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Cash flow question

I

ilfc

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Hello everyone, this is my first post with REIN, I am a relatively new investor and have a question.



My first rental property is a single family detached 2 storey in a nice area of Burlington, Ontario. We have been renting the house for 2 years to the same tenant, and have recently signed another 2 year agreement.



Currently I have a line of credit where I pay interest only. We generate about $650 of positive cash flow every month on the propery, but I am not paying any extra onto the pricinple. The property has a value of $340,000 and the LOC is at $240,000.



If I was to switch to a standard mortgage, we wouldn't produce very much cash flow from the property.



Is this a viable long term rental property, should I convert to a standard mortgage, and should I focus on paying any of the principle off?



I appreciate any advice, and aplolgize for the long winded post.
 
[quote user=ilfc]Is this a viable long term rental property, should I convert to a standard mortgage, and should I focus on paying any of the principle off?




usually mortgages are cheaper than LOCs ! Best fixed rates today are around 3.8% and variable are prime -0.8% (or 2.2%).



Plus one element of owning rental propties besides cash-flow and value gain is mortgage paydown.



So yes, I'd say you should switch to a 25 year mortgage that is fixed or variable (depending on your preferences .. some folks prefer variable as it is cheaper on average, but some folks prefer the lower risk but higher cost fixed rate)



getting a new 75% LTV mortgage for $255,000 at prime -0.8% with a 25 year amortization would create about $15,000 in cash and would cost you about $1100 in interest plus some principal paydown depending on what rate the bank would use (maybe 3 or even 4%). At 3.5% you'd pay about $1300/month, roughly $200 in principal reduction and $1100 in interest.



Next steps: get an appraisal, update your networth statement, then talk to a good mortgage broker and get some options !
 
If you are generating $650 after all expenses, I would say that's a reasonable return on your 100,000 equity (approx 7.8%/year). Especially since you wouldn't get the full 100,000 on sale after legal fees, realtor commissions, capital gains tax if applicable, and maybe land transfer tax (not sure how that works, we don't have it in AB).



As to your mortgage financing, I couldn't figure out a set of numbers that worked by making a $650 difference to your mortgage payment by switching to an amortizing mortgage. Interest only line of credit of 240,000 would have payments of $800/month at 4% (my LOC's rate, not sure what you're getting). If you changed to a 25 year amortization at that same 4%, the payment goes up to $1267/month. That assumes that you want a fixed rate loan, which doesn't make sense if you're ok with the variable rate on a LOC.



If you switched from a 4% LOC interest only to a prime-0.6 variable rate mortgage with a 30 year amortization, your payments would only go up to $936/month, as most of the principal payment would be made by the reduction in interest rate.



Obviously you'd have exposure to higher rates in the future, but your LOC has that now, so you'd be in the same boat. If you're planning to keep the property, I'd refinance to a conventional mortgage for a lower rate, and take the equity paydown as future profit.



Regards,



Michael
 
I think Michael and Thomas said it well-



If it were me, id switch to a mortgage with a variable rate, and then get into a position where i could buy another property.



Good luck!



jon
 
Thanks everyone. It sounds like the concensus is to switch over to a traditional mortgage. If anyone has any advice why I should keep it this way, I would apprecate the differing opinion.



If not, its off to the broker to see what they can do.
 
[quote user=ilfc]If anyone has any advice why I should keep it this way, I would apprecate the differing opinion.





Biggest reason would be if you are going to sell in a short period of time, then you wouldn't have to pay a penalty to get out of the financing like you would with a traditional mortgage.



Michael
 
Although others are ready to give advice I would first question how you arrived at your figure of $650 PCF.

Not knowing if you are experienced in long term income properties would require knowing the numbers you are using to calculate the expenses on the property going forward before being able to answer your question.



Some inexperienced LL forget to include some expenses in which case the long term numbers get off tilt. This could be magnified by the decision you are now considering.
 
Personally, I believe paying off MORE principal than required might not be the most effective choice unless the interest rate on that mortgage is higher than the returns on other investments done with that money.



Personally I'd make my payments small as possible, keep a healthy reserve fund to carry the property for 5 years. My personal amount would be 3% of purchase price sitting in an account. This would work if you had a sizable portfolio but if you have a smaller portfolio of 2-3 properties, it'll give you piece of mind knowing you're in a really stable position to hold for 5 years.
 
