Posted by Ronald * Starr(in No CA) on July 16, 2002 at 11:50:40:
Marcos-----------------
I have heard good things about John Schaub. But I have not heard him speak nor read anything by him.
It sounds to me like he has got a good system going. The fact that he has interest-only loans I think is interesting. That is my advice for all investors. If you know you will be able to pay off the principle when it comes due.
Good Investing**Ron Starr
Property Vs. Other Investment??? - Posted by Izz
Posted by Izz on July 15, 2002 at 14:33:19:
A question:
when you have principal reduction on a loan due to paydown of the balace over time, dosen’t that mean that in ADDITION to whatever cap rate I am getting I am virtually guaranteeing myself a millionaire if I have five properties worth 400k each, even if I owe 400k in mortgages on them (maning zero in equity?)
what I mean to say, id that no matter what trhe cash flow is, as long as I cover the mortgage payments for the next 25 years I will come out worth seven digits (barring nuclear war or the like?)
Re: Property Vs. Other Investment??? - Posted by Steve D
Posted by Steve D on July 15, 2002 at 14:56:12:
Yes, if you have 5 properties worth $400k and the mortgages have been paid off, they will add $2m to your net worth.
However as well as paying the mortgage, you have to pay taxes, insurance, maintanance etc., so it’s even nicer if they pay for themselves. Nicer still if it’s positive cashflow.
How you invest should be determined by your goals. Financial independance doesn’t necessarily mean/require high net worth - financial independance means your passive income is higher than your expenditure. If you want to retire in 25 years, you couls buy your 5 properties now, and in 25 years either live off the cashflow, or sell and live off the cash. In which case appreciation in the property value will be your largest focus.
However, if your looking to retire sooner (and invest as a hobby, or just want to work for yourself), you need to build positive cashflow sooner so your independant from your paycheck.
The other side of the coin is managing your expenses - if you can live on $1000 a month you can retire sooner than if you want a big house, fast cars, boats, travel the world etc. You have to figure where you will be happy, whats really important to you in life, and set your goals accordingly. I want to retire in less than 10 years (I’m 31 now), so I’m focusing hard on generating passive income and controlling my expenses (I refuse to sell my Porsche, but I don’t need a big house etc).
Re: Property Vs. Other Investment??? - Posted by Stacy (AZ)
Posted by Stacy (AZ) on July 15, 2002 at 14:50:17:
Of course, it’s more complicated than your simple example, but I see what you’re trying to understand. Yes, the time value of money will make you rich in 25 years. But, I’ll bet you would have paid $3 million for your $1 million over that time period in monthly payments and maintenance. Probably more.
Re: Property Vs. Other Investment??? - Posted by Ronald * Starr(in No CA)
Posted by Ronald * Starr(in No CA) on July 15, 2002 at 14:46:02:
Izz-------------
You got it dude. Real estate investing is great.
Good Investing***Ron Starr
Re: Property Vs. Other Investment??? - Posted by Izzy NY
Posted by Izzy NY on July 15, 2002 at 15:37:15:
I am 22 years old. I am buying properties that are just slightly over break-even, No “alligators”.
If all my properties are breaking after all vacancies( at a minimum), then I am looking at payting off 30 year mortgages before I am free and clear. I want to prepay as much as I am able with any possible free cash flow created.
Can I therefore assume that I will have equity of $2 Million in 20-25 years? I will be 42-47 years old then, g-d willing…
Izzy
Re: Property Vs. Other Investment??? - Posted by Joel MKE
Posted by Joel MKE on July 15, 2002 at 15:03:17:
Steve -
I’m in the same boat, so what kind of strategies are you using to get a high level of cash flow? I’m 32 and looking to be done by 40. It’s going to be great!!
Hope to hear from you!
Joel
Paying Down Loans Early VS Buying More Properties - Posted by Ronald * Starr(in No CA)
Posted by Ronald * Starr(in No CA) on July 15, 2002 at 21:38:43:
Izzy–(NY)----------------
Good for you starting at an early age. Your plan is sensible, probably feasible.
However, you may find, after doing some more studying, that you do not want to sock away your free cash flow into equity in the properties that you initially own.
Different people have different approaches and tolerances for risk. So you do need to do a program that suits you. The following ideas may stimulate you to figure out what you want to do with excess cash or investable cash.
