As discussed in my last post, under certain circumstances, long term real estate investors can opt to take a temporary detour from growing their capital base and recycle their positive cashflow to fund more acquisitions instead. The operative word in that statement is “temporary”. If market conditions (i.e interest rates, price/rent ratios) make it especially attractive to acquire quality properties and the investor doesn’t have sufficient capital to pursue both and she has the luxury of abundant time – then it makes sense to press the pause button. But this temporary pause does not change the principle that in order for the cashflow at retirement to be adequate, the investor must always build a large enough capital base first.
There are two ways to build a large capital base and they both involve paying off your portfolio’s debt. The difference is in the manner in which they go about achieving it.
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Method One: Appreciation
The first method relies on the “A word” (appreciation) and it works like this: Investor acquires 15 cashflowing investment properties. After a number of years, she sells off five of the properties that have appreciated the most and uses the proceeds to pay off the remaining assets in the portfolio. The biggest pro of this method is that when it works you don’t have to sacrifice your cashflow to pay off debt during the holding period. The biggest problem with it is that it relies on high appreciation which is about as predictable and reliable as Charlie Sheen. In my opinion the reliance on appreciation is a structural flaw because this method would not work in stable markets with slow and steady appreciation rates. So the end result leads the investor to put his hard earned capital in more volatile and temperamental markets (Hello California) and if long term investors wanted that they could just put their money in stocks. Last but not least, what happens if the appreciation does not materialize or worse, values drop right before you retire?
Method Two: Cashflow
The second method is based on the premise that while all long term investors want cashflow – the timing of that cashflow is the true determining factor. All investors want a great income stream at retirement but they aren’t looking to current cashflow to subsidize their current income. Put a different way, they aren’t waiting for the cashflow to come in to pay their light bill. Therefore, if we want cashflow at retirement and we don’t need it now, why don’t we put the current cashflow to work now to build a large capital base and in so doing, increase the cashflow at retirement. But having said that, what’s the best way to use the current cashflow to accomplish that goal? It’s called a Domino Strategy (see photo below) and it possesses the power of focused intensity that you should employ in your real estate investing strategy.
As an illustration, let’s take the numbers on a property a client just closed on yesterday as they’re fresh in my mind. We purchased the property for $125k, 20% down, 4% interest rate for 30 years and it has monthly positive cashflow of $400. So let’s assume you purchased just this one property and wanted to use its cashflow to pay the debt off faster. If you applied the extra $400/mo towards the principle, it would take you 143 months (just short of 12 years) to pay off this property. So far so good.
Now let’s assume you purchased nine identical properties instead and you take the overall positive cashflow from your entire portfolio and apply it towards the principle on one of the properties while making regular payments on the others. The entire portfolio becomes free and clear in 145 months.That’s the power of focused intensity and discipline. In virtually the same amount of time it would take you to pay off one property, you could pay off nine. Instead of $125k in capital base generating $12k a year in income, you could have $1.1M and $108k a year. And that’s without a dime of appreciation.
Slow and steady adds up to some real money really quickly, doesn’t it?