[quote user=johnsu] Personally, I believe paying off MORE principal than required might not be the most effective choice unless the interest rate on that mortgage is higher than the returns on other investments done with that money.




Objectively, you're right in general, but in this case the return on the extra principal is much higher than the indicated interest rate, because it also has the effect of lowering the rate on the entire loan amount.



For example:



240,000@4% interest only has payments of $800 interest, $0 principal, total of $800



240,[email protected]% variable, 35 year amortization has payments of $480 interest, $365 principal, total of $845



So yes, you're paying down $365 of principal each month that you could probably get a better return on, but you are also saving $320 of interest each month.



Thus, within one month your return on that $365 is (320 interest saved/365 principal invested)*100%=87%.



You're getting nearly all your principal back the first month due to lower interest rate, and that doesn't include the fact that as the mortgage balance goes down, the interest paid will decrease further.



Michael
 
[quote user=bizaro86]35 year amortization .. that ain't exist anymore for new mortgages .. thank God !

An investor needs now 20% down and a max. 30 year amortization for new mortgages or re-finances !



Perhaps CMHC will also do away with the 5% minimum to avoid sub-prime borrowers .. I suggested 10% in a letter to Jim Flaherty .. once, for a first time home buyer !



But then our next prime minister, JACK LAYTON, might re-instate 40 year amortization, a tar sands tax and $5000/month CPP for all, at age 18 .. higher minimum wages and higher corporate taxes !!



Thus: less investments in Canada, far higher unemployment, far higher deficits, higher interest rates, lower house prices, LESS CASH-FLOW !!



A sad day for Canada and real estate investors .. this day of March 25, 2011 when the parliament called for a new election in early May !!
 
[quote user=ThomasBeyer].. that ain't exist anymore for new mortgages .. thank God !

An investor needs now 20% down and a max. 30 year amortization for new mortgages or re-finances !




I don't disagree with your general sentiment, although I don't think 30 vs 35 year amortization makes that much difference either way. 10% down would be a huge change for a lot of first time home buyers, but would probably be good policy.



As for my numerical example above,

240,000 at 2.4% over 30 years still pays 480 interest initially, but pays $456 in principal, for a total payment of 936/month. The interest savings are 800-480=320/month (same as above), but the "cost" in additional pre-paid principal is now 456/month. The first month return is thus 70%, still very good.



[quote user=ThomasBeyer]But then our next prime minister, JACK LAYTON, might re-instate 40 year amortization, a tar sands tax and $5000/month CPP for all, at age 18 .. higher minimum wages and higher corporate taxes !!




If all of this happens, I'll have to find a new real estate forum to post on, since I'll be moving to Texas.



Regards,



Michael
 
[quote user=bizaro86] since I'll be moving to Texas.


see ya'll there .. maybe rent a suite in our building 1/2 h north of Dallas, in Denton ! But then, the US has bigger issues than Canada .. but an NDP/Liberal/bloc coalition will surely pump up the debt in no time too and we end up in a banana republic like the US too !!
 
Hi Michael,



Actually what I was referring too wasn't about fixed or variable mortgage. What I was referring to was taking the "extra payment" used for mortgage paydown and reinvest it into another investment that pays net profit better than the mortgage interest rate.



Money that the bank lends you as 1st mortage will be the cheapest money you ever get and paying down the mortgage is ok but lack of liquidity makes it less appealing.
 
[quote user=johnsu]Actually what I was referring too wasn't about fixed or variable mortgage. What I was referring to was taking the "extra payment" used for mortgage paydown and reinvest it into another investment that pays net profit better than the mortgage interest rate.



Money that the bank lends you as 1st mortage will be the cheapest money you ever get and paying down the mortgage is ok but lack of liquidity makes it less appealing.






I understood exactly what you meant. What I am saying is that you have to compare the total amount of money involved in both situations. You could take the extra principal you're paying and invest it elsewhere at >4%.



However, because switching from a heloc to a mortgage saves you a huge amount of interest, you have to factor that in as well, since if you invest the principal portion elsewhere you don't get the huge interest savings. You'd have to get a huge return elsewhere to come close to the savings involved in switching from a heloc to a mortgage.



Michael
 
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