Pay off one property or look at another?

Question

Hello BP!

So after reading Set For Life, I am finally past the $25,000 threshold and between the $50,000 - $100,000 threshold.

One question I can't answer for myself and can't seem to find any real good substance is: Should I pay off a house prior to buying another house? Or should I fund as many investment rentals as possible?

Here's where I am at.

I am looking at a investment property selling for ~$100,000.

It's cash flow positive.

I can put down $35,000 - $40,000 to cover the initial down payment & closing costs/rehab costs/taxes/insurance.

Now, I work oversea's, so I don't have rent, food costs, bills of any kind. Debt free.

My initial plan is to get the rental property with a PM.

I can realistically pay it off in full in 4 months (April2018).

My second goal would be to look for a second $100,000 with a PM and funnel the rent from Property 1 into Property 2 to pay it down faster + with my income, have it paid off Sept 2018 time frame. Assuming I pay it off aggressively.

With 2 houses paid off I can collect 90% of the rents (between $1600 - $1700 conservative estimates) and start funneling it into a 3rd Property, possibly a MFH @ $250,000 or another $100,000 property. Post 2018, into 2019, I can probably get Property 3 paid down to 70% equity or paid off, which will set me up for 2019 to look at a Duplex / Triplex / 4-Plex (which I'd really want).

Now, thats my plan. Alternatively, I've read people recommend having 70% equity in a property prior to looking for a another property, and some just advise to 'plant as many seeds as possible', obtaining several rental/investment properties as possible. Everything with my job is uncertain, I can be fired today, tomorrow, 1 year, 2 years, 5 years. Tomorrow isn't promised to anyone. But I can say my outlook is very good as far as a longterm job with the income I make.

I don't want to stretch myself / my finances so thin that a slight bump will knock me over. I'm really curious how others build their portfolio's. Any help / insight is helpful.

Even if I fund 2 - 3 properties, without actually paying them off, the rents combined would give me between $900 - $1100 in monthly cash flow. Which I suppose isn't bad, but could be better?

I also understand that I could just put in the initial downpayments have the renters pay down the mortgage, while I continue to use my extra capital for another rental / investment property, but have all financed/loans on houses scares the bejesus out of me, even though I know it's the most touted strategy.

Appreciate any insight!

Anthony Gayden · Answer

@Yuuj V.

"I don't want to stretch myself / my finances so thin that a slight bump will knock me over."

And yet your plan to put all your money into one or two properties will do just that. It will concentrate all of your money in very few places. It will give you only 1 or 2 streams of income. By trying to play it safe, you are actually putting yourself at greater risk to lose money investing in real estate.

I know it can be hard to understand, but the more units you own, the lower the risk. I have never had all of my units go vacant at the same time. Not only that, but as others have said, the tenants pay down my mortgages, not me, and by not pouring all of my cash into a small number of properties, I am able to expand quicker.

Now I am going to throw another thing in that no one has mentioned yet. That thing is appreciation. In an expensive market such as Boston, you can realize a great deal of gains through appreciation. In that game the more you buy, the more you make as time passes. Buying a few more properties with financing instead of cash can be a game changer.

Scott Trench · Answer

@Yuuj V. Congrats on saving up so much money! And, welcome to the realm of "good problems" that you (hopefully) will have for the remainder of your life, assuming you maintain a semi-conservative financial position.

The tradeoff here is a classic one that almost all real estate investors struggle with. Do you stay leveraged, and earn a higher return, or pay off properties and enjoy a high cash flow and remain debt free.

There is no "right" answer to this question. The guy who is leveraged often has better odds of creating more wealth and sustaining higher returns over time than the guy who pays off properties as fast as possible. But, the leveraged guy will have to operate at peak efficiency and will have more stress than the debt-free guy over the life of ownership.

For me, I do NOT pay off my mortgages early at this time. I may change my mind in the future as I move from my modest portfolio to a larger one and decide that I'd rather be wealthy, stress free, and achieving modest returns than be wealthy and operate perpetually at peak efficiency.

Personally, I think that while you are young and just starting the wealth accumulation process, that it's good to use leverage and take an active role in growing and managing a portfolio. Then, after you've given yourself the great problem of having a sizable portfolio and more cash flow than you need or want, to feel free to pay off the properties early or releverage and keep on going!

While you say that your job is uncertain, is your ability to earn a similar level of income equally uncertain? As in, could you just move to another job and earn within 20% of what you currently earn? If so, then you might feel good about maintaining some leverage. If not, then you gotta do what you think is best to create as much cash flow as possible as soon as possible and might want to be more conservative. Up to your perception of course though!

Scott Trench · Answer

Also, I am MUCH more conservative with the reserves. An HVAC problem can easily run close to that $5K you have saved up, so if a couple of things go wrong at once, you may be in for a stretch of trouble.

I built a reserve of $20K for my first property (mortgage of $1,500 PITI per month, so this was over twice the six months that is often encouraged), and then I add another $10K or so per additional property, and upping it just a bit more if I smell any big CapEx issues coming up. This is a really nice luxury, although yes, it may be a bit too much and therefore hurting the optimal returns I might get.

I prefer to keep a big reserve, especially with the first property. But, others have good opinions on this subject, and hopefully they chime in.

Brent Coombs · Answer

@Yuuj V., when you're "fired today, tomorrow, 1 year, 2 years, 5 years", what would you prefer: getting a small positive cash flow from each of 50 (leveraged) properties, or, a larger cash flow from just 5 (paid-off) properties? [I might be exaggerating a little, to make a point].

(I believe your answer should be: the first one!)

The main question you should be asking is: How much is each property that I'm paying $100k for today, already worth? ie. All your deals should aim to be: super-bargains!

