Investor · Denver, CO · Member since 2012 · 105 posts · 26 votes
I'm considering a purchase of 10 SFRs in Wichita. I have a few homes there already, and a fantastic property manager that I respect and trust.
I've run some preliminary numbers, and it looks like I might be able to cash out refinance my home at 3.75% which raises my mortgage payments by $350/mo. I can then finance 4 houses on 30 year fixed FNMA loans. The remaining 6 houses will be on a 20 year amortized commercial loan.
The plan is to take the net cash flow from all 16 props I would own and apply about $4000/mo against the commercial loan, with estimated payoff in about 4 yrs. Then I apply the $4000/mo plus what I had been paying on the comm loan against the four FNMA loans and they should be paid off in about 3.5 years.
Net cash flow from all 16 properties should yield about $110,000 / year, and it will take 7.5 years to get there. I'm relatively comfortable with the Wichita market, although it is not my own market so I dont know it very well. I've spoken with my bank there, my property manager who owns 100+ homes of his own in this market, and a couple of realtors and they all feel comfortable about this move.
My question is this: without getting more specific about the actual numbers on each property, what are some risks I may not have considered with this approach? If my income were to drop by 25% and 6 houses went vacant at one time I have reserves to carry me for about a year. I see this approach as less risky because I am paying off a property every 12 months or so.
Who else has used the snowball method of paying off rental properties? What can I learn from you?
@Account Closed mentioned pennies make dollars. And my view is, if you are focused on pennies, you won't make millions.
Why do tax firms have a high net worth branch? Because high net worth individuals realize that their largest expense is taxes. This acquisition will catapult you closer to that type of clientele, so you need to adopt their way of thinking by focusing on saving taxes which will cost you ~30%, not financing costs which will cost you ~6%. Note - I'm not claiming you are focused solely on financing costs, that's just the direction this thread went based on your original post.
The title of this thread should have been: "10 SFRs, $110k annual cash flow - Tax Strategies?"
I think the snowball method you describe is a fairly conservative approach (that's not a bad thing, by the way). Because you're paying off so much principal, it's not really risky, unless you use too much of your cash reserves to do so and don't have much of a cash reserve for a rainy day. The biggest risk is really just the opportunity cost of what else you could do with the money you're using to pay down the debt.
As a Wichitan I'm a bit biased towards our city - think it's a great place. Would be glad to provide any advice on the locations of the houses you are considering. We can be spotty in areas like anywhere else. I've talked to a couple friends of mine who have rentals, and they are finding it a bit tough to fill their vacancies right now. (They are working in the $1k plus range sfr's)
I had a bit of a challenge myself ($895 3bd 2 ba duplex). Fingers crossed as I'm supposed to meet the new tenants to sign the lease tonight. I've noticed quite a bit more competition the past couple years, might want to build a bit of a higher vacancy expense in your #'s -- also lots of new apartments ready to come on line next year. Something to consider in your #'s anyways. I think the rental market here is getting a bit saturated - nothing that can't be overcome, but something that might be an issue the next 2-3 years.
We still have lots of bad landlords/property managers so the opportunity will be there for professional operators who maintain their properties.
Thanks @Andrew Syrios - this is an early retirement play so I'm willing to forget about the cash flow from these properties for the time being. I just hope the Wichita market holds up over time.
@Shane H. - thats great info. I need to get better market data for Wichita. Here in Denver, I use numbers from a local brokerage and also look at weekly market reports from Chicago Title. Can you point me to a title company or brokerage in Wichita that can provide market reports down to the zip code like this? I'm also very interested in population growth and vacancy rates for the area.
what are some risks I may not have considered with this approach?
1. Losing liquidity.
2. Squandering the time value of money.
3. Paid off properties make you a lawyers target.
Really this is a crazy idea.
Why would you pay all the fees to borrow money for 20-30 years and then start making payments NOT due until 2045 with 2015 money? So you are going to take your real estate income and plow it into an asset that appreciates the exact same no matter your equity. And when the properties are paid off you lose any interest deduction AND if you want to get some cash out you'll have to pay fees and probably a higher interest rate just to get to use all the cash you pumped into the properties!