When you have a lot of equity in a property, some people call it “dead equity.” That is because two of your three financial benefits of real estate investing are going to be the same, regardless of the size of your equity or debt. The tax benefits are based on the purchase price of the property and different levels of debt do not influence the tax benefits.
The appreciation on the property is based mainly on the initial value of the property. Provided you keep the property maintained well, the appreciation will not be different with a large loan secured on the property or no loan secured on the property.
So, the only financial benefit that is effected by the amount of debt you are carrying is the spendable cash flow, after expenses and debt service. Loans are often the highest of the expenses, so when they go away, the cash flow can jump dramatically. This certainly looks attractive.
However, there is another way to think about the debt that you carry on an income-producing property. When you pay down the debt, this is the equivalent of investing your cash at the interest rate on the mortgage. You save, say, $70 a year by having paid off $1,000 in mortgage burden for a loan with seven percent interest rate. This is like having $70 a year paid to you for your $1,000 “investment” in the loan.
If you don’t have other places to invest that excess cash which pays you more than the loan interest rate, then it makes a lot of sense to pay down the loan early. However, if you find you can earn more per year with the cash than the interest rate of the mortgage, you would probably be better off putting that extra cash into the other investment, rather than paying down the loan early.
Now, there are some considerations which influence this. For instance, your tolerance for risk. Paying down the mortgage is a very conserve, low-risk way to “invest” your money. There is a risk you might not think of: “opportunity cost” risk that you will have to forego some other good investment because your money is tied up in the dead equity.
Also, to really compare the return on the early payoff of the debt vs other investments, you really should use a “risk-adjusted” return for each projection. If the other investment might have a very lucrative return but it has a high probability of a poor return, this is not as good a risk as the loan paydown. Thus, it needs to generate a higher return just to be equivalent to the early amortization of the loan.
However, if you invest in leveraged real estate and have any decent appreciation where you invest, you should be able to get far better returns with your extra cash than you get by paying down the mortgage earlier than called for by the amortization schedule.
If, instead of socking away your free cash flow in equity buildup of existing properties, you used it to buy more, leveraged properties, you probably will find the financial rewards to be greater. You will have more property to depreciate, increasing the tax benefits, provided that your taxable income does not exceed $150K a year. You will have more property which can appreciate in value also.
Depending upon what rate of return the new properties will provide in cash flow, you might even have more cash flow than if you simply stuck with the original prooperties and paid down the loans.
Think about this. The paydown on the loan gains you the rate of interest of the loan each year. Suppose this to be 7%. But, you buy new properties that provide you 15% cash on cash return. That is, you make 15% cash flow on each dollar invested in the new properties. This would not be an unusally high return for a good investment. So, would you rather have 7% return on your investable cash by paying down the original loans or would you rather have 15% return on that same cash, which is socked away into new, leveraged properties?
Now, with more properties, you may find yourself working more. So you might well want to do an analysis whereby you calculate how much additional cash return you get for the additional work. There is essentially no extra work to paying off a loan earlier. You have to write some figure on the monthly mortgage payment check, and it is no more work to write a larger amount than a smaller.
You might find that the extra money you generate from the new properties is a very handsome reward for the necessary added time to own them.
When you wanted to retire, you could, as one of the other posters mentioned, sell some of your properties if you wanted a large amount of cash. Or, you could sell them with you carrying back mortgages to provide a cash flow stream. Or, you might have enough cash flow from the increased number of properties, even with their loans not yet paid off, to satisfy you.
So, I hope that you see that paying down debt, while it has some attractions, may not be the most lucrative deployment of your investable dollars. When you are good at buying and managing long-term hold rental properties, you may prefer to sock away your extra money by buying more properties, not paying down mortgages early on the properties that you already own.
Good InvestingRon Starr***
Re: Property Vs. Other Investment??? - Posted by Steve D
Posted by Steve D on July 15, 2002 at 15:47:26:
Over that kind of timeline, providing they are well maintained, the properties should appreciate in value also, so yes, you should be a millionaire well before you are 40 providing you can keep the properties through good times and bad.
The other thing to factor in, is I assume you have 30 year fixed rate mortgages on them? Rents typically go up over time (again, providing they are well maintained), so if they are break-even now, in 10-20 years they could be very profitable.
