Pay Off Properties vs Purchase More Properties

[KB Bergeron]

Greetings Everyone!
My name is KB and I am currently serving in the military. I have 2 rentals (one I previously lived in and converted into a rental, and the other purchased as a rental) Question: Does it make sense to put forth as much $$ as possible toward the two rentals...in order to pay them off within the 6yrs of active military service I have remaining....to more effectively (recieve 100% rental income from both rentals) supplement my retirement?? Or should I concentrate on building my portfolio by trying to accumulate more properties. (by saving up for down payment, or by rerfinancing). Your experienced opinions are greatly appreciated. Thanks in advance for your help! :D

[Michael Rossi]

The 50% Rule is NOT a quick analysis. It's not an analysis of any kind. The 50% Rule simply says that throughout the United States, operating expenses for residential rentals run 45% to 50% of the gross rents. Obviously, you should do all the due diligence you can, but there is no more accurate way to determine the operating expenses over time than the 50% Rule. If anyone has a more accurate method - let's hear it!

Mike

[KB Bergeron]

Thanks Nationwide and Mike,

OK, so to put this in my own word so I can understand: Applying the 50% rule to a property allows me to look at the sellers asking price and say "this asking price will allow me to cashflow $100 or more"....or " I need to make a lower offer than the asking price b/c a lower accepted offer will allow me to cashflow $100 or more"...... (being that operating expenses are 45%-50% in the US).......correct right??

This information is priceless! You guys are Awesome!

(nice bike Mike)

[Christian Malesic]

Originally posted by KB Bergeron:

Thanks for clearing that up for me Christian,
So once I find a prospect, I use the 50% rule.....once the property passes this analysis, (walkthru) how/where do I get more detailed numbers in order to get a more accurate analysis? Are the tax docs located at the courthouse? Are they used to get a more accurate estimate of total cost?

(Is this all in a thread i haven't read yet?)

There is such a thread

How to Research

[Christian Malesic]

I am not agreeing OR DISAGREEING with MikeOH. I am trying to make the point that a mini-analysis or quick computation of any kind is not acceptable, in itself, to close on a deal.

MikeOH has made his point many times on many threads. It FEELS right. I don't know if there is hard data to back it up, but my experience would agree.

Just DO YOUR RESEARCH. That is what I am pushing here.

[Rich Weese]

I didn't read the entire thread, but I like both. Buy more properties AND pay them off. A lot depends on risk level you are comfortable with, current tax situation, age, employment, job security and attitude of spouse. All of these would make a difference in what I would reccommend to you. I have free and clear, but I also have some highly leveraged properties to help offset the income tax consequences. I try VERY hard to not pay the govt. any of my income- although I do file a return every year. They make a lousy partner... Rich

[Joshua Dorkin]

Thanks Rich for bringing us back to the discussion this post was intended to cover. Guys, lets try and stay focused. There are dozens of 50% rule posts; I hope we can take that part of this chat over to one of them.

Now . . . back to paying off properties vs. purchasing new ones...

[KB Bergeron]

Thanks for the info Rich,
That's what I was thinking form the start.... "Do Both"..., but i guess it depends on the variables you listed...basically your investment style and goals. I can definitely see the benifits of doing both! Thanks for the alternate view.

[Steve Babiak]

Not only is Rich correct on this, it is a really straightforward to do.

As your tenant/occupant/resident makes payments that you then use to apply toward your mortgage, eventually you will gain equity by having the lower loan balance. You can then leverage that built-up equity via second mortgage or line-of-credit secured by that added equity. That levered money gets you into the next property. Repeat same process.

So do both.

[Rich Weese]

Steve,
You must be REAL good. Only 31 posts and 236 influence. I don't know how that works, but it looks really impressive. Congrats for what you're doing. I agree with what you posted. Lots of ways to do real estate. Try them all. I'm doing 3 different methods right now. Buy and re-sell on owner finance, buy and hold, and do some lending- either hml or sharing in the exorbitant profits generated!! Rich.

[Steve Babiak]

Rich,
I don't have too much more of a clue about the scoring system either. Maybe Josh can help us to understand a bit better.

One thing I do: I will press the little + symbol on a post that I like, and that makes good sense and isn't just BS. I think that does help boost influence.

