Debt Free Investing
Rental Property Investor · Boone, NC · Member since 2013 · 22 posts · 4 votes
I'm not sure about you. But I'll take $6K a year with little risk vs. $1680 a year with higher risk, such as default. What happens when the $4000 hvac system goes out. With $6K, you still have $2K left. With $1680, you're $2320 in the hole. Then lets say the tenant does a midnight move-out and leave you with a $2000 cleanup. You just broke even, unless you use leverage and you're now $4320 in the hole for the year and you become one of those landlords wanting out and you sell for less than you paid just to get out of the trap. By my calculations, you're approximately 30% down for the year now. And we all know this scenario will happen at some point. Remember the tortoise always wins the race.
There are a number of investors on BP like yourself that are very anti-debt. There's really nothing wrong with it, though your returns aren't likely to be that great, particularly if you are paying at or near retail. It goes without saying that you accelerate your property acquisitions with debt, but that seems like something you're adamantly against as its inconsistent with your risk tolerance.
I guess from a bigger picture, I'm wondering, why RE? In my mind, leverage is the most important thing that makes it worthwhile as an investment vehicle. Otherwise, my experience has been that the numbers are generally pathetic and you could do better buying corporate bonds or dividend stocks or whatever. (I'm not talking about buying inexpensive homes that qualify for the 2% rule or anything, just buying normal homes at retail prices). Landlording is quite a bit of work and it's my opinion the returns should be worth the work.
Congratulations on college without debt. The two components of a sure thing plan is to have no debt and to live on less than you make. Of course this plan takes a little longer but it works every time.
My wife and I have had up to 50% debt at times but can certainly see the benefits of little or no debt. Many of the 70 properties we have bought have been from investors who bought with little or no equity and couldn't make it.
Again, congratulations. Keep up the good work.
Bill
I'm not sure about you. But I'll take $6K a year with little risk vs. $1680 a year with higher risk, such as default. What happens when the $4000 hvac system goes out. With $6K, you still have $2K left. With $1680, you're $2320 in the hole. Then lets say the tenant does a midnight move-out and leave you with a $2000 cleanup. You just broke even, unless you use leverage and you're now $4320 in the hole for the year and you become one of those landlords wanting out and you sell for less than you paid just to get out of the trap. By my calculations, you're approximately 30% down for the year now. And we all know this scenario will happen at some point. Remember the tortoise always wins the race.
@John Chapman @Adam Johns I do understand the power of leverage and that I can grow much faster by leveraging; however I do not feel that that is the right investment strategy for me. My goal is to have several paid off properties over the long haul that provide solid cash flow to live on. Also I will sleep better at night knowing that I own the properties free and clear. I am not much of a risk taker but I do want to be a solid investor.
@Brian Mathews Thanks Brian! I agree with everything you said. I do understand where @Adam Johns is coming from and that investment style does seem to work well for some. I want to be the tortoise. Slow and steady with solid cash flow and avoid giving cash away to the lender every month.
Lots to this question, and the answers above are spot on. I dont do monthly payments anymore after getting knocked in the dirt when the market tanked in 2007. My negative cash flow was over $30k/mo for over a year. Had a lot of empty houses with mortgage payments...Believe me, that isn't any fun. I had significant cash reserves and still got wiped out.
I dont have any rentals anymore, but I'd still own them if I could pay cash for them at the right price to rent ratio in the right neighborhood. I've actually made a few offers on dirt cheap ones this year that didnt go my way. Personally everything I own is paid for except for the two rehabs I have going and both of those are funded with private money that gets paid back when I sell them. I'm full time and dont have monthly income so avoid monthly payments like the plague. It makes for a pretty stress free life. The only thing I pay monthly is my cell phone and I forget to pay it almost every month.
I remember telling my accountant when I started how much I hated debt and he laughed and said "you're in the wrong business then". A lot of that is personal preference, but I have to say that the math works out better well when you leverage rentals, especially when you can borrow money at 4% for 30 years and prices are depressed. Plenty of people make lots of money doing it that way. You should be OK using some debt if you stay under 50% LTV, keep cash reserves and have outside income, especially if you are gonna do just a few. Paid for rentals are great, but one of the main advantage of real estate returns vs. other investments is the ability to leverage. If you aren't going to leverage, I'd say you'd be better off loaning that $85k to other investors, I'll pay you 16%/yr on it (I pay my private lenders 2pts and 12% for my rehabs) and you never have to collect payments for fix leaky toilets...
