Buy another rental property, or pay off second mortgage?

Question

I'm in the position where I will soon either buy another rental property, resulting in $500/month cash flow, or pay off the balance of a second mortgage which would also result in $500/month additional cash flow. Both result in the same cash flow increase for me. If I get another rental though, I have to deal with having another tenant and all that goes with it. However, I'd also get them to build equity in that new investment property for me in addition to the $500/month cash flow. On the other hand, just paying off that second mortgage is an easy, simple way to increase my cash flow. It has around $9,800 left. So I can pay $9,800 to pay that off and increase my cash flow by $500/month, or I could get a new rental property putting $30k down, $10k closing costs, deal with tenant issues, building issues, etc., for that same $500/month increase in cash flow.

It seems like the better choice would be to just pay off that second mortgage. Or am I missing something? Which would you do and why?

Thomas S. · Answer

@Jd Martin

I liken it to paying workers to sit around and do nothing.

Dead equity is akin to government employees.

Thomas S. · Answer

Paying down a mortgage does not increase cash flow. All it does is transfer the income source to the equity tied up in a property. Cash flow is based on 100% financing not on the amount remaining on a mortgage. If you are not calculating that way you are not now making the cash flow you believe you are.

Equity is dead money if you are not collecting a return on it from your rental income ahead of all other calculations.

A 1M dollar property bought with cash is a extremely poor investment if not earning a minimum of $4200/ month after all expenses. That would be a 5% return on equity and at that amount the property itself would be generating zero cash flow.

JD Martin · Answer

Sear that into your soul: equity is dead money. I liken it to paying workers to sit around and do nothing. That's not to say that you should be 100% leveraged, but unless you are already on the edge between what you bring in and what goes out, and have no reserves, I would use those funds to build a greater portfolio. Caveat: if there's nothing out there to buy, and the choice is between leaving funds idle at a quarter percent in the bank or paying off a 7% second mortgage, the choice is a lot clearer.

Chris V. · Answer

Only you can decide if you want to deal with the additional hassle of a tenant... BUT from a pure financial perspective, below would be my considerations based on the numbers above.

~ You will initially get $500 cash flow, but you can (and WILL) increase your rent over time.

~ You will get a nice tax deduction to write off the depreciation on the asset over 27.5 years.

~ Meanwhile the interest you pay on the second mortgage will continue to be a tax deduction as it is now.

~ You will get to write off the interest and insurance etc. you pay on the rental building, (which you are not counting in your cash flow but will be the largest part of your payment for years to come.

~ While appreciation should not be your main goal, it is cash flowing positively so you can afford to wait around and see if it does appreciate giving you a possible additional exit strategy in the future.

~ The rent income will could towards your PITI vs. income ratio next year making it easier to get mortgages etc.

~ Finally, if that second mortgage *really* bothers you on an emotional level you can use part of the cash flow coming out of the new property to get rid of that debt sooner.:)

Account Closed · Answer

I was never a big time investor, but I have a hard time reconciling cash flow that goes along with debt.

Just a thought, though - would it behoove you somehow to refinance your mortgage and incorporate the second mortgage into it?

Chris V. · Answer

Hmmmm, I would still argue that even if there is nothing out there to buy "right now", turning your assets into essentially dead equity would represent an potential opportunity cost.

Because if you are really interested in finding a deal, something will come along sooner or later at which point you'd have to decline... Because you "have no money"!:) All the while you are sitting on a large chunk of dead equity that you can not liquidity economically because of the high fixed cost of a cash out refi....

If there is no deal handy right now you could pay your second mortgage and then get a no-cost/no fee HELOC. You pay *nothing* until you use it and when you do you'll pay less than 7% interest (FOR NOW because it will be fixed to the prime rate or other flexible rate). I love these first world problems:)...

Brent Coombs · Answer

@Sean Forest, but, you'll still have "$30k down" for your next one, even after you pay out your second mortgage! Therefore, it shouldn't be an either/or scenario. Just negotiate better. Cheers...

Ali Boone · Answer

A lot of it depends on how you feel about leveraging in general. But are you really increasing your cash flow by paying out? It would take 20 months of cash flow to make up for what you paid off, all the while you aren't using the money for more investing. If you buy another property, that's more equity and tax benefits, on top of more cash flow, on top of whatever your current property brings in (if it brings any in).

So I would vote that if you don't worry about that mortgage (let the tenants pay it off, not you), you will see substantially higher returns for you.

This isn't exactly your scenario, but it's the difference between the returns on all cash payments and leveraged properties. You'll see that anytime you leverage (in your case, meaning don't pay off that mortgage and buy another property instead), your returns are mucho higher.

https://www.biggerpockets.com/renewsblog/2015/04/1...

Gabe C. · Answer

Of course it depends on your goals, but If you're that close to paying off the place, I would personally get another rental. You can pay down the other place quickly with your new CF. Then you'll be cash flowing $1k soon enough. You could always hire a property manager to reduce your headaches.

Also, your closing costs are $10k?!

Buy another rental property, or pay off second mortgage?

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