BTW - I finished the Edelman book you recommeded; good reading there. Now I'm looking for some more reading material (hint)...

[Rich Weese]

Steve- send me youe mailing address and a hypothetical book will appear. Next week, since I'm in FL buying property!! Time to buy in FL imo. I want to buy a LOT in next 12 months.( lot is not the land type of lot, real homes)

[Account Closed]

Read the blog regarding this thread.

What about the recapture of depreciation at time of sale? Shall this have any bearing on the topic of paying down P&I or re-investing?

[Will Barnard]

Blake, depreciation recapture would only take place upon the sale of the investment in a non 1031 transfer.
As for how it would affect you personally, you should consult a competant RE accountant.

[Kel S]

Originally posted by nationwidepi:

While owning free and clear offers safetly in not having a mortgage payment, you have a lot of cash tied up in the walls which only produce the cash flow return and expose you to lawsuits due to your equity position.

Nationwide, I have a question about this. When you say it exposes you to lawsuits due to your equity position, would that hold true if the properties are owned by a LLC? Would having an LLC offer some protection from such lawsuits?

To the original poster here are my thoughts:

While we are new to RE investing, we are doing things a little different in that we are going the buy with cash route. At least for the first couple purchases. Our goals though are to not have mortgages. Perhaps it's simple out of fear of having to rely more on the tenants to make the payments. It would be a really bad situation if say for example my husband lost his job and we had rental mortgages and vacancies. That risk just didn't sit well with us.

Another reason is we just prefer to be debt free. Or at least close to it. Right now we are working on paying off my husband's law degree student loan and after that we will only have our own house mortgage to pay each month. We both own used cars so no car payments at the moment either.

Based on everyone's advice so far we might be doing things a bit backwards. And at some point (which we are getting close to now), we will run out of funds to buy cash REO's and will have to replenish that. But it's just such a better feeling knowing we don't have to rely on someone else making the mortgage. Just have to worry about making sure the taxes/ins is paid if we had a vacancy for a short period of time.

The other thing is our long-term goal is such that we would like to have our return paid back to us on these investments in 15 years. At which point we hope to retire. These rentals will hopefully provide us with additional retirement income.

[Rich Weese]

You have a great plan and outlook, not normal for an attorney!! Congrats on the wanting to get out of debt. obama is making that less desireable every week. I believe in doing both. Have some properties free and clear and protected from any loss; insurance, trusts etc. Have the others mortgaged to the hilt for maximum growth. Rich.

[Michael Scott]

Buy more...Not sure about your market but properties or sooo cheap right now...Pay the ones you have down with the cash flow you create new ones. Reasonable Doubt!

[Jim Doine]

KB, great thread! I love all the diversified answers.Everyone seems to have their own strategy and what works best for "YOU" would be the proper choice. If you truly want to be a buy and hold landlord listen very carefully to Mike O.He has been there and done that.In my opinion I think you should sell your existing bad investments. It makes no sense to throw good money at bad investments to try and make them better.You need to find an investment area that will truly cash flow by Mikes 50p% rule. There are many such cities. Example: I have seen single family homes that you can purchase and rehab for 15K that rent for $600 per month. Even with 50% of rent going to expenses this property pay's back your initial investment in 4 years 2 months, and then its all gravy. Jim

[Wes Marden]

You have to know your risk tolerance in order to make the best decision on any investment. Having said that, negative cash flow can drag you down. I think agree with the first guy who said sell and find better property, however if you project decent appreciation in that area a refinance might make sense.

[Dory Peters]

KB,

I'm a numbers person; I enjoyed David Collins' explanation (and Will's additional commentary on David's comment). If you're like me, then perhaps seeing an example of how to work the numbers will help to add more teeth to all of the other great information already provided in this post.

ptcf = NOI-DS = DS(DCR-1) = dp(ROI)
cap rate = NOI/pp
(where ptcf is the pre-tax cash-flow, DS is the debt-service [or 12 months of mortgage payments], DCR is the debt-coverage ratio [or NOI/DS], dp is the down-payment, NOI is the net operating income, ROI is the return on investment, and pp is the purchase price)

NOTE: I'm going to make a few statements using the form A is B, and I'm using is in the mathematical sense--but not equating A and B as terms.

