Loan term and negative cash flow - Struggling with the concept...

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Loan term and negative cash flow - Struggling with the concept...

Nicholas B.
Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes

Regarding small scale rental properties or I believe "buy and hold" is the term used around here (sorry, I'm new to all this).

I notice that a lot of investors mortgage properties for 10, 20, even 30 years - whatever it takes to produce a (sometimes barely) positive cash flow. It seems that a lot of them end up in a "one day, I'll be rich" scenario of waiting out the mortgage before they really have solid usable income from the rent checks. Maybe they put a couple bucks in their pocket, but in the mean time, they're paying thousands in interest and often run into difficult DTI problems when they go to finance something in their name.

Do people who have the disposable income ever intentionally enter a negative cash flow deal in order to get to the "I keep the rent $" phase sooner and save the interest? Or more importantly, why not?

I'll add an example in case I'm not really clear:
Let's assume an initial loan amount of $60,000, $3000 / year of taxes and insurance, and a rental income of $1200 / month analyzed over ten years. Assuming that repairs and maintenance will be paid out of pocket. Total income would be $144,000 minus the out of pocket expenses. Please bare with me for simplifying all of this to get to the point. 

  • If I take a 5 year HEL at 4.115%, P&I = $1108 + $250(T&I) = $1358 x 60 months is $81,480. Then another 5 years of tax & ins totaling $15,000. Total investment is 96,480, leaving an income of 47,520. For the first 5 years, I'll have to float $158 / month totaling $9,480, but the next 5 years, I'll have $950 of additional income totaling $57,000.
  • If I take a 10 year HEL at 5.365%, P&I = $647 + $250 = $897 x 120 mo is $107,640 total, leaving an income of $36,360. Each month, I'll have a positive income of $303, totaling the $36k.

Maybe I'm missing something. I guess I just wonder why I read so much about making "positive cash flow" leveraged deals, but nobody ever talks about just getting the thing paid off and then enjoying the income. This is something that I'm actually considering doing in the future, so feel free to save me from myself. Thanks!

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Bryan O.
Specialist · Lakewood, CO · Member since 2014 · 1k+ posts · 1k+ votes
10y

You are talking about 2 different strategies and preferences:

1) Get the property paid down as fast as possible. Use any extra income to shovel into paying down the debt, then having greater cash flow later and the comfort of knowing that the property can lose value in a crash, but that they will never be underwater. They sacrifice that cash flow now for higher cash flow later

2) Get as long of a loan as possible and use as much leverage as you can. This maximizes your cash flow at the start and leverage is a very large value add when property appreciates, but if the property value goes down you may not be able to sell it to get free.

Both strategies work, but they are both different risk profiles and mindsets. They accomplish different things at different times with the same ultimate goals. Do you care how much interest is paid when you aren't paying it? I am young(ish) and in expansion mode, so I prefer strategy 2 right now. As my risk tolerance goes down I will transfer to strategy 1 so I can "retire". Once they are paid down more, maybe I'll just hold the notes...

So tell me, do you like Apple pie, or Pecan? Because that is our discussion.  ;)

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  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    10y

    Deleted (mistake), sorry.

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  • Justin Fox
    Software Developer · Vidor, TX · Member since 2015 · 922 posts · 639 votes
    10y

    @Nicholas B.,

    It may seem like a pittance of a return but you can put that cash flow towards other investments instead of the same one. If you can buy a property, get a tenant paying the PITI and vacancy/repair reserves AND make 3/400 dollars in cashflow, why put it back into the same property's principle for 5 years? Especially when you'll most likely cash out to purchase more properties?

    I also think there's value in being able to show on paper that your investments make money now.

    Justin

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  • Charlie Fitzgerald
    Lender · Las Vegas, NV · Member since 2015 · 2k+ posts · 1k+ votes
    10y

    You are also missing the benefit's of depreciation and appreciation...there are dozens of ways an investment property "pays" me...not just cash flow, or lack thereof.