Re: Property Vs. Other Investment??? - Posted by Steve D
Posted by Steve D on July 15, 2002 at 16:12:28:
I’m still relatively new at REI, so I’m still figuring out the best strategy for me personally - it has to meet my financial goals, but I’ve also got to enjoy what I do. Right now I’m working on a project I came across by accident - a few years ago three empty lots came available behind my house, and I bought them. Last year they appraised at 4 times what I paid. I was going to sell them, but got talking to a couple of people (a CPA, a Builder, and a Realtor, all of which own rental properties).
Where I am there is no zoning, and a lot of development (new mall is going in down the road over the next couple of years), and we are in the best school district in town. Either side of our neighborhood $500k+ houses are going up. The consensus of the builder, realtor and CPA was to build 3 duplex’s on the lots since there is a shortage of affordable rentals in that school district, so thats what I’m investigating right now. It looks like I can save ~10% by building 3 at once over building a single property. The lots are worth ~$50k, by spending $140-$150k per lot I can end up with a property that (going by comps) will appraise at ~$220k-$240k, and command $2500-$2600 in rent ($1250/$1300 per unit). I only paid $12.5k for the lots. With the amount of mortgage I want to carry, 72% occupancy I’m about break even, anything over 72% is positive cashflow, using actual maint & leasing cost numbers from people I know.
Having said that, there is a lot of risk going the construction route, project overruns plus the market could be very different by the time they are built, but there is enough of an equity cushion to pad the deal, plus I have cash reserves for 9 months or so, so it’s not going to bankrupt me, and I’ll certainly learn a lot over the next few months - and even if it goes horribly wrong and I only break even or make a small loss on the deal, the education I’ll get doing it will be more than worth it to me.
I also own a couple of companies (non REI related), one is negative cashflow right now (has been significantly positive in the past, and will be again when the economy picks up), the other slightly positive now, so REI is also a diversification for me, one that really interests me. End of the day, I have to enjoy what I do, or I can’t get motivated to actually do it.
–Steve
Re: Paying Down Loans VS Buying More Properties - Posted by Dave T
Posted by Dave T on July 16, 2002 at 23:34:05:
The paydown on the loan gains you the rate of interest of the loan each year. Suppose this to be 7%.
Ron,
Great post. If I may, I would like to amplify on the point you made, then suggest a scenario where debt reduction might make sense.
On a fixed rate loan, the monthly payment amount does not change. Even if you prepay $1000, your next monthly payment is still due on the first of the month. Therefore, you will not see any increase in your cash flow until the loan is actually retired. What really happened to that $1000 prepayment, is that it reduced the term of the loan.
Consider a $100K loan at 7% fixed rate with a 30 year amortization. The most efficient use of any prepayment money is at the beginning of the loan term. In this instance, if I add $1000 to my very first monthly payment, I have reduced the loan balance by $1000 very quickly, but I have not increased my cash flow at all. Instead, I will take almost one year off the term of the loan and avoid the last 11.75 monthly payments for a total savings of $7819.08. Since I don’t see this benefit for 30 years, internal rate of return calculations tell me that the yield on my $1000 “investment” at the beginning of the loan term is just 7.34%. Certainly, it would be a more efficient use if that same money can be used to acquire an investment with a greater rate of return.
And now for the scenario – a case for paying down the debt.
Real estate seems to have its “business cycle”. I only buy for long term rentals. There are times in my market when real estate is too expensive to acquire. I am experiencing this right now – a seller’s market. Properties in this market are too expensive to cash flow for me at market rents.
I am a seller in this market. I am selling my marginal producers (my breakeven, or near breakeven, cash flow properties). I deposit the sales proceeds in an interest bearing vehicle. Recently I bought 6-month CDs at 4% APR. My cash flow did not change because I am selling a breakeven property, and, I added cash to my investment savings account.
But, I still have excess cash flow from my “producing” properties. So, I have added a little extra principal payment each month on some of my loans. For a 30-year mortgage, increasing the mortgage payment by one-sixth of the P & I each month is the equivalent of making 14 regular monthly payments in a 12 month period. If I start this at the beginning of the loan term, a 30 year loan is paid off in about 15 years.
Now, when the current market frenzy dies down and/or market rents increase, I will once again find properties that will cash flow to add to my portfolio. Any cash needed to close a deal will come from those CDs I bought in my investment savings account.
