15 vs. 30 year Financing for Rentals

[Michael Class]

Hey everyone, new to rentals on my end. Im struggling to get my cash on cash over 9% when evaluating 15 year mortgages. I'm looking to build my portfolio of rentals using only 20% down for each. I have solid job income and really don't need any of the actual cash earnings so I just plan on continually reinvesting. My reinvestment capital would be monthly cash contributions from my primary income and my rental earnings combined.

Is it a no no to use 30 year financing to raise my cash on cash to 9-12%?
Thanks,
Michael


 

[Erik W.]

@Michael Class, a few thoughts on 30 vs 15.

First, several people have said "you can pay a 30 like a 15". True, but only one has said he actually does that. What that means is most people get comfy with a 30-year payment. Just like tenants go into freak out mode when we propose a sizable rent bump because their budget can't hack it, the same happens with REI's. After 3-5 years of comfortably low payments, few of us are equipped, either mentally or financially, to make larger payments. Our lifestyle grows and sucks up the cash flow. Maybe you're in the 5% who actually bank it and live frugally so you can ramp up the payments later. I don't know your level of discipline or commitment.

Second, most capital expenses happen in a range of 10-20 years.  Roofs wear out (20 years).  HVAC systems die (15 years).  Units need upgrades/freshening (12-15 years).  Hardwoods need to be refinished (10-12 years).  Carpet wears out (7-10 years).  If you rehab a place to decent standards and pay on a 15-year note, you'll most likely be free and clear on that property by the time you have to replace/redo any of those very expensive items.  Otherwise, in year 18-22 of your 30 year note, you get clobbered with huge repairs and have to take out HELOCs or use credit cards to finance those costs.  Basically erasing years of pay down with new debt.

Third, debt is always a risk. How much of a risk depends on many factors that we cannot control or forecast. Yes, interest rates are still at a historic low, almost 10 years after they trended down below the average for the past 100 years. Will it continue that way in the future? I don't know. You don't know. No one on this board knows. What's the point? The point is with fantastic cash flow from a paid off property you can bank sufficient funds to pay for repairs and upgrades. With debt....who knows if you'll have access to funds needed? What if you need a new roof in year 20, but HELOC / credit card rates are at 18%? You will pay that 18% because you still are in debt and have insufficient cash reserves.

Fourth, and possibly the most important consideration of all, if the property requires a 30 year note today to generate decent returns, I'm guessing it's probably NOT a very good deal.  My favorite type of property is one that generates 12% or better and still pays off in 10-15 years, tops.  Find a better deal that can support a 15 year note today vs. "maybe I'll get around to paying it like a 15 year someday...."  Lengthy debt allows us to overlook the problems with mediocre investments because we "fix" sub-optimal returns with lower payments.

Finally, regarding a growth model: would you rather have 10 paid off units cash flowing like crazy in a short decade and a half or 20 units spitting out a pittance each month for three decades?  Which one generates more hassle?  Which one means more hustling to fill vacancies?  

I started out with 30 year notes.  I've since refi'd them all to 15 years or less.  Thankfully, because I started in 2005, and it was kind of depressing to see those first note I'd been paying on for FIFTEEN YEARS with so little equity for all that time.  I've decided life is too short to give all my money to the bank.  The only scenario I can see working well with 30+ year notes is apartment complexes where the idea is to get in, create a ton of value, then exit in 3-5 years for a big payoff.  But for long term buy and hold....15 years or less is my vote!

I know others will come back with wanting to use cash flow to own more units, using inflated rents to pay down long term debts using "cheaper" money and that's all fine.  My perspective comes from doing this 15 years and knowing I want to be out of the bank's control within the next 6 years. 2 decades of sending money to the bank will be enough for me.  I'm 44 and I want to be 100% debt free by 50.