Sure your properties won't cash flow as much with mortgages BUT you will have all the cash you DON"T plow back into these properties to add to this. Plus maybe a little interest earned.
No similar reports that I'm aware of, however I could post some links that provide a big picture view that are typically put out once a year by a couple RE firms and Wichita State U.
JP Weigands (probably the largest firm in town) 2015 outlook
Hope that helps, have quite a few of my observations as well, however might get a bit lengthy for an online discussion and better suited offline.
I'm attempting the snowball method myself - I'm in the stage of making the initial small snowball larger - seems to take forever, though I'm at a point where I see an end in sight. I see nothing wrong with having free/clear properties - Never have liked the idea of being highly leveraged, it's what got most people in trouble during the bubble and will get them in trouble again in the next few years. Guess it's all relative as to what your personal strategy is.
@Account Closed reach out to Chicago Title in that market and see if they do the same thing there. They are nationwide and I've seen other companies like Land Title do their thing in several major markets.
@Andrew Syrios - you've got me thinking differently now. Maybe I keep the money and re-invest. I can always pay down or pay off if I choose, but this way I have access and can do what I want with the capital.
@Andrew Syrios - you've got me thinking differently now. Maybe I keep the money and re-invest. I can always pay down or pay off if I choose, but this way I have access and can do what I want with the capital.
I think the big question you need to ask yourself is "what is your goal with this investment?" If it is a retirement play, perhaps a more conservative plan is in order. But it sounds like a very solid portfolio, and if you want to grow your business, then perhaps using that capital for additional investments is the best way to go.
Sounds like a solid plan, nothing wrong with paid off properties. I know a lot of guys who lost their shirts being over leveraged in 2008. Everyone loves lots of leverage until the market turns, and rent collection decreases.
It all depends on your goal. If your goal is the income to retire on its a solid plan, if your goal is to expand its not such a good plan.
what are some risks I may not have considered with this approach?
1. Losing liquidity.
2. Squandering the time value of money.
3. Paid off properties make you a lawyers target.
Really this is a crazy idea.
Why would you pay all the fees to borrow money for 20-30 years and then start making payments NOT due until 2045 with 2015 money? So you are going to take your real estate income and plow it into an asset that appreciates the exact same no matter your equity. And when the properties are paid off you lose any interest deduction AND if you want to get some cash out you'll have to pay fees and probably a higher interest rate just to get to use all the cash you pumped into the properties!
Sure your properties won't cash flow as much with mortgages BUT you will have all the cash you DON"T plow back into these properties to add to this. Plus maybe a little interest earned.
The interest deduction is best avoided by paying off the loans early. Each $1000 you spend in interest only earns you at maximum $396 in tax savings...so the author would still be donating $604 each year to the Wichita Bank Shareholders Fund. By paying off the loans early, the author will be retaining that $604 to purchase additional homes, make repairs, or take a vacation to Fiji. (OP indicated this was for retirement planning.) Encouraging the author to continue paying interest in order to capture only a small percentage of it in tax savings (when there are so many other tax shelters for real estate investors, especially with regard to retirement) isn't fair. There are far more efficient ways of lowering a tax bill than sending money off to Wichita Bank shareholders.
To the author--
I think with regard to liquidity, you should carefully examine what your needs are. If you expect to require no major sources of cash in the next ten years, I say pay off the homes in the fashion described, as long as you're familiar with the sacrifice in returns you get by not continuing your leverage. I do recommend having HELOCs and significant pooled cash reserves to protect against the unforeseen--be that a credit crisis, higher vacancies than you expected, or any other form of "uh oh". Once you have paid off the homes, the excess net cash flow should be enough to self-finance each property's "uh oh" fund and give you access to some of the cash reserves for expansion of your portfolio. If, however, you expect to expand your portfolio quickly or become a private lender, access to capital is far more important, and I would encourage you to pay off the properties according to the mortgage schedules.
