Why do more people not use principal reduction???

Question

I have a $150,000 equity line that I can borrow from. I have two properties that I am currently looking at. Property A is a 13 unit apartment complex and Property B is a 5 unit apartment complex.

Property A is for sale for $560,000. It has a $49,547.13 NOI equating to an 8.85 cap rate. The owner would hold the remaining note.

Property B is for sale for $150,000. It has an NOI of $16,593. Its cap rate is 11.06%. I would pay cash (from the equity line) for this property.

If we strictly looked at Cap Rate and COC return, property B would win hands down. But, if I am looking for a long term investment property A would probably win. Here is why;

(I am going to self-manage, like many people on BP Forums and will thus be counting the management fee towards my "Total Equitable Profit" annually.)

Property A Analysis:

CBT - $2995.08

Mgmt Fee - $5384.87

Principal Reduction - $15444.37

TOTAL EQUITABLE PROFIT YEAR 1 - $23824.32

Property B Analysis:

CBT - $5373.08

Mgmt Fee - $2332.00

Principal Reduction - $4016

TOTAL EQUITABLE PROFIT YEAR 1 - $11721.09

Property A affords me the ability to completely leverage the $150,000 I have to spend AND doubles the equity/cash flow I create annually compared to property B. I understand that this is not perfect (and the fact that purchasing a property at a lower cap rate compared to a higher cap rate property means that the purchasor paid a higher price for a similar investment and thus has a higher principal balance compared to the other investment) and that leaving Cash Flow on the table to take a lower cash flowing property is not typical. BUT, I see a lot of merit in evaluating the deal this way. Opinons?

Analysis Assumptions:

5.66% Equity Line borrowing Rate

20 year loans

10% Vacancy Loss

6% Mgmt Fee

Dion DePaoli · Answer

@Daniel Miller

Let's clean up this a little. Take amortization back out and look at what you actually have going on:

Property A = $2,629.99 (your profit % = 0.46%) Property B = $3,105.15 (your profit % = 2.07%)

With your equity idea:

Property A = $23,404.94 (your profit and equity % = 4.06%)
Property B = $9,116 (your profit and equity % = 6.08%)

The rate of earned equity is a function of the blended interest rate of the two loans, the blended rates are as follows:

Property B Cost of Funds = 7.23% (the entire LOC)
Property A Cost of Funds = 5.70% (LOC + Seller Loan)

At the end of 10 years, you have paid down both sets of loans:

Property A = $208,595 or 63.84% of balance
Property B = $50,577 or 67.28% of balance

Less interest in rate, will be less interest paid over time in aggregate however, it will also slow the rate of principal reduction as a function of amortization. Remember, this is already accounted for in Net Profits, debt service (in this example) is a fixed payment.

If you analyse your IRR at that 10 year mark and add in the earned equity (which is the reduction above):

Property A IRR = 3.53%
Property B IRR = 4.65%

Property B still out performs property A, why?

-Because property B is more profitable. Not because of earned equity through payment amortization.

So equity as a variable may differ if Property A were to appreciate more. For conversation sake, we are assuming they are equal since it is not quantified. However, you can see that property A would need 1.12% more in appreciation in order to simply catch up to Property B. That could happen, if say rents will rise more in Property A than Property B over time, but that idea is not expressed in the post as a number.

So, while I commend you on trying to think out of the box it is pointing you in the wrong direction. In addition, you are taking on many leaps of faith. Assuming a Seller will finance your closing costs is one of them, that is not all that normal. So in it's nature, your analysis is not taking into considerations of natural barriers of doing deals which is having equity do to so. In addition to that idea, you do not seem to have money set aside for unit reserves which may erode your profit numbers a bit more or capital expenditures as a whole.

The reason folks do not use principal reduction in most standard analysis is because it has a minimal effect on things that can't be more easily understood in simple observation. Property B was more profitable in simple analysis and remains more profitable in complex analysis (when all things were equal). Things that are not equal will have affects, but you must treat those properly. That said, complex analysis is in itself, complex and needs to be done properly.

Remember, amortization is not short term linear math it is long term curved math. If you want to see what the actual affects are, you need to run the analysis to term. Making assumptions from year 1 only, can and will point you in the wrong direction.

It is not that you do not count "profit" in "principal reduction" it is that you do not realized earned equity in profit until it is converted to cash. That event in reality is a cash out refinance or a sale of the property. It is done that way for a reason, it is the proper way to do it.

You can not 'keep a record of property value' per se. Value is not realized until the equity is converted to cash. Value is defined as what a buyer buys for and a seller sells for in an arm's length transaction in an open market. It is impossible to keep track of that since you are only one of the two parties and anything besides selling is mere speculation and could result in error.