    1Reply
  • Bryan O.
    Specialist · Lakewood, CO · Member since 2014 · 1k+ posts · 1k+ votes
    10y

    You are talking about 2 different strategies and preferences:

    1) Get the property paid down as fast as possible. Use any extra income to shovel into paying down the debt, then having greater cash flow later and the comfort of knowing that the property can lose value in a crash, but that they will never be underwater. They sacrifice that cash flow now for higher cash flow later

    2) Get as long of a loan as possible and use as much leverage as you can. This maximizes your cash flow at the start and leverage is a very large value add when property appreciates, but if the property value goes down you may not be able to sell it to get free.

    Both strategies work, but they are both different risk profiles and mindsets. They accomplish different things at different times with the same ultimate goals. Do you care how much interest is paid when you aren't paying it? I am young(ish) and in expansion mode, so I prefer strategy 2 right now. As my risk tolerance goes down I will transfer to strategy 1 so I can "retire". Once they are paid down more, maybe I'll just hold the notes...

    So tell me, do you like Apple pie, or Pecan? Because that is our discussion.  ;)

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  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    10y

    Thank you all for the comments. I'm guessing that maybe it's just not talked about because it's not as glamorous as "earning an extra $300 a month by doing nothing" or "building your portfolio using other peoples money". 

    There's a lot to learn about all this, but for somebody in my shoes, it seems the plain and simple is a penny saved is a penny earned. Saving $21k in interest seems pretty damn sensible to me.

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  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    10y
    Originally posted by @Charlie Fitzgerald:

    You are also missing the benefit's of depreciation and appreciation...there are dozens of ways an investment property "pays" me...not just cash flow, or lack thereof.

     @Charlie Fitzgerald, can you clarify the relationship of the loan to your statement? I have a basic understanding of both terms, but I can't seem to think of any way that they relate to the term of a loan or having the loan paid or not. Thanks.

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  • Charlie Fitzgerald
    Lender · Las Vegas, NV · Member since 2015 · 2k+ posts · 1k+ votes
    10y

    1.  With no loan you have no mortgage interest paid deduction...so depending on your overall taxable income situation, it might hurt you to not carry a mortgage.

    2.  Bigger loan means less of your money in the transaction...cost of debt should be calculated into the transaction and paid for by the tenant or recaptured at sale.  Less of your money in 1 home maybe allows you to purchase another home...or two.

    Appreciation and depreciation are going to happen in either case...paid off home or mortgaged home.

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  • Russell BrazilBusiness Member
    Moderator
    Real Estate Agent · Washington, D.C. · Member since 2012 · 17k+ posts · 30k+ votes
    10y

    @Nicholas B. I always believe in stretching out the loan as long as I can to create the most cash flow.  That does not mean though that you can not pay the loan down quicker.  Creating the opportunity for the larger cash flow gives you more flexibility.  Yes you may want to pay the property off in 10 years, but the flexibility of having it stretched to 30, so you have that cash flow in case you get laid off from your day job or need to replace a roof, or have a non pay tenant for 6 months can literally save you from bankruptcy.

    All of my properties are financed at 30 years, but at about my 5 year mark before retirement, Im going to roll all the monthly cash flow into paying the mortgages off.  However it is important to note that your return is less when you do this.  Leverage magnifies your returns.  

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  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    10y
    Originally posted by @Charlie Fitzgerald:

    1.  With no loan you have no mortgage interest paid deduction...so depending on your overall taxable income situation, it might hurt you to not carry a mortgage.

    Maybe I'm getting off of the original topic here, but as far as deductible interest:

    Say hypothetically, I'm already filing itemized and all of the interest in this investment will be tax deductible. It will all remain in the 28% bracket for the entire 10 years. 

    In example 1, I'll pay $6,486 in interests and deduct $1,816, leaving a cost of funds at $4,670.

    In example 2, I'll pay $17,658 in interest and deduct $4,944, leaving a cost of funds at $12,714. 

    I'm using this simple math because it's what I understand. To me, this seems pretty obvious though. How would it make sense to pay and extra $11,000 in interest in order to save $3100 in taxes? I've never really understood this ideology... 