I'd be more worried about paying $85k for something that rents for $1k than owing $45k with a $300 payment on something that rents for $1k, espcially if its a duplex and one side covers debt service. I would think you can do better than that in Memphis and still stay out of bad areas. If you carry some debt you can spread your risk of vacancy and damage out over more props too.
One of my favorite things I've read on Bigger Pockets was something like "one door is too many, 1,000 doors is not enough". The more you own the more you can spread out the risk and pay for someone else to handle the headaches.
Sounds like you're gonna win either way with your mindset, though. Great to see someone on that kinda track!
Actually, the $6K and the $1680 both assume 50% expense ratio on the $12K in gross income -- that 50% expense ratio covers all capital expenditures (like the HVAC system) as well.
So, in both cases, the $6K figure and the $1680 figure are AFTER these types of expenses.
The $6K and the $1680 are your net profit.
I'm not saying leverage is right or wrong (while I have an opinion, that's for everyone to decide for himself); but I can say that if you're generating $6K on an $83K real estate investment, you can probably do better elsewhere.
@Lance Cummins Very similiar strategy here. My girlfriend and I are looking to purchase our first multi-family within 12-18 months. I'm just curious, will your second purchase be a multi-unit as well? Or single family?
@Brian Mathews , I completely understand your point of view and your conservative approach has already proven itself by you and your wife graduating from college debt-free. Congrats on that!
I don't think there is anything wrong with taking the tortoise approach and accepting single-digit returns. However, I also agree with @John Chapman 's question: why RE? Those returns can be reasonably achieved with other, less hands-on (than landlording) investment vehicles, so I think you should consider those as well. Doesn't have to be one or the other - in fact, you might be well-served with a balanced investment approach, where your RE investments are an appropriate portion of your overall portfolio.
Incidentally, while I don't know your market, in MY neck of the woods, I'd be quite satisfied with an $84K deal that generates $1000 rents (yes, I know it's not meeting the 2% rule, but it's by no means terrible in my opinion),
@Brian Mathews these calculations aren't quite right:
@Adam Johns is accounting for such events by subtracting 50% off the gross rents before arriving at the $6K or $1680 numbers. The cost of that AC or the tenant damage is already covered by that 50% number. Its not in addition to the 50%, as you seen to be thinking.
Of course when you're a landlord cash reserves are essential. Some years will be under 50%. Some (this year, for me, thanks Mr. Holey Sewer Line) will be worse. Cash reserves are your buffer.
@Lance Cummins your statement "avoid giving cash away to the lender every month", while conservative, is flawed. You are absolutely correct that the cash approach is safer. But your safe strategy is in fact the one that's "giving away cash". Because your cash on cash return is lower than if you were using leverage your giving up some returns in exchange for a more conservative strategy. So, don't think of leverage as "giving away cash". Rather, just as the word says, you're leveraging the bank's cash.
Here's a better way to think of those calculations. If your property can earn 7%, as in Adam's example, that's what you'll get if you buy in cash. In commercial investing, that's called the "cap rate" or capitalization rate. Now, if you use a 25% down payment and borrow money at 5%, you will still earn that 7% on the portion of the property covered by the down payment. In addition, you will earn additional returns on the remaining 75% of the property. That is, you earn 7% on that 75% but you have to pay back the bank at 5%. So, your earnings on the financed portion of the property are 2% of the value. Because that portion is 3X the size of the down payment, you're earning an additional 6% on your down payment, for a total return of 13%. That's almost double the return you get if you pay cash.
Now, you should be saying, hey, but my payment would include principal. Indeed, it would. So your cash flow less because of the principal payments. The shorter the loan (which is effectively what you're really doing), the lower your cash on cash return. In exchange you are building up equity in the property. Once its paid off, as in your all cash scenario, you get the full return.
