Paying off mortgages for rental property or holding the loan?

Question

Im posting this for a friend that buys alot of rental houses that he rehabs.  He is trying to try a new strategy and wondering if paying off a rental property right away is better than just holding on to the loan.  Note these are loans for less than 50K.  We are trying to come up with a long term strategy and what would be better for the future of his company.  Any help is appreciated! 
James

Bill Gulley · Answer

I'll suggest that you search here and elsewhere for the term "use of funds" the economic and financial impact of leveraging assets.

Secondly, what you are saying by paying off low interest debt is that you have no better use for the cash or nothing better to put money in that yields a higher return or benefit. That is probably not the case since interest rates are so low!  This looks to "opportunity costs", the cost or economic loss of selecting another investment or use of funds.

When rates are lower than the rate of return you may get in other investments, you should be borrowing all you can get. With a few exceptions this should be the path taken to expand any business.

In the mid 90s when rates were falling, many were refinancing thier homes and reinvesting the money at a higher after tax rate. Rates were around 7.25/7.5% then. Equity in the walls of any property is basically an idle asset, increasing by appreciation on paper. There are only two ways to use equity, borrow it or sell it.

If you friend is leasing, he is selling the use of the property, a leasehold interest in the property. His return on his investment, his equity, may go down if you consider the profit received on and above the lender's portion. While your net worth will increase by reducing debt, the profit from the debt is converted to profit on his money, if his money is more valuable, his economic return is less.

His cash flow increases due to the fact he has no debt to cover. In essence, the property is actually paying him on his money, paying interest only in a way from the rents generated. If the market rents paid remain high, his return can be higher than an alternative investment. This can be great for retirement, where you park your money as most in retirement have lower alternative investments, they are not expanding or remaing in business for growth but rather conserving assets.

All properties have an economic life span, at some point, due to various factors, the economic return will go down unless additional capital is added. Improvements as well as maintenance will be required to maintain the same or better return than at that property's highest use. External factors also reduce the value of RE over time, it's no longer the best location for example.

Look at a house built in 1960, usually a tract house. Today, that property may rent for 10 times it's original rent, in 1960, gas was 25 cents a gallon, a loaf of bread was a nickle, so you can see that the value of a dollar over time is eaten up by inflation. His equity will increase basically at the rate of inflation, less depreciation, while rates fluctuate many say it averages around 3%.....

So, my point with all this is;

Financial leverage is good during periods of growth, growing a business, in RE you can make a return on the lender's funds while using your money to expand holdings.

You need to identify your cost of money and opportunity costs, if your money is more valuable than the cost of borrowing, borrow all you can.

Equity is an idle asset in the walls of RE, it only grows at the rate of inflation unless other capital improvements are made, but while that increases the value the return may not increase and if it does, it will at some point decrease over time economically.

One last note as to the use of funds. Rents generate a small monthly income, you can't buy a house or really do much business with $800 a month. However, a lump some of $120,000 can be "purchased" with that $800 per month. You'll have many more opportunities with that 120K than you will 800 a month! :)

Ben Leybovich · Answer

James Friedrichsen  Your question is too vague to be answerable.  What type of loans are these?  What are the terms?  What are your friend's goals?

This is a post I wrote for the BP blog.  Perhaps this will add to your thinking:  http://www.biggerpockets.com/renewsblog/2013/03/05/leverage/

Callum K. · Answer

Financing ten $25k properties would scare the hell out of me as far as lending fees are concerned, but my banker would love me.  I hope its hard money you are borrowing.

Tim Delp · Answer

James Friedrichsen you reference your peronsal rental property where you say you basically break even and you say that after 30 years when you look at all the interest "you" pay if you sell it for what you paid for it you basically break even.

First problem with your analysis is that you are not paying the interest, your renter is paying off your house for you.  So assuming you have no appreciation at all what so ever if you are able to break even for 30 years you own an asset that didn't cost you anything.  That's assuming you never have a rent increase and also not factoring in any tax benefits you receive for owning the rental.

James Friedrichsen · Answer

That is true.  I might look into refinancing my house but i gotta have the closing money first.  im already locked into 5.25 but i think i could get lower in that case it would benefit my particular case in the long run.

Kelly N. · Answer

Hi James,

Great question, and I agree with the posters above.

Yes, when you sell, you might not break even given the interest money you have paid over the term of the lone, but remember this money wasn't paid by you, but by your tenants.  Interest rates are so low right now it is hard to justify putting that money towards paying off or paying down these loans when we can be using the extra cash to buy more property or other investment that will perform better than the loans.

That being said, I believe in taking a different approach for your own personal home- pay that off ASAP and don't borrow against it.  For me, the security of owning our own home is worth the potential income loss, so we refinanced last year to get our interest rate cut in half and 10 years shaved off the term of the loan.  (We were 5 years into a 30 year mortgage, refinanced to 15 year fixed)  The payments are $80 more than what our 30 year loan was, and we had the expense of the refinance, but it'll more than pay for itself on the interest we save.

Good luck!
Kelly

Ben Leybovich · Answer

I can't say what is best for you - this is a function of your goals and comfort level.  All I can do is point out certain "truths" that I have noticed over time, and hope that what I say is helpful to you in some way.  Good luck!

James Friedrichsen · Answer

lol i wish i could say its common sense.  I guess im not educated in strategic finance.  i dont deal with banks that much, guess im old school.  but i def see your point.  theres still alot of room in my head to learn.  Keep in mind also we are not buy $100K plus homes, we are getting these for $15k-$25K.  so i guess leaving the note on the banks dime(if we borrow) would be best in the long run if we keep rentals.

Ben Leybovich · Answer

James Friedrichsen  Experiance...:)  Besides, is it not common sense?  The more of your money is in the pot, the more of your money is at risk…Of course, there are a lot of qualifiers in this conversation.  But, a 30-year salable note at 5% should never be paid off – period.  You’ll never again find cheaper money with which to build your business!  And in terms of Cash on Cash, the less cash in the higher the return.

Also, let’s not forget one other thing.  When you own lots of equity, you have a liability target on your back!  We live in a litigious society.  If you think that putting paid-off property into an LLC gets you 100% liability protection, I think you may be disappointed.  Corporate veil can be pierced by a skilled attorney.  As such, if you pay attention to what “big money” does, you’ll realize that assets are leveraged; the money is borrowed and therefore is tax-free.  Thus, even if you are ordered to liquidate, there is no equity to be had, which tends to serve as a deterrent to law suites.  It’s sad, but it’s true.

Nothing is full-proof!  But, leverage is the single great advantage of RE as an investment vehicle both relative to ROI and asset protection in my opinion.

James Friedrichsen · Answer

Ben Leybovich, i like your post.  Where did you learn that?

Paying off mortgages for rental property or holding the loan?

Most Popular Reply