Posted by Dave T on February 08, 2002 at 02:24:07:
My argument is not with your strategy, but rather with your use of the terms “return” and “maximizing returns”. In my experience, the term “return” is often a synonym for “yield” and is usually understood as “return on investment”.
I applaud your strategy when an investor, such as yourself, is in a position to take advantage of equity to produce income. In fact, I have used this strategy myself.
Let’s say that you purchase a rental property for $100K cash. You rent that property for $1200 per month, with $1000 monthly cash flow. Since your investment in the property is $100K and your annual cash flow is $12K, your annual return is 12%. Assume that your income and expenses stay constant, but, with a modest 5% appreciation, your equity doubles in about 15 years. Your return (return on investment) is still 12% even though your equity has grown to $200K through appreciation.
Now to implement your strategy, let’s say that shortly after you purchase your $100K property (all cash), you find a $50K property you can purchase and realize a $500 monthly cash flow. Because you used all your cash to purchase the first property, you decide to convert some of your equity to cash with a refinance. Let’s refinance your property for $50K to get the cash to purchase the new property. Since this is a hypothetical discussion, let’s ignore closing costs and financing costs.
You take the $50K from your refinance and purchase the new property (free an clear) for $50K. At 8%, your $50K mortgage will cost you about $367 per month, but your new investment will generate $500 cash flow per month for a net cash flow increase of $133 per month.
Now instead of one property generating $1000 per month in cash flow, you have two properties that generate a combined cash flow of $1133 per month. Since you still have only $100K of your money invested in the properties, your return on investment has now improved to about 13.6%
But wait, you want to do better. Instead of buying just one property for $50K cash, you decide to buy four properties with 75% financing. You make $12500 downpayments on each of four $50K properties and finance $37,500 on each new property purchase. The mortgage payment on a $37500 loan (at 8%) is $275 a month for each new property. Now you have five properties generating $1533 cash flow per month (net operating income of $3000 minus debt service of $1467). Because you have not added any money out of your pocket, your investment in all five of these properties is still only $100K but your return on your $100K investment is now about 18.4%. By leveraging your equity, your return in this instance has increased from 12% to 18.4%. By the way, you still start with $100K equity in these five properties, and with 5% appreciation, your equity will increase to around $400K after 15 years (actually a little more because you are paying down debt as well). For our $100K investment, the FMV of these five properties will be about $600K in 15 years versus only $200K in our single property example.
I think we both agree on the validity of the approach. When the benefit derived from the leveraged equity is greater than the cost of doing so, it makes sense to take advantage of the opportunity.
I can’t comment on whether to use a 1031 or a leveraged equity approach to achieve your goals. You have to work up the cash flow numbers for each approach to determine which is best for you in light of the costs inherent in each approach.
I do note for your consideration, that in a 1031, the cost basis in your relinquished property plus any cash (and/or debt) you add to the replacement property purchase, becomes your new basis for the replacement property. To me, you would not get as great a depreciation expense in a 1031 exchange as you would by using leveraged equity to purchase an additional investment property.