Rental Property Paid Off - HEL to Buy Another?

[Nathaniel Donnelly]

All,

I am in San Diego and currently in a refi with the home I live in that will include paying off one of my rental properties. It would probably appraise at $240k to $250k and I am currently renting it out at $1500/mo.

I have a buy-and-hold strategy and would love to have as many homes bought and paid for (by tenants) as possible by the time I retire. I am now 37 years old.

My question is this: What is the best way to achieve this goal? I was thinking about pulling out a home equity loan to put down 25% on another investment property...which would be ~$75k for a ~$300k property. Still not sure how realistic that is with everyone paying in cash for homes in this range here in SD.

I also would like to increase that $1500/mo positive cash flow if possible.

Anyone familiar with a) the San Diego market and/or b) long-term buy-and-hold strategies that may be able to pass along some advice?

Thank you in advance!

[Mike H.]

Interesting explanation on the 50% rule. I guess thats why my numbers come out a lot less than 50%. My taxes and vacancy are about half of that rule of thumb on my properties. And I don't pay any utilities at all. Even for the ones the village requires me to pay (i.e. water/sewer bills), I re-bill that back to the tenant Plus I PM my own properties.

As far as leveraging your properties, I would definitely say to do it. Obivously, you are refinancing your primary residence and paying off the rental for other reasons (i.e. its the only way you can refi and remove PMI because of the DTI ratio guidelines).

But now that you'll have a paid off rental property, the question is does it make sense to get a loan on it to use the money in some other way.

1) I definitely wouldn't use it to pay down your primary residence. Thats the cheapest money you're ever going to get. Your rate on the investment property will be greater.

2) Use it to buy more rental properties. To me this is an absolute no brainer. Buy every one you can - as long as they have some cash flow.

This is clearly the cheapest money we're ever going to get over the next decade or two. And, while I'm not at all familiar with California, my understanding is prices are still lower there than they have been in some time - if you cherry pick the deals of course.

What kind of return are you getting on your money if you have 300k sitting in a house that is making 1,500 a month? You're better off selling. Now what kind of a return are you getting if you borrow 75% of that (225k) and use that as down payments for 3 more houses?

Lets say you can have 1 house at 1,500 a month in cash flow that is completely paid off. Your profit is 1,500 a month plus appreciation on a 300k house. Rents will go up over time so maybe in 10 years, you'll be getting $500 a more in rent but your taxes and insurance will go up as well so maybe you'll be making 1,750 in profits. Plus your appreciation. Thats your return.

Now, if you refi that 225k and get 3 more houses just like it. Your profit will drop to, say 400 a month. But that would be on 4 houses. So now you're at 1,600 a month in profit. And here's where it gets good.

Your principal paydown will be about 800 month on those 4 loans. Your appreciation will be on 1.2 million in homes instead of 300k. 2 or 3% of 1.2 million looks a lot better to me than 2 or 3% on 300k.

And, lastly, in another 10 years, your principal paydown will be 300 month per house (1,200) and now your cash flow will be 650 a month per house times 4 houses.

Here's how it looks when I guesstimate numbers for my stuff. And why I'm a firm believer in buy and hold. And, again, this only works for buy and hold. If you're counting on appreciation of 10% over the next 3 years to make the deal work, then its not a good fit. I figure in true buy and hold, you're looking more at the historical averages to make the numbers work.

Keeping 300k paid off and doing nothing:
1) 1,500 in income Year 1.
2) Houses double every 20 years. In 20 years, house is worth 600k
3) Rental income 10 years = 1,750/mo
4) No principal paydown.
5) No mortg interest deduction so higher taxes.

OR

Taking out a loan on that investment property and buying 3 more just like it.
1) 1,600 month in income Year 1
2) In 20 years, 4 homes are worth 2.4 million and owned free and clear.
3) Rental income 10 years = 2,600/mo
4) Principal paydown starts around $800 a month and in 10 years, at about 1,200 a month
5) Mortg interest deduction so pay less in taxes.

Whats your risk? High vacancy? If the vacancy rates shoot up that means one thing. People are buying houses again. If that ever returns, then your risk is that you get stuck selling the house and lose all the real benefits of buy and hold.

One last thing I left off. I put the numbers above as if you were paying 300k for a 300k house. The reality is you should be paying about 250k or less for houses worth 300k or else you aren't buying right. So don't forget to add in the appreciation you'll gain as well.

To me, its not a debate. Bottom line for the people who want to hold the property free and clear - you're not in real estate for the right reasons if thats the only risk you can tolerate. The returns aren't great enough if you ask me.

The true value gain in investing in real estate is the ability to use OPM to add properties and cash flow. Thats just the only way I see real estate being the home run it is. Flipping and wholesaling is great. But its a job. You can build tremendous wealth with it. But its still a job. Buy and hold using leverage - in a smart way (i.e. with solid cash flow) - is the way to build wealth slowly but SURELY. IMHO of course. :-)