Cash Flow or Pay off?

Question

Hey BP!

I wanted to start a discussion to hear other arguments or inputs other than my self generate content on the following:

1.) Is maximizing cash flow or loan paydown/payoff more important?  #askBP

2.) Why?

Thanks for your time!

-Sam

Samuel DeMass · Answer

Thanks for the replies!

I tend to have similar views about the balance as the majority it looks like.

I view it as the option to execute on the highest and best use of the income stream at with time as the critical actor.  It seems apparent to me that actually using it to pay down debt is counter productive, until you're ready to refinance if that's your objective.

It makes more sense to me to save the cash flow (true cash flow, not vacancy/maint expense savings) in a stockpile to use it when an opportunity comes along, whether that looks like a new property or an opportunity to improve either financially or physically the existing state of a income producing property.

The opportunity cost of something else coming a long is probably what I'm skirting around, but in my mind it makes sense to bring in a respect for time and opportunity to the equation.

I also feel like something I extrapolated from Gary Keller's Millionaire Real Estate Investor is worth sharing for anyone reading for nuggets.  It touches on a lot of the sentiment shared above and brought a really interesting concept to my attention.

I almost exclusively use COC (Cash on Cash) return for my metric of choice when pulling the trigger.  It makes sense, but it's a snapshot metric.  The second I sign the closing docs and the title is transferred my initial cash I'm investing becomes equity.

Equity by nature is based on value and principal remaining on the loan, it's the difference of the two.  The basis of the concept is as the debt is paid down, your ROE (return on equity) goes down.  If COC is a snapshot metric, ROE is the operating metric.  At a certain point, your ROE will sink to a point where the highest and best use of your equity/capital is NOT being invested in the property.  In other words, the faster you pay down the loan, the faster your ROE sinks and you should do something about it!

Like most, I like seeing numbers to instill concepts, so lets assume:

Purchase Price = 100K

Down Payment = 20K = Equity (for easy math, assuming no equity is in the deal)

Loan = 80K

For simplicity lets assume after taxes, insurance, vacancy, property management, and maint/repairs/capex, the property cashflows $3.5K/yr.

Therefore the COC is 3.5K / 20K = 17.5%

Now, lets look a few years into the future.  For easy math, value appreciation, rent appreciation, and tax benefits are being omitted:

Value = 100K

Loan = 65K

Equity = 35K

ROE = $3.5K/35K = 10%

Ok, 10% isn't bad, I'll take it...fast forward a few more years:

Value = 100K

Loan = 50K

Equity = 50K

ROE = $3.5K/50K = 7%

Well, 7% is the stock market average right?...lets pay down all that debt and be "risk" free

Value = 100K

Loan = 0

Equity = 100K

ROE = $3.5K/100K = 3.5%

At least I'm beating the nominal 3% inflation rate...

A disclaimer, I'm leaving out a lot of important variables for simplicity of math to help uncover the trend I was trying to point out.  Most of the variables that move over time only exasperate this trend.  The only thing I can put my finger on that would reverse the trend is a non-proportional increase in rent appreciation compared to a slower value appreciation.  Even so, I think they generally trend in a linear fashion and generally nullify each other relative to the ROE issue.

I went way over the top on this explanation, but it was good for me.

I hope you've also enjoyed it.  Please let me know if you have feedback for me or have differing opinions.  We're all in this together.

Take care,

-Sam

Chris Simmons · Answer

Generally, the consensus is to have cash flow.  A bird in the hand is better than 2 in the fryer...or something like that.  Anyway, the thought is that cash flow today is better than potential profit in the future.

Ask yourself this question.  If you had $150,000, would you pay cash for 1 house and collect rent debt free or would you rather put $25,000 down on 6 houses and collect the rent while still servicing the debt?  What generates better cash flow?  What is a more secure investment?

Your answer to that question should also apply to your scenario of sacrificing cash flow to crash debt on one property vs building up cash flow to apply as down payments on other properties....or potentially just spending on something else i guess.

While most of the people would prefer more properties and debt, that requires a long term hold, careful cash management and less, if any emphasis on future appreciation....at least in terms of counting on any.  If it happens, great.  And of course, it matters greatly as to what kind of property are you buying?  Low income, C properties or higher end, more stable, desirable but lower ROI type A properties?  Finally, what are your financing options?  Do you have these on 30 year fixed rate mortgages or variable type financing?  What rate are you paying?  Things like that.  For properties that I can get on 30 year fixed rate mortgages below 5%, I have no desire to put one penny into extra principle payments.  For commercial loans with slightly higher rates, acceleration clauses and 5 year terms based on a 20 year amm....yeah, i will sometimes pay those down faster depending on several factors.