Overall, I think this type of strategy is great for a conservative investor who wishes to build net worth by a defined amount very quickly. Epictetus, the ancient Greek philosopher, noted that grounded optimism often leads to the greatest satisfaction in life. By mitigating risks and securing a reasonable growth plan, I think you're setting yourself up for that satisfaction during your retirement. But Epictetus also taught that we must be willing to change the rules and our strategy to fit our circumstances -- if you're not the type of conservative investor this strategy suits (as I imagine Mr. Bowling above is not), then don't use this strategy. If you want to build your gross worth very quickly and slowly pay down the debt as you near retirement, this is not for you. If you want to have access to capital in case another 2008 occurs, this is not for you. The beauty of this strategy, however, is that it is malleable -- as long as you are open to realizing changing conditions, you can stop expedited paydown any time and start using that cash to expand your portfolio, take a vacation, or invest in something else (for diversification). The important thing is ensuring you are capable (financially and mentally) of making the decision to alter the strategy amid changing conditions.
Devise something that suits your personal investment objectives, risk profile, and lifestyle and along the timeframe that you need.
Do you have a local bank here you will be dealing with? If not have a couple of referrals I'd be glad to shoot your way. Refinancing/setting up some additional credit as I type this and have spent quite a bit of time qualifying/researching different banks in the area.
As for market data are you mainly interested in sales prices/rents for a neighborhood, days on market etc? With more specific locations I'd be able to give you a good idea on what to expect, or I'm sure your agent might be able to as well. If you search by zip code here it will give some pretty skewed data - lots of good/bad areas overlap in the same zip.
Just out of curiosity are you purchasing the package from an individual investor who really spruce's up the kitchens/bathrooms? First name of Brad?
The properties are in 67201. I have 6 there that I have never seen, so I cant speak to the neighborhoods. I'll look up the addresses later today. I purchase from a turn-key provider whom I've known for 25+ years. He's also our property manager and we have been very pleasantly surprised at the performance of the properties we've already purchased through him. I'll PM you his info if you like.
The interest deduction is best avoided by paying off the loans early. Each $1000 you spend in interest only earns you at maximum $396 in tax savings...so the author would still be donating $604 each year to the Wichita Bank Shareholders Fund. By paying off the loans early, the author will be retaining that $604 to purchase additional homes, make repairs, or take a vacation to Fiji. (OP indicated this was for retirement planning.) Encouraging the author to continue paying interest in order to capture only a small percentage of it in tax savings (when there are so many other tax shelters for real estate investors, especially with regard to retirement) isn't fair. There are far more efficient ways of lowering a tax bill than sending money off to Wichita Bank shareholders.
Which plan is more conservative, really?
First, the interest deduction is JUST AN ADDED BONUS to leverage, liquidity and the time value of money. If it was the only advantage then its value is not huge but added to the other advantages it adds up. Pennies make dollars.
He would need to run the numbers but his plan to take AFTER TAX money to plow into a property for 7.5 years with NO return seems more stupid than conservative. OK, so he goes the distance and pays off the mortgages in 7.5 years. He now has a greater cash flow from the properties. The government will want to charge him taxes AGAIN on the extra cash flow that is the result of dumping AFTER TAX money into the properties. Dang, that can't be good. But hey, he is "cash flowing" more in year 7.5 but a sizeable amount of that "cash flow" is just getting back his 2015 dollars in 2023! How long is the break even point when he is actually getting MORE cash instead of just his 7.5 years of cash dump back?
Now my MORE conservative plan would be to bank the extra money for 7.5 years (maybe invest in a Llama farm, kidding). I have 7.5 years of money EARNING interest. In year 7.5 I can take out whatever is needed to match the cash flow of the properties if they had been paid off. My money is STILL earning interest!! What if in year 5 there were CD's available at 6%, 12%, dare I say 18%?
Guess where my cash is going? Now if my money was trapped in the properties and I wanted to get in on the CD bandwagon I'd go to the bank and say hey I want some of MY money back. Sure, at 8%, 14% or 20%.