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  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    10y
    Originally posted by @Russell Brazil:

    @Nicholas B. I always believe in stretching out the loan as long as I can to create the most cash flow.  That does not mean though that you can not pay the loan down quicker.  Creating the opportunity for the larger cash flow gives you more flexibility.  Yes you may want to pay the property off in 10 years, but the flexibility of having it stretched to 30, so you have that cash flow in case you get laid off from your day job or need to replace a roof, or have a non pay tenant for 6 months can literally save you from bankruptcy.

    All of my properties are financed at 30 years, but at about my 5 year mark before retirement, Im going to roll all the monthly cash flow into paying the mortgages off.  However it is important to note that your return is less when you do this.  Leverage magnifies your returns.  

     Thanks @Russell Brazil. I can respect the "safety net" aspect of it. I also respect that you have a specific plan, but I hope I can pick your brain about your methods. 

    Being as longer term loans generally fetch higher interest rates, not only would they cost more interest over the life of the loan, but also a higher pro rata cost on the current principal. Have you analyzed the effects of shortening some of those loans now & the cost savings? or even specifically paying off certain loans in order to accelerate the interest savings?

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  • Charlie Fitzgerald
    Lender · Las Vegas, NV · Member since 2015 · 2k+ posts · 1k+ votes
    10y

    If your acquisition is structured appropriately, then you are paying zero...all of the costs are covered by the rental income and depreciation and interest deduction, OR, at some point it will, OR, at some point the appreciation will.

    0Reply
  • Vincent Crane
    Realtor · Atlanta, GA · Member since 2015 · 693 posts · 357 votes
    10y

    If the total costs exceed the rental income then it's negative cashflow. If you pay off your loan over 30 years, your payment is lower. If it's 15 years, your monthly payment is higher because you're paying off the same amount of principal in less time.

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  • Lynn McGeein
    Real Estate Agent · Virginia Beach, VA · Member since 2012 · 2k+ posts · 1k+ votes
    10y

    @Nicholas B. , when you say "Maybe I'm missing something. I guess I just wonder why I read so much about making "positive cash flow" leveraged deals, but nobody ever talks about just getting the thing paid off and then enjoying the income. This is something that I'm actually considering doing in the future, so feel free to save me from myself. Thanks!" 

    The simplest answer I have is that I'd rather my tenants pay my mortgages down for me, putting the smallest down payment that I can (these days, usually 25%) and lock in 30 years at these historically low interest rates so I can buy more homes with the money I do have available and qualify for more because it doesn't kill my DTI ratio with negative cash flow. When we're ready to retire, we'll sell a few and use the built-up equity to pay off the others.

    1Reply
  • Russell BrazilBusiness Member
    Moderator
    Real Estate Agent · Washington, D.C. · Member since 2012 · 17k+ posts · 30k+ votes
    10y

    Being as longer term loans generally fetch higher interest rates, not only would they cost more interest over the life of the loan, but also a higher pro rata cost on the current principal. Have you analyzed the effects of shortening some of those loans now & the cost savings? or even specifically paying off certain loans in order to accelerate the interest savings?

    The amount of the payment going to interest does not really matter. Looking at two simple scenarios here. Should you buy 1 property for $100k or 5 properties at 20% down and $20k each into them. Where is the better return? (Im using $50 a month insurance $100 a month taxes, and no other costs to simply the math and a mortgage of 4.5%)

    So this would generate $444.65 a month in free cash flow on each of the 5 properties. ($2223.25 total) This gives you a cash on cash return of 26.68%.

    Or you could take the $100k and buy 1 property outright. This will give you $850 a month and a cash on cash return of 10.2%.

    Now in example one you are paying a huge amount of money towards interest, yet even so your return is incredibly higher. This is the power of leverage. Leverage is what makes real estate a phenomenal asset class. Yes you can apply leverage to stocks, it just isnt a customary thing for the every day individual to do.

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  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    10y
    Originally posted by @Charlie Fitzgerald:

    If your acquisition is structured appropriately, then you are paying zero...all of the costs are covered by the rental income and depreciation and interest deduction, OR, at some point it will, OR, at some point the appreciation will.