Hope that helps. Good Luck.

Dion DePaoli · Answer

Frankly, none of this make sense.

First, what is "CBT" standing for in the examples. That is an unknown acronym.

Property B is on par with your line of credit. So the line of credit would be your cost of funds. You do not list the amortization of the line of credit, let's assume it is 30 years. So, the property has NOI of $16,593 before debt service. Debt service is $10,401 annually. Leaving $6,191 as free cash.

It is not clear if the management fee is included in NOI, which usually it is, but based on your story, it seems like this needs to be applied on top. So, we then reduce the $6,191 by the management fee of $2,332 which leave us with $3,859.

So principal reduction would what ever portion of the $3,859 plus the naturally occurring principal reduction of amortization which for year 1 is around $1,962. So the maximum principal reduction is then $5,821.

Now, in year 1 you mention the "equitable profit" is $11,721.09. Not sure where that number comes from. If you use all your free cash to reduce principal, you actually don't have a profit for the year. You would not realize any gain in equity by principal pay down until you liquidate the property. If it was meant to suppose profit plus equity earned, it is not clear if you included appreciation which seems like you are assume greater than 3.0%. Remember, if you didn't pay down the principal, you would only have $3,859 in profit.

When we go back to property A, it is a little clearer how you improperly set this up. You have a line of credit for $150,000. The sale price for the property is $560,000. So, remaining $410,000 is held by the owner we are not given terms though. The cost of the debt is missing in it's entirety. (it is pretty safe to assume it's not free money) For illustration, if we assume 30 years at your line of credit interest, the annual debt service is $29,119. So, essentially, this property has a $4,641 free cash flow. Amortized principal reduction would be $5,362 (seller held) plus $1,962 (LOC) in year 1 or $7,325 in total. If you take the fee cash and apply it to principal, you reduce principal by $11,966. Again, you have no profit, you paid your loan down.

In both cases, your numbers seem messed up. You don't have your expenses in your calculations correctly. Further, reduction of principal in a loan is a bunch of "Who Cares" since the only way to do such a thing is to use the actual profits. So instead of this approach, simply find your profit and stop there, how you apply the use of your profits is not as meaningful as to what the profit actually is.

Understand what you are trying to find in your approach, which really would be what are the long term affects of paying interest and carrying principal balances at certain levels. Not a bad analysis per se, but get the real profit number first. Then get the real costs of your loan. Then see how it can apply to reduction in time, which will really affect the long term interest paid. The principal due, is due, you can control how much interest you pay by prepaying the loan(s) prior to maturity but you can't pay less principal than you borrowed.

Jose Rubio · Answer

All the explanations and formulas can't beat this phrase.

Bill Gulley · Answer

Any time you can buy a property without using your money and it cash flows to you while paying for itself, it's a good deal. :)

Steven Hamilton II · Answer

@Duncan Taylor ,

I will add that you will want to get actual bank statement proving the income.

Daniel Miller · Answer

@Dion DePaoli

I am not disagreeing with your analysis and I appreciate you taking the time to answer me post. I understand all of the numbers were slanted in favor of Property B. Let me throw out a scenario.

At the end of the ten years you sell both properties for exactly what you paid for them. You will have realized approximately $5,000 more from Property B in CFBTs over the course of ten years. You earn approximately $31,000 (through earning back or not realizing a management fee of 6%) by managing property A (instead of Property A). Principal Reduction realized for Property A over ten years is $50,577, while Property B has been paid down $208,595. I completely agree that all the numbers says Property B is the better property, but in this scenario why is this not better for me? I have not made an offer on Property A because of that. Its held me back a couple different times. It does not seem like a "great" deal. In reality, it is not. But, it is a solid deal and I am looking for a property to hold for ten years. Also, I do believe Property A's location will organically appreciate (near downtown core) and not simply keep up with inflation, like I believe Property B will.

I have time and I am looking for a long term project. Many of them.

I did include replacement reserves on Property A. It was the only expense added uniquely to either property.

Bill Gulley

Yes it does! They do not come around too often just have to keep your eyes open.

Chris Adams · Answer

Great conversation going on here.

I have a couple thoughts, @Daniel Miller Is this going to be your first property?

1. The smaller property would seem the better way to go here since your leveraging 100% there is going to be less maintenance, lower chance of catastrophic events that could cripple you.

2. By using all of your available funds from the LOC, you are restricting yourself from buying more deals in the future, until you pay down the LOC. I think you should consider how and when you can convert either building into a more traditional financing method to free up your LOC allowing you to purchase more properties.

Daniel Miller · Answer

I wish I could Bill it would not be realistic.

I cant take out any other financing, other than from the previous owner (holding note) or from the equity line I have open.