Even if the economy remains similar you are still paying the cost of inflation on all the extra money trapped into the properties. Say 3% times 7.5.
I'd say my plan is way more conservative.
Hey you guys sitting around on the computer getting paid at work. How bout a spread sheet comparing the two plans?
I tend to agree with Bob, although i take a mixed approach. This is the old leverage vs no-debt argument. Run the math and see what you are comfortable with.
If I pay down my properties now, what return do i get?
What is my return if I take that cashflow and use it to purchase more properties with leverage?
What risk am I comfortable with. What reserves will i need based on my risk tolerance?
Personally, I know i can get outstanding returns reinvesting my money. I also like the stability/flexibility of having decent reserves and a few free and clear properties. I take a mixed approach that uses around 75% of my cashflow towards future purchases, 15% towards paying extra towards mortgages and 10% towards cash reserves. I keep the math the same once properties are paid off. This approach snowballs slightly, but also allows me to grow at a faster pace.
Agree with @Jason Miller, take some amount of blended approach as both strategies have their strengths. Pay extra on mortgages and save higher reserves, reinvest the rest.
From an emotional standpoint, this is great way to sleep at night.
From a financial standpoint, this is way too risk averse and inefficient. You're going to lose leverage, lose tax advantage, and most importantly lose LIQUIDITY. if you want to be financially secure against a potential negative market than liquidity is what you want. your plan will provide the opposite.
Depends on what you want in your life to decide what's best for you.
The interest deduction is best avoided by paying off the loans early. Each $1000 you spend in interest only earns you at maximum $396 in tax savings...so the author would still be donating $604 each year to the Wichita Bank Shareholders Fund. By paying off the loans early, the author will be retaining that $604 to purchase additional homes, make repairs, or take a vacation to Fiji. (OP indicated this was for retirement planning.) Encouraging the author to continue paying interest in order to capture only a small percentage of it in tax savings (when there are so many other tax shelters for real estate investors, especially with regard to retirement) isn't fair. There are far more efficient ways of lowering a tax bill than sending money off to Wichita Bank shareholders.
Which plan is more conservative, really?
First, the interest deduction is JUST AN ADDED BONUS to leverage, liquidity and the time value of money. If it was the only advantage then its value is not huge but added to the other advantages it adds up. Pennies make dollars.
He would need to run the numbers but his plan to take AFTER TAX money to plow into a property for 7.5 years with NO return seems more stupid than conservative. OK, so he goes the distance and pays off the mortgages in 7.5 years. He now has a greater cash flow from the properties. The government will want to charge him taxes AGAIN on the extra cash flow that is the result of dumping AFTER TAX money into the properties. Dang, that can't be good. But hey, he is "cash flowing" more in year 7.5 but a sizeable amount of that "cash flow" is just getting back his 2015 dollars in 2023! How long is the break even point when he is actually getting MORE cash instead of just his 7.5 years of cash dump back?
Now my MORE conservative plan would be to bank the extra money for 7.5 years (maybe invest in a Llama farm, kidding). I have 7.5 years of money EARNING interest. In year 7.5 I can take out whatever is needed to match the cash flow of the properties if they had been paid off. My money is STILL earning interest!! What if in year 5 there were CD's available at 6%, 12%, dare I say 18%?
Guess where my cash is going? Now if my money was trapped in the properties and I wanted to get in on the CD bandwagon I'd go to the bank and say hey I want some of MY money back. Sure, at 8%, 14% or 20%.
Even if the economy remains similar you are still paying the cost of inflation on all the extra money trapped into the properties. Say 3% times 7.5.
I'd say my plan is way more conservative.
Hey you guys sitting around on the computer getting paid at work. How bout a spread sheet comparing the two plans?
I'm not sure why you wrote the response you did and I'm doubly not sure how in the world your refined strategy is more conservative. There are significantly more risks associated with what you described, which makes it inherently less conservative. Conservative strategies are designed to conserve and protect capital, not garner the greatest returns. I have no objection to (and in fact already did) indicate that the strategy the author proposes will not garner the greatest returns. Which is why I'm confused about your post that focuses exclusively on returns.