     @Charlie Fitzgerald, please recognize that I'm not trying to challenge you here, just trying to distill it all in a way that I can understand.

    Say that I am "letting the tenant" pay the interest costs, but still collecting $1,200 / month. (I mean, if I could get anything more out of the rent, why wouldn't I, regardless of my costs?) Unless I'm missing something, once amortized over the 10 years, it still ends in a net difference of $21,000 minus the $3000 of tax savings, so at the end of the day, I'd have an additional $18,000 in my pocket by investing the $10k out of pocket over the first 5 years.

    It just all seems way too simple, though.

    0Reply
  • Charlie Fitzgerald
    Lender · Las Vegas, NV · Member since 2015 · 2k+ posts · 1k+ votes
    10y

    It's just a matter of velocity of money and leverage and personal attitude towards both.  When I acquire properties for long term hold, I want to get them for as little out pocket as possible. Ideally, they are cash-flowing sufficiently (b/e or +), or can do so within a short time (6-12 months).  If not, it does not concern me as much as I am in it for the long haul, and even if I am out of pocket $100, or $200, or $500 a month on a property for a year (let's say), the totality of the benefits associated with owning that property for 15-20 years while a tenant pays it off for me and it appreciates by 75-100% over my strike price, along with the interest deductions that lowered my taxes, make it a worthwhile investment.  That's just my strategy.  Yours might be pay it off as quick as possible.  That's your strategy.  Both are right, or wrong, depending on personal preference.  The only thing that me paying a house off quick saves me is 4-5% interest that I am not paying anyway.  I can make a lot more on my money investing it into more properties that over time earn me 8-20%.  That's just me.

    2Reply
  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    10y

    So, I guess what I'm gathering here is that it's a matter of scaling upwards as fast as possible. So the model works if the plan is to buy as much property as possible with a given availability of cash in the shortest amount of time. It seems buying one or two properties using this model is simply a mis-application of the concept. 

    1Reply
  • Bryan O.
    Specialist · Lakewood, CO · Member since 2014 · 1k+ posts · 1k+ votes
    10y

    The absolute number is your ROI. If you have leverage, you have higher ROI. If not, you have lower. The amount of interest is irrelevant. The real math is what % return you get based on how much money you put into the deal. The more money you spend on the property (the lower you pay down your mortgage), the lower your ROI, but the lower your risk once paid off.

    1Reply
  • Nicholas B.
    OP
    Finance, Credit, and Insurance · Northwestern, PA · Member since 2015 · 56 posts · 20 votes
    10y
    Originally posted by @Bryan O.:

    The absolute number is your ROI. If you have leverage, you have higher ROI. If not, you have lower. The amount of interest is irrelevant. The real math is what % return you get based on how much money you put into the deal. The more money you spend on the property (the lower you pay down your mortgage), the lower your ROI, but the lower your risk once paid off.

    I understand this as explained above, but again, in a single property example, a 10 year ROI is higher by paying the property off sooner making the interest relevant.

    I'm not attacking you, but it's blanket statements like this that confused me in the first place. Since nobody contradicted the examples I used, I'm going to assume them to be true. If you're not planning on scaling, it's a foolish misapplication of the concept and you will not generate a higher ROI. You'll pay more interest, therefore reducing your ROI when amortized.

    I don't want to "buy as much as I can with what I have as fast as possible", so that breaks the model. Barring other evidence, I think I have my answer. Thank you to everybody who helped.

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  • Bryan O.
    Specialist · Lakewood, CO · Member since 2014 · 1k+ posts · 1k+ votes
    10y

    You are correct for a single property example. I didn't realize you only wanted to have 1 property. Best of luck in your goal!

    2Reply
  • Tim Macy
    Real Estate Agent · San Antonio, TX · Member since 2014 · 311 posts · 176 votes
    10y

    Your example is true and I believe you have your answer, but I don't think anyone addressed your situation and what the leveraged strategy actually looks like.

    Instead of buying one 60k house, you buy 5 at 20% down, which would really be more like a 70k HEL.