Bill Gulley · Answer

Consider two property "B"'s. :)

Daniel Miller · Answer

@Dion DePaoli

CBT stands for Cash flows Before Taxes.

It does make sense. Ill post all of my numbers right now. It is not traditional. A couple of my numbers were off and I will correct them right now.

I am 26 years old and my specific goal is to purchase a property that I can and will hold for 10+ years. The entire purchase will be leveraged. I will take advantage of favorable interest rates and choose a property that best fits my location, Cap Rate, Cash-on-Cash return, income (cash flows) and future rent appreciation parameters.

I have an Equity Line I can borrow from at a rate of 7%.

I treat this equity line like a 20 year loan. It does have some adjustments a few years down the road but it should not alter the property substantially. I want to pay this down quick.

Property B is a 6 unit property that currently costs $150,000.

Its breakdown is as follows:

6 units, 3 separate duplexes each at 1700 square feet, block buildings, C+/B- part of town and not near the downtown core that I live in and see prospering quicker than the rest of the county.

Gross Potential Rents $43,200 - 10% VAC Loss = $38,800

Total Operating Expeses (RE Taxes $5,367, Water, Sewer and Trash $3,600, MGMT Fee 6% $2,332.79, Repairs and Maint. $3,600, Insurance $5,301, Lawncare $1,200 = $21,400.81

Net Operating Income = $17,479.19

I borrow all the money at a rate of 7% (additional 3% added to purchase price to account for closing, and entity creation and register)

Total Purchase Price = $154,500

Cap Rate - 11.31%

Debt Service for FIRST year only:

Principal Payments: $3,675.48 Interest Payments:$10,698.56

Total Debt Service:$14,374.04

Cash Flows Before Taxes: $3,105.15

To me, Cash Flows and Principal Reduction are my two biggest goals. The management fee, because it is paid to myself, cancels itself out. So, I add $2,332.79 back to the Cash Flows Before Taxes.

Cash Flows before Taxes + Principal Reduction + Management Fee = $9,116

The property will be either giving me cash flows or creating equity through repayment of principal (the property will be working for me) at a rate of $9,116 a year. That is what I gain, not including any appreciation, from owning and managing Property B in the FIRST year (that number will continue to increase).

My question is that if I am going to hypothetically own a property for 10, 20 or 30 years, is leveraging out as much as possible even if the numbers might be more competitive at a lower price point a solid strategy, within reason?

I think it is. The 13 unit apartment complex I mentioned earlier in this thread (Property A) is something I am leaning towards. It is in a neighborhood that is going through minor/medium revitalization. It is close to the downtown core. Its numbers are as follows:

Gross Potential Rents $97,200 - 10% VAC Loss = $89,748.00

Total Operating Expeses (RE Taxes $8,002, Water, Sewer and Trash $7,164, MGMT Fee 6% $5,384.87, Repairs and Maint. $8,450, Insurance $7,400, Lawncare $1,200 AND REPLACEMENT RESERVES $2,600 (Property B was built in the 1980s and is concrete/block. Property A is two separate buildings. One building is a wood frame, asbestos tile 4-unit. It will have the occasional issue that Repairs and Maint. cannot cover) = $40,200.87

Net Operating Income = $49,547.13

This transaction has a different debt service set-up. The first loan will be from the Equity Line and will be treated like a 20 year loan. It is borrowed at 7%. The second loan is at 5% and will cover the remaining balance of the purchase price. (additional 3% added to purchase price to account for closing, and entity creation and register)

Total Purchase Price = $576,800 ($154,500 financed at 7%. $422,300 at 5%)

Cap Rate - 8.59%

Debt Service for FIRST year only:

Principal Payments: $3,675.48 + $11,717.60 = $15,393.08

Interest Payments:$31,527.06

Total Debt Service:$46,920.14

Cash Flows Before Taxes: $2,626.99

I then add back in the MGMT Fee and the Principal Reduction and my total equity realized and cash flows for the year is $23,404.94. This project for me, right now, trumps Property B. Its cap rate is not nearly as high. Its ROI is not as high either. But, there is a significant advantage in the debt service (and management fee getting added back in). The principal reduction will increase from $15,393.08 in Year 1 to over $19,000 in Year 10.

I understand that you cannot "count" profit in principal reduction, but in reality if you have a very good understanding of your local market and are diligent about keeping good financial records one can have a very clear and accurate understanding of what their property is worth. Thus, reducing principal annually factors nearly as much into my decision making as cash flows, within reason. I am not suggesting put $100,000 down for a $1,000,000 building that will produce negative cash flows right off. I would never condone that.

Why do more people not use principal reduction???

Why do more people not use principal reduction???

Most Popular Reply

16 Replies