The simple matter of fact is that investing in CDs or other properties or the stock market or any other investment incurs risk that is not undertaken by paying off the mortgages. The risks of owning ten fully paid-off houses consist of lawsuits, natural disasters, vacancies, etc. If these risks are x, then having ten houses creates a risk of 10x. But by purchasing 10 more houses, you are increasing the risk. If there is a cash flow risk on 20 levered properties, then every property is affected, and therefore there is contagion risk as well. But if there are 10 properties and only one still has a mortgage, there is no contagion risk to the author's ability to pay off houses 1-9. Under your proposed scenario, there are also interest rate risks, timing risks, tax policy risks, market risks, and macroeconomic risks, as well as inflation risks, that are unaccounted for. So much risk demands a less conservative designation.
Now, in totality, this means that the strategy the author proposes will probably make less money in the long run. But the probability of making that money is much higher, and the conservation of capital is much more strongly assured. It is therefore more conservative to pay off the mortgages.
With regard to interest deductions, I also stand by my statements. Between depreciation, repairs, and twenty thousand other deductions that are possible for landlords, it is possible to supplant the interest deduction with necessary spending instead of passing money on to Wichita Bank. But the author specifically mentioned that this is for retirement, which would indicate that the easiest solution would be to host it in a 401(k) or IRA. This is the more efficient solution, providing greater returns and a lower risk profile, eliminating the lawsuit risk you first mentioned. So it is more conservative than your proposal and provides greater returns than CD arbitrage. If you'd like to continue talking about interest rate deductions, I'm happy to do so on a separate thread, but let's let the author continue to focus on his strategy and topic instead of scrolling through our separate side-bar.
Whoa @Spencer Brennon, you are jumping to conclusions. I never said anything about buying other properties although that is a great idea but I agree that it could increase risk. I compared plowing after tax money into the property for NO return vs buying federally insured CD's. Where's the increased risk? It's in having more equity in a highly illiquid property.
As far as ALL the other real estate deductions, they in no way negate the value of the interest deduction so why not take it on top of the real value of the leverage, liquidity and time value of money?
@Account Closed mentioned pennies make dollars. And my view is, if you are focused on pennies, you won't make millions.
Why do tax firms have a high net worth branch? Because high net worth individuals realize that their largest expense is taxes. This acquisition will catapult you closer to that type of clientele, so you need to adopt their way of thinking by focusing on saving taxes which will cost you ~30%, not financing costs which will cost you ~6%. Note - I'm not claiming you are focused solely on financing costs, that's just the direction this thread went based on your original post.
The title of this thread should have been: "10 SFRs, $110k annual cash flow - Tax Strategies?"
Great input, everyone. This is exactly the discussion I was hoping for.
A couple more ideas now that I've had some time to consider what to do with the capital once cash flow begins:
1. Redirect $24k net cash flow to max out my Roth Solo 401(k), plus $6k into my regular Roth IRA. I'm over 60 and I have an existing regular Roth so the five year waiting period doesn't apply.
2. Roll the Solo 401(k) Roth into the regular Roth and avoid the five year wait. Contribute the remaining excess cash flow into a profit sharing plan. After 7.5 years I have the option of withdrawing my Roth tax free and applying it towards the debt, or not.
I can self direct the investments in all of my IRAs. This is for retirement, but I don't want to be overly conservative. Liquidity is important to me.
----
Note: I'm writing this in the first person, but the advice is for my father who is reading this thread and has been impressed with your knowledge and incite. The wheels for this plan are already in motion.
This might be a loaded questions given all the other potential variables that could be in play - but for example sake - this hypothetical purchase -- do you have any suggestions or strategies one could look at to help minimize the tax liability? Of course with the standard disclaimer - only your opinion, not legal advice, seek your own CPA etc.
@Account Closed
@Account Closed
@Account Closed
Thanks for posting this thread - has helped changed my viewpoint a bit given the participation and feedback.
