way) but just exposing my thinking for critique.
This is good stuff and I don't always remember to think this way. I do consider timing, for example: It's more important that our cash flow be higher for the next 5-8 years because of our teen daughter's education, maybe settling down, and more traditional (expensive) family travel vs. my wife and I "backpacking across Europe" type of travel. Hence, killing off the mortgages on a couple of 7 units that still have 11 years left out of 20 makes sense because it should increase our cash flow MORE for the next 11 years than it would putting it into a stock and bond portfolio.
Despite understanding the "absolutes" (i.e. it's more profitable to put as little down as possible, and have as long and big a mortgage as possible to enhance return on initial equity), we still tend to lean toward expiring mortgages, especially during higher valued stock market. Not saying this is the right way (or even A right way) but just exposing my thinking for critique.
Again, you're interjecting the Stock Market into your REI analysis. Why? Don't. You end up missing the greatest advantages of REI...the compounding effect of the returns and reinvestment of those returns, and...the reality that you can take all of your money out (cash you put in) of the original investment, and still be gaining the same (and inflating) returns on that original investment...exponentially.
Sorry, but the Stock Market can't compete with a halfway descent REI Plan...but you have to have an actual REI Plan. Speaking of Plans, can you ever really have a short/long term investment plan in the Stock Market?
Gosh I wish I could grasp this in the way I think you mean it. Purchasing more RE is simply not an option. I have no reasoning other than "we've decided that we don't want to." There's more to it than that, but any idea can be proven right or wrong by simply having a better argument. There's ALWAYS a great reason why my wife and I should put our noses to the grindstone and accumulate more and more units. We simply aren't going to. If that makes us stupid, I'll have the tshirts made tomorrow.
But I really do want to understand where you're coming from because I fear I might be missing something. We do have a point by point 5, 10 and 15 year plan, and even have a spreadsheet which gives us every possible consequence, tax and otherwise, to keeping, selling, etc. I even have th tax consequences broken down by the cost of depreciation recapture vs. LTCG.
That being said, I do interject the stock market, (when I really mean any place to put capital other than real estaet, like ROTHs, Solo 401ks, etc.) The reason is, because the extra money has to go somewhere. If I sell a building and have 100K cash in my hand at closing, I have to put it EITHER in my investment portfolio, pay down mortgages, buy more property. #3 will never be an option. So why do you think it doesn't make sense to think of our portfolio when we are weighing the pros and cons?
Thanks for any clarity you can shed.
Our plan A: Sell all units and retire on 3.5% of our investment porfolio, travel extensively, and within approx. 10 years buy a place overseas ot take advantage of geoarbitrage (i.e. settle where our american middle class income makes us 1%'ers)
Our plan B: Sell SOME units, in order of ascending quality, putting a predetermined amount into short term cash, the rest used to pay off existing mortgage on building still owned (but only if 100% of the mortgage can be paid off, thereby increasing cash flow to offset the decrease in cash flow by losing the building). This tactic would change if the S&P 500's CAPE10 valuation were in the lowest 3 quintiles (it is currently in the highest quintile..see below)
Our plan C: Nobody wants our buildings at the prices we want, so fººº it, we'll keep em' till we die. Wait until the S&P is in one of the bottom TWO quintiles, refinance 50% of the available equity in our buildings and plow it into our portfolio. If the S&P is in the BOTTOM quintile, refinance 100% of the available equity in our buildings and plow it into our portfolio.