First, if one were to purchase a property with all cash, then the following are true: 1) the purchase price is the down-payment, 2) the ptcf is the NOI, and 3) the ROI is the cap rate. For example, let's say one purchases a property with the following characteristics: pp=120K, NOI=12K, and DS=0 (due to an all cash purchase).

cap rate = 12K/120K = .1
ptcf = 12K-0 = 12K
ROI = ptcf/dp = 12K/120K = .1

Second, if one were to purchase a property correctly with positive leverage, then ROI is greater than or equal to the cap rate. For example, let's say one purchases a property with the following characteristics: pp=120K, NOI=12K, DS=10K, and dp=12K (which implies a loan at 90% LTV).

cap rate = 12K/120K = .1
DCR = 12K/10K = 1.2
ptcf = 12K-10K = 2K
ROI = ptcf/dp = 2K/12K = .167

Notice how the purchase price, NOI, and cap rate are the same in both examples; yet, the ROI differs. I'll show three more leveraged examples to help drive the points home.

Following is an example of positive leverage misapplied (ie the ROI is less than the cap rate). Let's say one purchases a property with the following characteristics: pp=120K, NOI=12K, DS=10K, and dp=24K (which implies a loan at 80% LTV).

cap rate = 12K/120K = .1
DCR = 12K/10K = 1.2
ptcf = 12K-10K = 2K
ROI = ptcf/dp = 2K/24K = .083

Let's say one purchases a property with the following characteristics: pp=120K, NOI=12K, DS=9.6K, and dp=24K (which implies a loan at 80% LTV).

cap rate = 12K/120K = .1
DCR = 12K/9.6K = 1.25
ptcf = 12K-9.6K = 2.4K
ROI = ptcf/dp = 2.4K/24K = .1

Let's say one purchases a property with the following characteristics: pp=100K, NOI=12K, DS=8K, and dp=20K (which implies a loan at 80% LTV).

cap rate = 12K/100K = .12
DCR = 12K/8K = 1.5
ptcf = 12K-8K = 4K
ROI = ptcf/dp = 4K/20K = .2

By the way, it's OK if you don't understand how all of these numbers work together right now. You can learn that over time. For now, it's important for you to understand that there really is a method to the madness, and that there is a way to use real numbers to quantify how leverage can work for/against you. And it's ultimately up to you to structure your deals henceforth, so that the numbers will work for you--whether or not you opt to use leverage.

[KB Bergeron]

Kel S,

I had the same question about the LLC....because I thought the whole reason to set it up was for protection against lawsuits and the like.

Nationwide, how does having a large equity position put me at risk??

We have very similar situations and thought processes as far as debt, buy/hold, and retirement. I was probably wrong in thinking this, but I was thinking if I paid the mortgages off, I would have a larger percentage of income per house....to supplement my retirement. (when that time comes) The alternate views help me to see things another way and I think in the end will help me to make a more informed decsion on which technique I will use......if not both!

[Rich Weese]

KB-
I'm not an attorney, but I do pay a LOT to them for advice, LLC's and trusts as well as advice.
An LLC is not a cure all. The equity you have in a property is still at risk to various things. If you are the beneficiary of the LLC, judgements against YOU may be satisfied by the equity you have in said property.
I was advised to add another level of protection which is an IRREVOCABLE Trust . Depending on the way it is done, I'm confident your equity in the LLC is then protected from judgements and creditors. There would also be no cross-over from one LLC to another.

Rather than sell down the road, just keep the properties and re-fi them. Maybe the max of borrowing against more than 4 will be a thing of the past by then. If not, a 1031 does delay the tax man . Rich.

[Jon Klaus]

Rich, earlier in the thread you said "Have some properties free and clear and protected from any loss; insurance, trusts etc. Have the others mortgaged to the hilt for maximum growth."

What are is the criteria for homes you pay off? Fully leverage?

[Rich Weese]

Jon- I think I replied to your questions in the LONG post I just entered in the clash of the titans thread. If not, re-post your questions and I'll try to answer Rich.

[Jon Klaus]

Wow, thanks for sharing your experience Rich--here it is:

http://www.biggerpockets.com/topics/34916-appreciation-vs-cash-flow-the-clash-of-the-titans-?forum_id=48&page=5#posts-176018