In my last post, I provided a rough outline of the best real estate investing strategy for regular real estate investors in five steps. One of the cornerstone elements of that strategy is a concerted effort to use the positive cashflow to aggressively pay off the mortgage debt in your real estate investing portfolio. This produced a very interesting follow-up question in the comment thread from Neil:
I routinely see suggestions that buy and hold investors should always use a pay down strategy as you have suggested here. However, with today’s rock bottom interest rates and the powerful leverage that financing produces, I plan to milk those low rates for as long as possible and to recycle the cash flow from those properties to purchase more properties instead of paying down the existing properties. I believe this will produce more cash flow overall at retirement, in fifteen years, because I will own more cash flowing properties, even though some will still be leveraged. I must admit, however, that I am not sure I know how to calculate whether the paydown or acquisition strategy is better. As you write your next piece, perhaps you would weigh in on those kinds of considerations.
Neil makes a good point. The congruence of bargain basement mortgage interest rates on investment properties, solid tenant demand, low vacancies and rising rental rates make the current environment perfect for more acquisitions. So then, should you use your cashflow to pay off the mortgage debt or recycle it into liquid capital to acquire more properties instead?
As it’s the case with most good questions, the answer is: It depends.
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Timing, Time and Capital
Capital growth through debt pay down and recycling cashflow to fund further acquisitions are not always mutually exclusive.
In fact, in most long term real estate investing strategies you see them both utilized at different stages. It’s a matter of timing. While you’re in the process of acquiring the assets you need to obtain the income you want at retirement, recycling the cashflow as acquisition capital will speed up the process considerably. Then once you are done acquiring, you can start paying down the debt aggressively.
But it’s all dependent on how much time you have at your disposal. A real estate investor that has 20+ years till she wants to retire is in a very different position than the investor that needs to retire in three years. The first has plenty of time to delay paying down the debt and focus on acquiring as many quality assets as possible while the going is good. The second does not have the same luxury. They must focus all their resources (cashflow, savings from job income etc) to pay off their debt.
Last, available capital comes into play in this discussion as well. The “either or” type question assumes that the real estate investor must choose between paying off the debt and acquiring more assets. But it ignores the very real possibility that the investor might have sufficient capital to do both. In other words, an investor that already has the capital to acquire more assets (or has the capability to save enough from her job income) would be better served to attack both fronts simultaneously.
The Slippery Slope to Perpetual Leverage
I think this calls for an important note of caution. While it might be advisable to temporarily put off the capital growth phase of your strategy in favor of taking advantage of acquisition opportunities, it is never in the long term investor’s interest to eliminate it in favor of a perpetual leverage model. As opposed to the strategy I advocated for in my last post, this model involves an investor that builds the desired cashflow by simply acquiring more and more mortgage assets. As an illustration, Investor A and B share the same goal: They would like to create an income stream of $60,000 per year from their real estate investments so they can retire. Investor A uses a Blueprint real estate strategy that calls for the acquisition of 5 quality properties and the subsequent mortgage payoff to a free and clear portfolio by retirement. Investor B uses a Perpetual Leverage model and needs to acquire 12-13 properties that while leveraged produce that same annual income. Further, Investor B intends to follow his Lender’s payoff schedule and not make any attempt to pay off the debt on her portfolio any faster.
So what’s the problem with Investor B’s strategy? Well there are a couple of major problems actually. First, Investor B’s portfolio carries significantly higher risk. That might seem like a bearish statement given the “flowery fields” environment we find ourselves in currently. But remember two things. As Mark Cuban once said, everyone’s a genius in a bull market. And most importantly, Murphy’s address book is always up to date and he knows where you and I live. When you commit to invest in real estate long term, you have to assume that somewhere in your investing timeframe, the wind isn’t going to be in your favor. And most importantly, if your strategy doesn’t have the capacity to absorb a soft market because increasingly risky bets, chances are that the unfriendly wind will break down your sails and leave you stranded. Second, when you reach retirement, would you rather manage more or less assets? Don’t answer that.
I’ll leave you with one more piece of advice. Most long term real estate investors go astray when they focus more on return than they do on income and risk. Let me ask you a question: Which is better, a 15% or an 8% return on investment? Here’s the answer: That’s the wrong question. The right question- What’s the capital base you’re calculating your return on? If you own three leveraged properties that produce $15,000 of income per year on your $100,000 invested capital, is that better or worse than 8% or three paid off properties that produce $40,000 in annual income? At retirement, the only two things that matter are the nominal income your portfolio is producing and the level of risk in it. Everything else is distraction.
Thank you Neil for the thoughtful question and the fuel for this post. Please keep them coming.