What is your rule?

[Mike McKinzie]

I am in an unusual position. I have taken over the family trust but it is specifically written that I cannot sell anything until my older sister, who is mentally handicapped, passes away (except if needed to pay taxes).

Therefore, the only way to expand the investment portfolio is to finance some of the properties (21 are free and clear). So bouncing around numbers in my head, I thought that I need to get at least 200% of the mortgage payment in gross rents, ie. If I borrow and have a $3,000 monthly payment, then I need to buy property that will produce $6,000 a month in rent. But using the 50% rule, this is a 'break even' proposition. A real life example: I borrow $559,000 which, at 5%, is a $3,000 a month payment. The property I borrow against rents for $2,600 a month (two on a lot), so I lose $1,700 a month on that property (using the 50% rule). So I use the $559,000 to buy properties that produce $6,000 a a month rent, netting $3,000. Taking the $1,700 loss from the $3,000, leaves me with a net of $1,300 a month. My original net? $1,300 (1/2 of the $2,600). All that work to break even, so why do it? Or did I figure something out wrong?

[Vikram C.]

Mike, a couple of things:

1. First, the 50% rule is a ballpark and your yields could be a bit higher if your costs are only, say, 40%. And even assuming the 50%, in your example your return will be the appreciation plus principal reduction on your mortgage. I understand those are typically not enough to justify an investment but I just want to point it out for the sake of completeness. In your examples, since you are fully financing the new purchase without any equity portion, there will be no return on the cash that most investors expect.

2. Now, with respect to your example, as I see it, you will have 2 properties yielding $8,600 in gross rents each month with a payment of $3,000. This, as you correctly pointed out, yields a cash flow of $1,300 per month assuming the 50% rule. This is because there is no cash flow from your new investment as the entire cash after expenses goes to pay for the mortgage. You still get the benefit of price appreciation and principal reduction, as I mentioned earlier, but you do not get any initial cash flow unless you can keep your expense under 50% of gross scheduled rents.

I suspect I am not stating anything that you don't already know. :)