I have excess cash flow that is not needed to support my life style, and I have sufficient cash reserves on hand for the unexpected. So, for investors who fit my profile and are temporarily impeded by a seller’s market, perhaps debt reduction as a wealth building strategy can make sense.
Awesome post Ron! - Posted by Dave J
Posted by Dave J on July 15, 2002 at 22:26:56:
I just printed this one out and gave it to my wife. We were out to dinner tonight and we got into the debate over wether or not our excess cash from real estate investing is better spent on paying down the principal of our residence or by pushing back into the company to be reinvested. I tried to explain the concepts of leverage but, I wasn’t near as eloquent as you. Mine sounds more like arguing my points.
Re: Property Vs. Other Investment??? - Posted by michaela
Posted by michaela on July 15, 2002 at 17:13:06:
you mention, that there are 500k houses going up around you. don’t you think, that you’d be really wasting the lots, if you built 240k duplexes instead of 500k houses? building some high-end houses would pull up the value of your own house. also, you might be able to build those with 150k and walk away with a lot of profit, that you then can use to buy a dublex somewhere else. building 240k duplexes for rental would keep the values of the neighborhood down, if there’s a trend for high end homes. not knowing your neighborhood, but 50k for a lot, that could be used for a 500k house sounds low. in my neighborhood builders pay 100k for lots for 400k houses. you may want to check on those numbers. maybe you can sell 1 or 2 of the lots to a builder, that builds high-end houses, put that money into a 1031-exchange, (sinc eyou did have the intention to build, but then changed your mind) and roll that into building on the 3rd lot, using the subs of the other builder, who will give you a 10% discount (put that into the contract, if you sell the lots to the builder). it would generate more profit for you, than those duplexes. just a thought
Re: Paying Down Loans VS Buying More Properties - Posted by Ronald * Starr(in No CA)
Posted by Ronald * Starr(in No CA) on July 17, 2002 at 24:29:45:
Dave T-----------------
I love your post. Your comments about paying down the loan early and not getting your real return until the end of the loan makes a lot of sense to me. I like that you did a net present value analysis. And it shows that you actually get 7.33% return on your early investment, not the 7% that seems intuitive. I’ll have to try to understand why that is.
I see your point about paying down the loan when you are not in a position to take advantage of the greater returns available in real estate investing. This is the situation that I mentioned early on. IF you don’t have an investment which makes a better return than the loan interest rate (now we see it to be a little over that interest rate, actually), it makes sense to pay down the loan.
Now, when you are in a strong market, I suspect you have a strong appreciation taking place. It might well pay you to buy more properties, even with a negative cash flow, since you can probably sell out in a few years and make so much money on the appreciation that it more than offsets the negative cashflow. This is what a lot of investors have done in CA in the past. If one can sell near the top of the market, it is probably a good strategy. This might not be easy to do, however.
And, it might make sense to continue to hold the negative cash flow properties for a few years. Eventually the rents increase enough to make the properties cash flow neutral and then, still later, cash flow positive.
Good Investing and Good CalculatingRon Starr****
How I think and more thoughts on loan payments - Posted by Ronald * Starr(in No CA)
Posted by Ronald * Starr(in No CA) on July 15, 2002 at 23:16:44:
Dave J-----------------
Thanks for your encouragement. It took me a while to figure out how to say it. And I’ll probably be able to improve on this in the future.
My approach is simple. I want to understand what is going on with real estate investing, clearly. I thus try to figure out the dimensions along which to think about things. The concepts that make things clearer, cut throught the nonsense and the fog. The ways to analyze what is going on. I want simple ideas, not complex ones.
Thus, I have the concepts of CAT and YES, which are in my post for beginners. That can be found by putting “beginners success” into the search function of either the main bulletin board of the CREONLINE.COM website or the board2–Carleton Sheets–forum.
On this topic the concept is simple, I think. How much return can you get with reducing leverage vs how much putting the money elsewhere. Then throw in some thinking about risk and whether the ideas are practical or not. I believe that buying more real estate as an investment is practical. I do it myself and many other posters here do so.
It seems to me that, if one can get more return with new properties than the return paying down debt, that one should be buying new properties. I think that investors would, theoretically, do best having non-amortizing loans. Either interest-only or, better yet, straight notes whereon the interest is only paid at the end of the term, when the principal is paid off. Amorizing loans are great for getting people into their homes. But not for investors.