    If you cash flow $300 a month on each house which seems very achievable over a 10 year period with your numbers, you're looking at 18k a year.  With no increase in rent, you're at 180k over 10 years.  Add in the equity that you should get at purchase, appreciation (which is never depended upon, but can be a nice bonus), mortgage pay down, and depreciation you could find yourself well over 200k+ in cash flow and net worth increase.

    Reinvest half of the money you made and do it again after 5 years, and 10 years from now you are in a completely different place than you are taking your HEL and buying one house.  

    Investors effectively using leverage are not waiting for the mortgages to get paid off to make money.  When you can use 5% money to make 20% returns, it usually makes sense.

    2Reply
  • Lance Robinson
    Investor · Scottsdale, AZ · Member since 2015 · 130 posts · 102 votes
    10y
    Originally posted by @Nicholas B.:

    Regarding small scale rental properties or I believe "buy and hold" is the term used around here (sorry, I'm new to all this).

    I notice that a lot of investors mortgage properties for 10, 20, even 30 years - whatever it takes to produce a (sometimes barely) positive cash flow. It seems that a lot of them end up in a "one day, I'll be rich" scenario of waiting out the mortgage before they really have solid usable income from the rent checks. Maybe they put a couple bucks in their pocket, but in the mean time, they're paying thousands in interest and often run into difficult DTI problems when they go to finance something in their name.

    Do people who have the disposable income ever intentionally enter a negative cash flow deal in order to get to the "I keep the rent $" phase sooner and save the interest? Or more importantly, why not?

    I'll add an example in case I'm not really clear:
    Let's assume an initial loan amount of $60,000, $3000 / year of taxes and insurance, and a rental income of $1200 / month analyzed over ten years. Assuming that repairs and maintenance will be paid out of pocket. Total income would be $144,000 minus the out of pocket expenses. Please bare with me for simplifying all of this to get to the point. 

    • If I take a 5 year HEL at 4.115%, P&I = $1108 + $250(T&I) = $1358 x 60 months is $81,480. Then another 5 years of tax & ins totaling $15,000. Total investment is 96,480, leaving an income of 47,520. For the first 5 years, I'll have to float $158 / month totaling $9,480, but the next 5 years, I'll have $950 of additional income totaling $57,000.
    • If I take a 10 year HEL at 5.365%, P&I = $647 + $250 = $897 x 120 mo is $107,640 total, leaving an income of $36,360. Each month, I'll have a positive income of $303, totaling the $36k.

    Maybe I'm missing something. I guess I just wonder why I read so much about making "positive cash flow" leveraged deals, but nobody ever talks about just getting the thing paid off and then enjoying the income. This is something that I'm actually considering doing in the future, so feel free to save me from myself. Thanks!

     Nicholas,

    I'm chiming in because I don't think anybody is specifically replying to your specific example and they haven't dumbed it down enough for you so it's just driving you crazy. 

    It's fairly simple, in a one house example, you can save money by paying it down. The way to look at it is really how and where you can invest your money. Rapidly paying down your property will save you interest. Which could be say 4.5% return on your money. Instead of rapid pay down, you could buy other properties that would produce a higher return on your money at say 20%. I hope this helps to make sense of it all. My advice is to always invest your money where you get the highest ROI. You may get a 5% annual return in your example (didn't run the numbers) but you could invest elsewhere to have much money in that same time frame.

    I hope that helps to clarify for you. 

    Lance

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  • Mona V.
    Investor · Cary, NC · Member since 2015 · 71 posts · 26 votes
    10y

    Nicholas,

    Sorry to chime in late but i actually had the same question at some point like you did and I finally decided to put all the cash flow money back in paying back the mortgages, one at a time. I actually calculated for my properties how long will it take for me to pay off all of them if I start putting all the cashflow in one property at a time and pay them off earlier, and how much in total return will I get if the houses are paid in 30 years, difference was decent for me to push me to pay loans off.  I did use a little pessimistic rate of return if that cashflow was used to purchase other properties.