There's nothing wrong with your strategy. If can produce OK returns. I'm not convinced, though, that if you really can accumulate that cash that its the most profitable strategy. Honestly, I think hard money lending is a more profitable strategy for folks with cash. Its what I do with IRA money rather than owning property. And I think you can probably find better deals than the one you describe in Memphis. $84K for $1000 in rent is OK, but nothing great. Memphis is a popular area for turnkey investments (absolutely not recommending these). Since you're there, you should be able to find those same sort of low priced rentals. "Nice" rentals are often not the most profitable. I don't mean switch to a war zone, but lower priced properties will generate better returns. Selected carefully and operated well they aren't any more troublesome than the student rentals you're buying. Your strategy is already limiting your returns. Don't futher handicap yourself by lmiting yourself to nicer properties.
If you are adamant on buying with cash you have to use that to drive the price down. What I would do in your situation is buy the property for cash, get it rented out and then do a cash out REFI into a 30 year note. This will keep your cash flow higher than a short term note and allow you to roll that money into another property. This gives you the best of both worlds. It allows you to drive the price down with an all cash offer, and allows you to juice your returns with leverage. You need to look a debt in a different light. I am personally not a huge fan of Dave Ramsey, while he has great advice for personal debt his advice on long term assets is so so at best. Debt is not this evil thing that a lot of people make it out to be. On a completely different note congrats on securing your future, just keep in mind that in the future you will adjust to rising standards of living and its not easy to go back.
@John Chapman @Andrew S. Yall do have a great point. Maybe I should rethink my investment strategy. Without using leverage for RE investments I may get better returns in the Stock or Bond markets. Being a husband and hopefully a father someday I want to provide a very solid investment base with good returns to provide for my family before taking on much risk.
@Augustin G. I hope to invest in multi-family someday but they will be several years from now.
@Jon Holdman Wow! Great advice. Thank you. You have Given me some great things to think about. You have pointed out that maybe I am the one "giving cash away". Its good to have another point of view. Thank you.
I'm not sure exactly what you are asking. Are you asking for advice about what would be a good non-RE type of investment that is exceptionally liquid (basically, the equivalent of cash)? If so, then I'm probably not the guy to ask. Anything like that is going to be like a CD, money market, or other exceptionally low return vehicle, which everyone knows about. I don't know much about stocks and bonds, other than how to lose money on them and, like many people on this site, I'm generally disenchanted with the stock market. I generally make sure I have enough cash reserves, decent insurance, and then plow the rest into RE. I think that a truly passive, risk free investment with decent returns probably doesn't exist (or is not available to smaller investors like ourselves). It's my perception that's why people turn to RE.
Forgive me for being blunt, but you're young and should be focusing on growing your capital, not trying to preserve it and generate some miniscule return. (That's for later in life.) From my perspective, the greater risk is that you are not aggressive enough in seeking returns, make tiny returns for a decade or two, and are way far behind when you're kids are getting ready to go to college and you're burning out at your job. Bear in mind, I'm not saying you've got to start flipping or land speculating or anything.
If you're hell bent on avoiding risk, then I would probably focus on growing my income at my job like crazy, since you're money won't be working that hard for you. In my opinion, that's way riskier than RE, since jobs are, in my opinion, risky and can disappear in a flash. I don't say all this to be mean, but candid.
I'd like to build on John's post. While it's not risk free as no investment is. I think the lowest risk is the investment in one's self through education and learning as much as possible. One of the best investment's I make is through my hvac business, which required learning and education as well as marketing and advertising. I see almost an immediate return on pretty much anything put into it. I put $50 into postcards a month ago and got a $4000 sale few weeks ago. I don't know what the ROI on that is, but much better percentage wise than almost anything aside from the lottery. I did another one 2 weeks ago and got a service call last week and a referral to the lady's son, a real estate agent in the area and her neighbor.
Any advice for a beginner? Does this sound like a solid game plan?
Hey @Lance Cummins welcome to the site!
Something else to consider if you want to invest debt free, is to research markets and find one that will get you better returns. I invest in the Detroit area (not the city) and I can pretty easily find two homes around $40k each, that will rent for $850/month. So while you see a $1k return on $80k, I can get $1700.
You will find others posting on here with similar returns in other markets.
I do have a couple mortgages on rentals. I have one without a mortgage and I'm looking to get one more soon like the example I explained above. I balance my risk by not taking on too much debt. Again, it's all relative and unique to each individual.
Also, if you buy right and manage to sell during peak periods, you can take advantage of appreciation, 1031 tax exchanges and trade up to bigger, more profitable units - all without adding cash