Now, note the use of the word “theoretically” in the previous paragraph. The important point, even more important than the rate of return one gets with borrowed money, is to pay off the loan. And, if one has rental properties, the money comes in in drips and drabs, a little bit each month. So, an amortizing loan with monthly payments “fits” pretty well with the cash flow situation. Thus, it does make some sense, on a practical basis, to pay down loan slowly with the monthly cash flow. This is not maximizing the return one can get. But it helps insure that one pays off one’s obligations as agreed.
If one has big chunks of cash coming in fairly regularly, one would never need to do amorizing loans, as an investor. One would just take in one of those big chunks of cash or several coming in near the same time and pay off the non-amortizing loans that one uses. That would be the interest only and the straight note loans. Thus, this approach makes a lot of sense for the transaction investors and rehab folk, who are flipping properties and getting big chunks of cash at a time. They are not getting monthly cash flow from rentals, so they should not be committing themeselves to make monthly amortizing loan payments nor, if they can avoid it, interest-only monthly payments.
I guess we could call this the rule of financial consonance. Match your loan pay-out obligations to the money coming in pattern.
Good Investing and Good Cogitating***Ron Starr
Re: Property Vs. Other Investment??? - Posted by Ronald * Starr(in No CA)
Posted by Ronald * Starr(in No CA) on July 15, 2002 at 20:54:49:
Michaela----------
I like the way you think. Don’t just take his idea as a given, think of what else might be feasible there.
Gee, with no building restrictions maybe he could squeeze 12 units onto the three lots?
The analysis of the lot value and possible way to structure a deal was insightful thinking, it seems to me. We’ll all have to keep our eyes on you. You’re sharp as a tack.
Good InvestingRon Starr**
Re: Property Vs. Other Investment??? - Posted by Steve D
Posted by Steve D on July 15, 2002 at 17:38:06:
It’s the neighbourhoods on either side that have the high dollar houses - those are all new developmnts - about half a mile away (and a different zipcode). The neighborhood I’m in has been there since the 50’s, prices range from high 200’s to trailers that are falling apart, so I would agree with you, but it’s not the right place for a $500k house - half a mile in any direction and it would be. 20 years ago there was nothing but trailers in my neighbourhood, today the average property going up is low/mid 200’s, and the trailers are slowly but surely being replaced with houses. Another 20 years and all the trailers will be gone - it is going to take time for the neighborhood to come up.
Otherwise, I would agreee with you, but what I’m building is towards the current high-end of a rapidly improving neighborhood, which should put in a very good position for long term appreciation on the properties. Or at least that’s what I’m hoping. If I believed the property’s would support more, I’d build more, but the neighborhood doesn’t have the prestige.
Thanks for your response though, I always appreciate opinions of those with more experience than me (which is just about everyone right now).
Thanks,
–Steve
John Schaub - Posted by Marcos
Posted by Marcos on July 16, 2002 at 08:34:33:
That’s what John Schaub is doing at this time, he has gotten private investors for his hold properties. He pays interest only at 9%. And he has no bank loans at this time. He sells off 3-5 properties a year with Lease/Option and buys 3-5 more each year. He lives off the money he makes selling on Lease/Option, and his rentals shelter all his earnings on the Lease/Options, so he pays very little taxes. Of course this is an oversimplification.
I’m assuming you’re a fan of Schaub’s Ron.
Marcos
Ron, I thought about that… - Posted by Steve D
Posted by Steve D on July 16, 2002 at 09:15:30:
Because we are a little out of town, we are on septic fields, and 2 three bedroom units is as big as I can go and still have room for the septic field.
Re: Property Vs. Other Investment??? - Posted by michaela
Posted by michaela on July 15, 2002 at 21:12:45:
well, thank you kind sir! (blush) but wait, there are plenty of stupid questions just waiting to come out of this mouth…er…fingers. lol. you’re right about the no zoning restrictions and other possibilities. i didn’t even think about that. and depending on if his area is as crazy about lofts as they are in atlanta, he can have fewer walls, leave the ducts in the ceilings exposed, have a concrete floor and call it a loft instead of an apartments and - tata - an extra couple hundred $ per unit. 