I operate on a range of scenarios depending on the property and the financing as mentioned above.  I have 4 active single family rentals right now with a fifth whose rehab is almost complete and ready to be placed into service.  The first 3 have 30 year fixed rate mortgages.  # 4 will soon as well.  #5 might stay with my private lender for a while.  I have a 2 year, interest only loan with him.  If I can get it sold via a lease/option before the note is due, I might due that and collect my $35,000 or so in sweat equity....someone else s sweat of course.  I don't want to sell within the first year due to tax consequences.

I also have a contract on a duplex that is supposed to close any day now once the title issue is resolved as well as a contract on 2 condos and a small home north of me.  I secured commercial financing for the duplex and I am buying both condos via cash advances on my credit cards.  2-4% fee along with 0% interest until late next year.  Since I work at a day job still, I can take my currently $3700/month, soon to be $4700/month and then after the duplex $6100/month and pay off my credit cards within about 6 each months....even after servicing the debt on the other properties.  Not bad to buy two condos with plastic and get them paid off in a little over 12 months.   So in this case, specific to this type of debt, I am for crashing it asap.  Then I will do the same with my duplex.

Then I can go back to my commercial lender, releverage the duplex, add in two condos and borrow around $800,000 to buy a multifamily property.  And then I can rinse and repeat as needed.  Along with hopefully quitting my day job.

Jeremy Pace · Answer

Don't think of them as two different things, think of them as two steps in the same process.  You want to max cash flow for all of your properties, so that you can do things like pay down debt if you decide that's what you need.  What you do with your sweet hot cash flow doesn't lessen the flow, it just changes the use.

Bhekizwe M. · Answer

Cashflow first.Large paydown would be to minimise risk to passive income in cyclical markets

Samuel DeMass · Answer

I might also point out that when your ROE starts to not fit the "highest and best use" of your capital, then it's time to do something.

That could be in the form of a Refinance to pull out equity to improve your returns, or sell the property to move into a bigger more suitable scenario.  There is certainly a point in which you don't want to be highly leveraged just to pull out the capital in a property if the market value gets over inflated.  You're better off selling and putting that money to use in a new income opportunity.  Buy low sell high type stuff.

Another interesting idea would be to get an interest only loan to maximize your cash flow while maintaining a steady state ROE.

Have you given this much thought?

Raky Patel · Answer

I was just thinking about this on the way to work today. For me personally I plan on acquiring 10 houses as quickly as possible. From there I will use the cash flow from each to pay off one house. I will then get acquire another leveraged property. Rinse and repeat. Essentially I would like to build a stream of $20k/month. I will eventually get into multifamily as well. Not sure as to the number of units my plan will take/what my plans will be at that point in time, but that is my goal for now... I have been known to change my mind. :) I suspect in the vicinity of 30 paid in full units.

I think if you can afford to not live off the cashflow, it would be wise to use it as a tool to expand your real estate business. Figure out when you want to retire and plan around that. For me, I am 34 right now and would like to be retired around 50.

Peter MacKercher · Answer

I think it's best to eventually own, but it depends what your strategy is. Not owning doesn't bother me, either. You need to ask yourself how long you're going to own it. I'll always finance at the longest term possible and put more down if I need to. That gives me room if I have a bad month.

Kyle Scholnick · Answer

Cash flow is most important to me at least, the beauty of real estate is the use of leverage to increase returns, take advantage, but don't go over your head and get 50 rentals with huge loans on them. If all of a sudden you have vacancies on 6 of them at once, that is a huge blow to your cash flow and you need to be able to cover that yourself, so have big reserves for each property as well.

Derrick Craig · Answer

I love option #2 Cash flowing Buying and Holding Building Wealth for future I don't mind paying the bills or Mortgage loans along the way it helps with Landlord irs tax write offs. If there is an opportunity to sale one of your properties and purchase several more to replace the cash flow you lost from the sale and better yet increase the cash flow 2 or 3 times then that makes the sale even better.

This is only my opinion, since I am only 37years old retirement is a long ways away for me. Even though I retired from my regular 9-5 corporate America job in 2013.

Cash Flow or Pay off?

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