Pay Down Philosophy

[Joel NA]

I have a question about how to handle the cash flow for two of my properties.

One is a four-plex that I'm rehabbing and will hopefully flow nicely. There is little appreciation as it's in a small town where prices are low. The other does okay cash flow-wise but sits on the very edge of a university and is already worth much more than I paid for it a few years ago. I'm able to rent it 18 months in advance.

My immediate focus is building up my reserves for each property. When I get to a comfort zone in that respect, however, I'm confused about what to do. Should I take the returns from my four-unit building and pay down the more valuable marketable property? Or is it wise to let each property "pay itself down" on it's own merit, so to speak?

I'm sure there are those who would say "stay leveraged" and keep buying properties. I agree, but I also want to get a property in the clear soon.

Thanks-- happy holidays all!

[Bryan Hancock]

From a strictly financial standpoint you should stay leveraged. The ROE generally has an "optimal" point in theory that involves high leverage. Additional debt will drive up the cost of future debt so there is an optimal point.

Another way to think of this is that additional investment dollars or spare capital should compete for uses. Paying down a mortgage that is around 5%ish is a horrible use of money that won't produce additional cash flow in the future with a fixed-rate note. It will also require transaction costs to pull it back out of the investment.

There is a risk/reward tradeoff for this and it really is an asset allocation question for a competent advisor that knows your whole situation. Investing dollars in prepaying mortgages on cashflowing properties is generally a bad use of free cash flow IMO.

There is also an argument that additional positive cash flow makes you lazy. Whether or not this is a good thing is in the eye of the beholder. It really depends on your goals, tolerance for risk, financial situation, etc.