    I also missed a very important part of calculating return on investment over the years, depreciation of money over time! Basically if the decision is between saving 20K in 15 years in interest by paying off your loans, or making 40k in 30 years by not paying, your actual rate of return might actually be higher for saving 20k in 15 years based on inflation etc.  Its just an example with random numbers, I haven't really compared those numbers. I came across this book which I believe is the first place I found which teaches cash flow numbers a little differently, still going through it -

    http://www.amazon.com/gp/product/0071603271?keywor... 

    In the end numbers won for me, but its not true that I might not have gone the same way even if return was a little less. My end goal was to have a substantial income being generated for me monthly so that I can get financially independent fast, and to make that as fast as possible, I would pay off my rental homes asap. Either way you are trying to pay it off using rental income. I wouldn't feel financially independent with loans to think about, its a personal decision. Depending on the number of houses you have and how much cash flow they are generating, and if a lot of debts can bother you, it might be different for you. 

     I think maybe its personally how you view flow of money, or your "model". I never see "tenants paying off my interest", I see that as "my money going to the bank" which I could have saved :). But I am also a more conservative investor than many people and don't like over-leveraging too much. I would rather design for the worst case scenario even if the return is little less, as far as return is in the area I expect (or more :)).  I would rather do flips to raise capital to buy new buy and holds, instead of using the cash flow. 

    And ofcourse advantages to paying them off faster was also that I could get loans from banks easily, since I am a newcomer to this world and really don't have any creative financing skills right now. 

    Hope anything out of my story is helpful:).  

    1Reply
  • Christopher Leon
    Realtor · Schaumburg, IL · Member since 2011 · 289 posts · 118 votes
    10y

    Hi @Nicholas B. interesting post as I am currently doing this. I do not personally have disposable income lying around, but I am currently purchasing a property (w/ OPM) knowing it has a negative cash flow (-$115 to be exact) Allow me to explain:

    In my market, there are many an undervalued properties still floating around. I happened to find one priced pretty low in comparison to what others are selling for currently. Back in the day, these things sold for 100% more than my purchase price today... The way I see it is, I know the product, I know how to manage it (the tenants I'll attract), I'm only 29 and plan on doing this for the rest of my life, and it's in an area I'm already vested in - to me, its a long term play to build net worth. Truth be told, I want to buy whatever I can now (as long as I can hold on to it - which is key) because I know later on I will look back saying "I should have bought more". I look at the net: with respect to my entire portfolio, sure this unit weighs me down $115 a month, but, as long as I can absorb the loss, I'm comfortable. Moreover, my plan is to acquire this unit, rent it in as-is condition because I can, get it up and running, then re-position the high interest financing while rates are still low. Here is the thing: most people get all bent out of shape about "negative cash flow" and I get it - you can't build an investing career/business off loses, BUT, since I'll never see a real estate market like this again (and neither will you - generally speaking) my ideology is, if I don't buy it now, I have no chance at all in making  any money. This particular deal makes more sense for me, too, because I'm already vested here anyway. For anybody just getting into this business, please understand, this only makes sense if you can absorb the loss and hold the unit without losing it - which in this case, I know I can. As far as I'm concerned, I'm buying a place to help out a less fortunate person by providing clean and affordable housing and they're going to cover 89% of my monthly nut. Sure, I'll have to pay $115, but it's not such a bad trade off when im considering this deal as a net-worth builder, a forced savings plan, and, I will get tax benefits from deductions which makes my effective cost of owning this unit a positive. That's my rationale - you can't expect to survive buying units at a loss; but, for some people, buying anything is better than doing nothing - provided it's not garbage and you know how to manage it effectively. Oh, I forgot to mention - I'm purchasing it with no money out of my pocket, too! Thanks for the post, Nick. 

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  • Christopher Leon
    Realtor · Schaumburg, IL · Member since 2011 · 289 posts · 118 votes
    10y

    @Nicholas B. I may have totally missed the underlying question for this post. I was under the impression you were asking if people get into negative cash flow deals, generally speaking. After re-reading your post, I see your question was a little more in depth, specifically, related to saving a lot of money in interest over the long term. Sorry if my first reply was off-topic. 

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