Which loans to keep versus pay off?

Question

Over the last few years of buying leveraged properties, I have amassed a decent amount of mortgage debt. I've decided to take a break from acquiring property (At least I say that. Who knows what will happen!) and to begin focusing on slowly deleveraging. The question is which loans should I focus on paying off versus sticking the money in Vanguard? Here is a loan overview breakdown.

Property Amount Rate Term Amortization

Commercial 1 $1.1M 3.6% 10 year 30 year (Yay Freddie multifamily loans!)

Commercial 2 $480k 6% 5 year 20 year

Commercial 3 $235k 6% 5 year 20 year

Commercial 4 $229k 5.5% 7 year 20 year (Could be refinanced to residential loan)

Residential 1 $142k 4.5% 30 year 30 year

Since all these properties are down in Galveston, one benefit of paying off the loans is the control of the insured amount. We need flood, windstorm, and liability on all properties with loans. While I understand having insurance especially in a hazard area, I'd prefer to insure for closer to the amount that I'd actually be able to get or simply self insure. I'd rather have my insurance money going into a vanguard account than lining someone else's pockets.

Using VTI as a baseline, let's say the average return I'd get from index investing would be 9%.

My original thought was any debt over 5% should be paid off first. With the lowering of insurance costs, I could make the case that these would near the 9% return. After that point, all investment funds would just be put into index investments. Upon payoff of a loan, an LOC would be opened just as a backup source of liquidity.

My question is at what percentage do I draw my line? Should I just keep them all and simply invest in vanguard and other projects? Do I just knock out these debts first and live off the returns?

I would love to year everyone's thoughts!

Mark OGara · Answer

@Timothy ChurchI was just taking an online real estate modeling course and I think the leveredIRR and unleveredIRR would be good models to optimize paying off the loan.

Timothy Church · Answer

@George PauleyThat definitely makes sense! While I do want to re-leverage with LOCs, I will go through a period where I'm continually decreasing my return. I'm beginning to lean towards putting the money into Vanguard until it reaches a point that a loan can be paid off in full. During which time I can do some short term investments such as hard money. Once it is paid off, open a LOC to have access to that equity and repeat it. That way I can slowly lower my debt for my peace of mine but have funds accessible at all times.The main reason for the LOCs is a desire to purchase properties, rehab them, and then refinance them with some debt. Being a realtor, I've seen far too many times that a bank delays closing or costs a deal due to not meeting deadlines. I prefer the ability to purchase and then refi on my schedule.

George Pauley · Answer

Paying off loans always sets off alarm bells in my head. :)My first question would be what is your ROI on each of these properties? I'm guessing that they are considerably higher than the interest rates on the loans. Arbitraging high ROI vs low capital rates is a fundamental concept in real estate investing. Paying off loans always works counter to this concept as it decreases ROI. (Because you are increasing your investment size.)Another concept is that of Return-On-Equity (ROE). ROE is like ROI except that we divide by equity in the property versus initial investment. As you pay down mortgages, the ROE will also decline because you are increasing equity. When the ROE becomes less than your ROI on some other investment, then its time to get the equity out of the property and into that other investment. Put another way, you have equity that is not working efficiently for you. Paying off early just accelerates this process.Finally, there is opportunity cost. Assuming you have the cash to pay down some of these loans: If you pay down these loans you will no longer have the cash. Now, further assume the economy downturns and buying opportunities start making themselves available. You won't have cash, and the loan company won't give you that money back when you most want/need it. I would not advocate holding on to massive amounts of cash waiting for a down turn. But I'm guessing you can find plenty of short-term investments that pay higher rates than the mortgages you would pay off. (Hard money lending comes to mind.) Heck, at the rates you list, you can likely find dividend funds that have higher returns.Of course, life isn't always about maximizing ROI. Peace of mind, risk tolerance, etc are factors too. Only you can make these (non-mathy) decisions. But hopefully I've given you a thing or two to think about?

Timothy Church · Answer

@Joseph Cacciapaglia There aren't any prepayment penalties on any but the Freddie Mac. I've thought about refinancing at least the Comm 4 over to a residential loan. The issue is that all (excluding Freddie) are personally guaranteed so I don't know how many I'd be able to refinance back to back. The other issue I've found with refinancing the commercial is that they are in an awkward loan amount being that they are sub $1M loans. Only banks I have that will do it charge a premium.Currently, they are all cash flowing well so I could just let them be. Just trying to figure out the best space to put future income.I do want to invest outside Galveston soon! If I get one paid off, I'm thinking of using the LOC to buy something across the pond! That's still a bit down the road.

Joseph Cacciapaglia · Answer

Do you have any prepayment penalties on the commercial loans? Have you looked at refinancing them? It seems like your rates are pretty high for today's market, but that really depends on the quality of your assets. If you are covering your mortgage payments by a wide margin, I don't see a benefit in paying them down. From a return on equity perspective, you will almost always benefit from some level of leverage. I understand the goal of lowering your risk, but at some lower level of leverage, you should feel pretty safe, depending on what your properties are like. I don't think I'd want all my eggs in the Galveston basket though. Not that I have any issues with the market, but getting some level of geographic diversity would increase your safety.

Timothy Church · Answer

Long term goal is stable cashflow with less risk. The part I'm on the fence about is that until the loan is paid low enough and there is a LOC in place, all that cash is essentially locked up. I am currently a personal guarantor on all of them excluding the Freddie Mac loan and would love to lower my personal reliability.I guess the point becomes is it better to save up that money in liquid (aka after-tax) vanguard accounts and then bulk pay off down the line or to just put it straight towards the loan. I'm trying to balance paying off the loans with having accessible cash just in case.

Evan Polaski · Answer

@Timothy Church maybe you have thought of this and simply didn't bring it up, but you also get to write off your interest expense on these against your income. Beyond that, what is your long term goal? Better monthly cash flow? Lower risk? Better DTI ratio for when acquisition time comes?Are you a personal guarantor on all the commercial mortgages?From personal risk, I would pay off my personal mortgage first. But then pull out a HELOC while valuations are still high in case another recession is upon us and buying opportunities abound. Beyond that, I would start paying down Commercial 3, as mentioned, then 2 to get those off the books AFAP, then 4 then 1, simply from an interest expense play.

Theresa Harris · Answer

Assuming everything else is equal, I'd start with commercial 3. It has the highest interest rate and is a smaller amount that commercial 2. Once it is paid off, you can keep paying the same amount plus any extra from commercial 3 to pay off the next one.