Whoa @Spencer Brennon, you are jumping to conclusions. I never said anything about buying other properties although that is a great idea but I agree that it could increase risk. I compared plowing after tax money into the property for NO return vs buying federally insured CD's. Where's the increased risk? It's in having more equity in a highly illiquid property.
As far as ALL the other real estate deductions, they in no way negate the value of the interest deduction so why not take it on top of the real value of the leverage, liquidity and time value of money?
I'm sorry that I wasn't clear in my post -- I was lumping together your proposal (investing the cash in CDs) with others' proposals, because all of them incur additional exogenous risks. I understand that you were proposing the idea that CDs would be safer than the mortgage paydown. I reiterate that this is not necessarily the case, because CDs incur risks not inherent to a principal paydown strategy. I dispute your characterization of the properties as highly illiquid: while true liquidation is difficult in a downturn, there are products that offer synthetic liquidity, such as cash-out refinancing and HELOCs, as well as collateralized loans against the portfolio, once it reaches a certain size. (We're not sure whether the 14 properties are $50,000 houses or $500,000 houses, so I can't be sure whether CLOs apply.)
Liquidity is a risk because there might be a need for cash or cash equivalent assets that the author won't be able to meet through extant cash reserves and gross cash flow from the properties. A standing HELOC or other revolving account is perfect for such situations. As time progresses, in fact, the additional cash flows from the properties (each year an additional one will no longer be paying the mortgage/Wichita Bank shareholders) will decrease liquidity risks and provide greater opportunities in the long run. If the author stashes the cash in a CD earning an inflation-adjusted 0% each year, then the reserves will be exhausted at some point well before year 30, which is fine because cash flow from the properties is meant to supplement the reserves in the long-run. But in this long-run, the additional cash flows from the properties (due to no mortgage payments) will enhance the liquidity position, by supplementing the amortization of these reserves more completely. In this way, I dispute the idea that in the long-run, liquidity risk is lower through a CD investment.
Let's take a specific example: a tornado runs through Wichita and every house needs a new roof after year 9, for a total cost of $100,000. The author under my scenario dedicates $100k of the $110k cash flow for the year to the roofs. Net impact: profit of $10k for the year. Under your scenario, the author uses all of the cash flow ($25k) and dedicates $75k of CD cash reserves to the roofs, meaning that for the past two years all of the interest on that $75k will be sacrificed (ironically, this also means the author can't claim the interest tax deduction because he has no taxable income, further hurting his cash flow! So I hope you realize there IS a way to negate the interest deduction). There's not a lot of time value of money on zero dollars! Net impact: the author loses out on all profit for this year and still has to take $75k out of the CD cash reserves, meaning lower returns in perpetuity. (What's the time value of money on a negative dollar?)
But here's the important distinction: under my scenario, the author in year 10 would make $110k in cash flow and cash reserves would be higher than in year 9 by $10k. In your scenario, the author in year 10 would make $25k (plus nominal inflation-adjusted interest) and the cash reserves would be lower than in year 9 by $75k. Liquidity risk under my scenario decreased and under your scenario increased.
With regard to the time value of money, your assumptions are leading you down the wrong path. The returns of "plowing after tax money" (and I will say again that the author never specified it was after tax money) into principal pay down are denominated in the discounted interest savings from the disappearing mortgages. Time value of money is only relevant with regard to when you receive the returns/money. Under your scenario, CD payments are quarterly. Under my scenario, discounted interest savings are monthly. I'd rather receive my savings on October 1st than on December 31st. In other words, every dollar I pay in principal in year one provides me with 4.5*$1 (4.5 cents) of extra cash flow in that year, never mind the discounted future interest savings. That interest savings alone is higher than the CD payment of 1.5/2 cents I would have gotten. All of this is an interesting paragraph, but it's not entirely relevant because it doesn't impact how conservative either investment is.
As I said in my previous post, the interest rate discussion does not belong here. So while you are still incorrect in your assumptions about it, I will not be commenting further on the fallacies.
A follow-up for those interested in Wichita market data, I called around and found this market data through the board of Realtors - this is what I was looking for.