Buy 2nd Rental or Pay off 1st?

Question

I recently purchased my first rental property (Duplex) for $65,000. I had to put 25% down for a 30 year mortgage so I still owe just under $49,000. I do have an investment mortgage on this property because I do not live there. Both units are currently rented out. The property was appraised and $75,000 when I had it appraised recently. So right off the bat I have $10,000 equity.

Now I'm able to find plenty of information about going about buying your first property but not as much info about the next step. I have a good amount of money saved again and want to see what my best option is.

Now my question is since I owe $49,000 on my rental property am I better off paying that property off completely or do I just simply move onto purchasing my next property.

Thomas S. · Answer

You also need to keep in mind that cash hoarders pay a very high price for leaving any dead equity in a rental property.

True positive cash flow is generated by a property with 100% leverage. Every dollar of equity is actually buying artificial cash flow at a very high price.

Assuming cash has a opportunity value of 10% paying down a 4% mortgage is generating a loss of 6% return to generate that artificial cash flow.

Losing 6% to save 4% is a very high price to pay for cash flow.

Brent Coombs · Answer

For your $65k outlay, you're grossing $1,200/m? VERY good! AND you've already got another $20k to invest? Then YES - "simply move onto (your) next one"! Seeing as your loan terms already seem favorable, AND you're a good saver too, I wouldn't bother refinancing it until it would get you ALL your original deposit amount back (and would still give you positive cash flow, even at the consequential 100% leverage) Well done!

[Useful goal: Refinance to have NONE of your own money left in the original deal - for INFINITE returns!]...

Joe Villeneuve · Answer

What do you plan on doing with that appreciation?  I'm not saying it has no value...I'm saying it isn't one of the most important numbers when you are buying a rental.  You buy a rental for cash flow.  In order to "use" your appreciation, you have to either refinance, thus reducing your cash flow, or sell...and it isn't a rental anymore.

If you are analyzing a rental as a future flip, then the appreciation is important.  Otherwise it is just a trophy.  I've never been able to figure out how to pay the for a pizza delivery with my equity.  I guess I can't figure out which part of the house is paid off...so I know which bricks to use.

Nam Nguyen · Answer

I'm in the same boat. From what I gather it depends on how fast you want to grow. Many of the answers I've received is "No, don't pay off the mortgage if the numbers are working for you.  Use that as a deposit to buy another 1-2 properties and have some cash leftover for repairs".

I have a 15-year mortgage on my property and thought I was doing ok bringing home $200.  The folks here on BP helped me do the real math and I'm actually brining in a cool $7.50 a month lol. Have you done the math in yours?

Jay Dean · Answer

@Chris McDonald - You are currently leveraged about 65% ($49,000 / $75,000).

My personal goal is to never be leveraged by more than 50%.  This is conservative and means I don't stand to make money as quickly but gives me a little breathing room if something does not go as planned.

I am also not a big believer in paying down a mortgage.  Once you do this, your cash is tied up unless you can do a cash out refinance or sell the property.

Cash money in your pocket is more useful.  The down side is that it won't earn you much money.  This frustrates investors, so they move quickly into another property and increase their leverage.  If things go south and they don't have any liquid assets, they will be forced to make decisions like selling units (potentially in a down market).

In your shoes, I would establish my rainy day fund reserves and save up for the next down payment.

Security come with patience, but increased potential comes with risk and leverage.  You have to decide how to proceed.

Joe Villeneuve · Answer

First, your presentation here is full of non-important numbers, and missing almost all the important numbers.  Here are the numbers you need to make this decision...which are the numbers you should know like the back of your hand.  They are also the only numbers you (should have) used to make the decision to buy this property in the first place.  (Keep in mind that you buy a rental property primarily for the cash flow):

1 - Cash you used to get in (you have that = $16,250)2 - Monthly/Yearly Cash Flow (this is why you buy a rental)...and it better be positive...and your calculation only includes cash, not depreciation, appreciation, etc...

Second, understand that although the loan here is in your name, you are not the one paying it (as long as you have positive cash flow...which if you didn't, you wouldn't buy the property in the first place...right?).

Third, and missing this is a common problem many "experienced" REI have, upi must always have your "exit strategy" from the property you are buying linked with the "entrance" strategy for the next property you will be buying, in place and planned before you buy.  In other words, you must know where you are going before you start moving...and that isn't simply "going" in the "front door", but also leaving out the back with your eyes on the next front door.

Ralph R. · Answer

@Chris McDonald

Chris sometime when you are bored google an online IRR calculator for real estate.  make sure its for reale estate.  many do not allow for real estate expenses and you must figure those your self separately.  you can plug your numbers in and see when your optimal time to sell is.  In my area most of my properties show a negative return the first year or two.  (large cash input, no cash back yet).    Then around year 3 they jump way up. say 8-12%. The Rate of return will increase pretty steadily by a percent or a little more every year until year 7 or 8. Then it will continue to increase by much smaller increments, maybe a I/2% or so.  That's because as my equity increases my rate of return decreases.  After the loan is paid off it stays pretty flat, with very small increases each year.  Paying your house off quicker only hastens this drop in percentage return.  You are in effect lowering your own rate of return.  some of the numbers you enter will be assumptions, such as sale price, rent increases etc etc.  you need to be prudent when making any decisions using IRR.  The reason Im suggesting this is to give you some idea as to how your return falls off when you gain equity.  This will help show you when you want to sell or do your re-fi.  Im not sure its ever prudent to just pay an investment property off.

RR

Joe Villeneuve · Answer

Sorry @Nickey Calford but the math doesn't add up.  When you're paying off your property early, so you can retire when you pay it off, I'm already retired with higher cash flow.  From the time we both start down different paths, to the time of payoff, both of us are getting the same appreciation, so the only difference between paying off the mortgage early and not, is you are "buying" your equity...I'm having it gifted to me by my tenant....and have a higher cash flow adding up while my tenant buys my property for me.

In summary, both of us get the same appreciated equity.  However, your accelerated equity is paid for by you, while mine is paid for by my tenant.  Are you familiar with the story of the tortoise and the hare?

Nickey Calford · Answer

Joe, it is true you can't pay for pizza:) but for some investors it's about building passive income to retire on, pay for kids college/wedding... our market has gone up 26% in the last 12 months, predicted to go up another 20% in the next 12...  so that appreciation is giving way better returns than most GCI's, Stocks and bank interest rates...

In our market you are lucky to see cash flow of $200 if your goal is to eat out once a week then that's the way to do it... if your goal is to live modestly and retire early then having the mortgage paid down in 15 years and the property appreciation almost double buying and holding is a great way to build equity.

Everyone has their own niche to investing... some want to see a quick turnaround, others want a monthly residual right away, others want a long term retirement fund.... most real estate millionaires have tried many ways and have figured out the one that works the best for them.  If someone could put together a step by step process on how to start with $20000 and end up with $1000000 that was fail proof we would all be rich!

Buy 2nd Rental or Pay off 1st?

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