Let your tenants do your mortgage-paydown thing, while you concentrate on wise-investing!

ie. Your tenants still pay you, even when you run out of your own high income!

ie. Your income can be better-used to find higher than mortgage interest rate return, right?

But to alleviate your concerns, I'll reiterate: Buy super-bargains only! My 2c...

Joe Villeneuve · Answer

All of your answers are in what you wrote, you're just not seeing it. You are completely missing, or just brushing over, the most important aspect of all of this. Just follow the cash...your cash.

For each scenario you mentioned (payoff fast using all of your cash, payoff fast using cash flow, pay minimum of your cash...just DP...and leverage the rest), do this:

1 - Add up all the cash you put in (for each option)

2 - Add up all the cash flow you get back (for each option)

3 - Realizing that the difference between Step #1 and 2 is your net cash flow,...

...which option is better?

Let me add this to the thought process. If you leverage to the max, any money you take out of your pocket to (in your mind) pay down your principal up front, is only paying for your negative cash flow...upfront. It's not changing negative cash flow into positive CF.

EXAMPLE:

Cost $100kCash Flow/m 850CF/Year 10k80% mortg. 5k/yr80% CFY 5k/yr

If you pay off property within 4 months: Assuming 3 properties paid off in order
  First property 2nd       3rd TOTAL
Cash out of your pocket $100k $100k $100k $300k
Cash flow before payoff 3k 3k 3k
CF after payoff (year 1)    3k 1.5 0
Total CF year 1 6k 4.5 3 13.5k
CF after yr 1 (full yr) 10k 10 10 30k
Payback of your Cash In over 10 years...assuming no added costs or vacancies.
Actual profit/cash flow 10 yrs negative cash flow of $16.5k
In other words, you don't break even until very late in year 11....for each property

If you let the tenant payoff the property for you:
  First property 2nd 3rd TOTAL
Cash out of your pocket $20k   $20k     $20k    $60k
Total CF year   5k 5k 5k 15k
Payback of your Cash In   4 years...assuming no added costs or vacancies.
Actual profit/cf over 10 years Positive cash flow of $90k
In other words, you are breaking even at the end of 4 years...for each property

Use the same $300k in cash you would have used paying off properties and applied to only using it for DP's, you would get the following over that same 10 year period:
Aassume -
Cash out of pocket = $300k
DP/property 20k
# of properties 15
rate of purchase 5 every 4 months ($100k...using same spending timeline as other option)
all properties purchased within first year: $5k cf/yr profit after break even

Year 1 5 - 10 Cash out of pocket $300k 0Profit starts 5th yr owned 0 $375k Total profit after 10 years(Remember, you're still $16.5k to the negative at the end of year 10)

Yuuj V. · Answer

@Scott Trench Thank you for the insight, and for writing an amazing book.

Getting within 20% of my current income wouldn't be too difficult. I would just have to switch jobs / locations probably, but it would not be difficult. I believe I can stay out where I am at for 2 - 3 years, and accumulate several houses and have them managed by a PM. Everyone brings up a good point about leverage, and I will pursue that path myself.

As for the cash reserves, 6months + $10K is probably not a bad idea either, and something I can definitely do. Thanks for the tip.

@Anthony Gayden You brought up a good point that I don't think I really sat and thought about. Concentrating all my money into a single house, and hoping it doesnt get burned down :P. Spread the risk, diversify!

It becomes all about scaling the portfolio, it makes more sense now. As well as building wealth and moderate income.

I won't be buying in Boston, I'll be investing long distance in other states. Even with my salary, I can't afford Boston, nor would I want to. Those properties are really good, duplexes and triplexes, but looking at $550K+, even $350K for SFH. I just rather use that DP and spread it to 2 - 3 houses in cheaper markets. (assuming 20% down payment).

I'll come back to Boston another time when I'm ready for the big leagues.

Yuuj V. · Answer

@Joe Villeneuve,

Thank you for a breakdown of the different scenarios! that really painted a clear picture for me.

I should've run the numbers... numbers don't lie. Your make shift charts really hits the nail on the head for me and now I know what I'm going to be doing this year... 2 - 4 houses? :)

Have the tenants pay down my mortgage, while I make cash and focus on my next investment!

Thanks again!

@Brent Coombs Thanks for your 2c, they are worth more. I believe the property I am looking at is under valued. The houses around it, according to Trulia and Zillow, sell for $20K+. How this one is selling for ~$110K is either really lucky, or something wrong with the house. I'm hoping that they are just motivated sellers.

I just watched BP PodCast 197, and the guest explains that he only bids for 70%, sometimes not even looking at the prices and just throwing in a 70% bid anyways. Deals deals deals!

@Russell Holmes Appreciate the input. After reading Rental Property Investing, I always include that in my rough draft of a home purchase blueprint. Still a gold nugget to remember for sure. I ballpark myself around $5K in reserves, to account for vacancy, $1K in break-fix. Would you recommend have individual 'buckets' of reserve for each house? I guess it couldn't hurt, but wanted to know your thoughts.

Yuuj V. · Answer

To add on,

I had to re-read my words a lot.

I think what this really comes down to is Safety vs Risk.

Its safer bet to pay off the homes and have no debt and no problems if a tenant leaves vs having homes financed, and when the homes are tenant-less, have to upfront the costs myself from my own pocket, and be able to pay that.

But, its also monetarily better to have financed homes that are cash flow positive vs using your cash to pay down the house before you see any profit.

Both have long term positive's.

Equity is built over time using someone elses money, vs you paying down the equity before you reap any reward.

Funny what you can learn from writing down your thoughts and than re-reading them :P :D

Pay off one property or look at another?

Pay off one property or look at another?

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