Cash positive rental properties or leveraged debt ?

Question

So I have $200K liquid in the bank (I have my own company) and I earn about $260K a year (before taxes).

By my calculations, if I buy a $250K condo in a well sought after part of the city, and pay it off COMPLETELY in 2 months, then rent out the condo (which is in a city I live near) , the cash flow I should have each month should be about ~$1600/month (after the HOA fee).

If I then buy a second condo worth $250K and use the rental income from the first & 2nd condo to pay for 2nd condo's mortgage in addition to paying down the 2nd condo within a year, I should have a ~$3400 cash flow in the next year or two when the 2nd condo is paid off and $500K in equity that I can borrow against if I want.

Do you see any downsides to this strategy ? Its aggressive and all hinges on buying the right condo in a well sought after area of the city, but once I have the $3400 a month, I can then use that to buy bigger places or commercial real estate.

I think my strategy is good because the $3400 would be passive income for life (since the condo is in a well sought after part of the city, which is easy to rent), and then I can use that passive income to not work anymore (if I chose to do so), and the rate of return on it (plus the historical appreciation of real estate (~14%)) would net me about ~20% on each condo I bought.

My end goal: I prefer having real estate that I own free and clear that generates cash monthly. Monthly cash flow would allow me to retire in 3 yrs (if I wanted to) after I have 4 properties generating ~$6800 a month. I prefer a monthly cash flow much more than increased debt with a more expensive property(s) that bring in little cash (and increased risk).

Do you think there is a better strategy as far as using the $200K in the bank (ie: buying more houses at once, commercial, apt complexes) ?

My main concern is that I am under utilizing my assets (eg: the $200K cash), and that I could be using it better. I dont own any 401K, stocks, etc. I do have a personal home worth over $600K currently.

Thoughts ?

Frank Adams · Answer

ariesonthecusp; I wrote in my first reply;

By which I meant, why don't you own any stocks or stock mutual funds?

Obviously you're doing pretty well financially but I sure wouldn't put all my eggs into REI. The most I've ever had is 50% REI, and I've generally kept it way below that.

I also worry about your quote in the original post;

The economic terminology for this is "extrapolation bias". For further reading on the subject I suggest you read about "Tulipmania", the "dot-com boom" of the late '90s and the "real estate boom" of the early 21st century, whoooops!

all cash

Will Barnard · Answer

Well said, I agree. Taking on a mortgage does incurr interest expense but does allow for more buying power. As Wheatie said, after doing the numbers on each deal, calcualte your return on the cash investment. I look for at least 25% ROI, if not, you should be looking elsewhere.

Jeff Weissman · Answer

Dear ariesonthecusp,
Please see my post called, "14.3% Cap Rate, 43% Cash-on-Cash SFR in Jackson, MS" in the "Deals...forum. This might be a great way for you to get started & learn the business. If you're not interested, maybe someone you know or work with is! If so, please pass it along! Thanks & good luck. You're on the right track!

Jon Holdman · Answer

Don't get me wrong.  I buy property with loans.  Most folks do.  But do the math yourself and evaluate your true return.  Interest is a big drain on your cash.   On the other hand, it may let you acquire more properties than you could with cash.  Real Estate is a math intensive business.

Lynel Charfauros · Answer

No one said anything about the money that you could be deducting as a loss.. The depreciation deductions is what makes a non-paid off property your "tax shelter". There are ways to keep a morgage(deducting intrest and property taxes from income taxes) and keeping the property a positive cash flow. A paid off propery has its advantages, but deductions are minimal.

Jon Holdman · Answer

The depreciation deduction is unrelated to mortgage debt.  You can take the depreciation whether there is a loan on the property or not.

You may be thinking of interest deductions.  Interest payments are deductible also.  Crummy deals will often have negative taxable income, once the expenses, interest, and depreciation are deducted from the collected rent.  All the times I've done the math, good deals seem to have some positive taxable income even after all these deductions.

If you don't have a loan, you don't get the interest deduction.  But, you don't have to pay the interest.  If my choice is to pay $10,000 a year in interest, get the deduction and reduce my taxes by $2,800 (net outflow $7,200) vs. not paying the interest and not getting the deductions (net outflow $0), I'll not pay the interest.  Paying out all that interest is a net negative for your pocket.

If you're putting cash into a deal, you really have to separate the deal from the cash investment.  I look at cash-on-cash return to see what I'm getting back on my money.  A 10% cash on cash return is not that good a deal, IMHO.  I can get 4-5% by putting the money in a CD, and have zero hassles and zero risk.  So, this deal is really only earning me another 5-6%, at considerable hassle and risk.   Stocks would be somewhere inbetween.  More return in the long term than CDs, maybe less than real estate.  Certainly less hassle.  I've had stocks keep me awake at night, but they've never called saying the heaters out.

Lynel Charfauros · Answer

Compound interest is the greatest power known to man!  Wheatie is so dead on right on this! If not the original poster , I greatly appreciate your insight on the subject, and i am looking forward to reading more!

Pat Zorne · Answer

If you have that much cash you would be better off leveraging it to buy a larger property.  With 20% down you could buy a milliion dollar property with positive cash flow.  Hold that property for a couple of years and sell and take the profit and leverage it towards something larger and continue that process

Will Barnard · Answer

I believe you are on the right track choosing RE as the income producing and retirement plan vehicle, however, you are missing out on the power of leverage to start. This is not to say that All Cash is wrong, just to say that your plan does require you to eventually use debt financing for the second or third purchase. Since you are already planning that, why not start out with debt financing on the first as well.
This of course does not mean to over-leverage, but perhaps placing 50% down on two rather than 100% on one may equate to better returns.

As All Cash also pointed out, make sure to include all the other expenses to evaluate your cash flow and thus your ROI.

Another option would be to get a commercial property to start which can produce higher returns and monthly cash flow. I do recommend that you get educated first before jumping in. Sit down with a knowledgeable/reputable financial planner or CPA who has lots of experience in RE to create a plan that fits your risk tolerance/ current goals, and future goals.

Best of luck to you.

Frank Adams · Answer

I'm a believer in using cash instead of debt too! But I have a specific question about your numbers. You said the condo would cash flow $1600/mo after condo fees. Is that also after taxes and insurance too? $20,000/year on $250,000 invested is only 8%, the stock market beats that in ANY 10 year period you pick.

You said that historical apprciation on RE is 14%, I'd have to say that is very "area specific" and over a very short term. 14% means prices are doubling every 5 years, even if that's been the historical case, it can't be maintained in an economy where real incomes are falling.

You've also neglected all of your other costs in the condo calculations, management, vacancy, upkeep, repairs etc.

I'm not sure of your age, but with your income (5X the national average) why are you not participating in OWNERSHIP OF BUSINESSES, other than your own?

all cash