What do you do with a bit of cash flow?

[TommyK]

Hi Fellow REIN (expert advise needed!)

I know this issue has been brought up before by other members. However, I feel that everyone`s situation is different so it is still worthwhile to seek some expert advice on here.

I have a rental property that generates about $200 cash flow a month. I currently own principle residence as well.

Some of you have suggested the following before on what to do with the cash flow:

1) spend the cash flow
2) save up for down payment on other projects (slowly)
3) pay down principle resident since the interest is not tax-deductible

*But I want to explore the option of paying down on my rental mortgage.

My situation:
I do not need the extra $200 a month to live on. I have a 5-year plan where I want to create a residual income of $2500 (yes I need more properties for sure). So if I don`t plan on selling the property in 5-year period, and I plan to keep holding onto it to generate long-term cash flow, then wouldn`t it make more sense to pay down on the rental mortgages whenever I get a chance? I understand that selling the property will trigger taxes; but if I hold it for long-term and sell in the year that I expect to have the lease amount of annual income, then the impact on tax is minimized.

ie) If I accelerate my payments on rental property $200 a month (that`s $2400 a year pay down)
2400 x 5 years = $12000 additional pay down

Wouldn`t this amount affect greatly on the interest portion of the mortgage payment on the rental property?
Hence I may generate more cash flow once I refinance in the next few years.

For my own residence, if I decide to sell in the 5th year, and if I make money, then it will be tax exempt anyway.

I would like to know what some of you are doing in your situation.

Thank you!!

Regards,
Tommy

 

[MonteDobson]

I would suggest option 3) pay down principle residence since the interest is not tax-deductible

Since this is non-deductible (otherwise considered "Bad") debt, you want to pay it down the fastest. Set up a re-advanceable mortgage product on your principle residence where the LOC grows as you pay down your principal, you can then invest these funds and get a tax deduction.

Even though it is only $200/month, it will shave years off of your amortization schedule.

 

[dwb]

QUOTE (TommyK @ Nov 22 2008, 02:12 AM) ...then wouldn`t it make more sense to pay down on the rental mortgages whenever I get a chance?

Sure, you`ll be paying down that mortgage on that rental property, yes. But you`d also be paying down your significant tax benefits too. Slowly eliminating tax benefits isn`t a great strategy in my opinion.

Use that $200 to make extra payments to your principle residence mortgage... eliminate your principle residence as fast as possible. Once that principle residence is gone then, and only then, turn your attention to eliminating your rental property mortgages.

Also use the tax benefit you receive at tax time from those rental properties to make lump sum payment to your principle residence mortgage as well. Principle residence mortgage is BAD debt!!! Get rid of it!!!

 

[Dan_Eisenhauer]

One of the principals of real estate investing is the use of leverage... keeping a property as highly financed as possible... in order to maximize your ROI. When you pay down an investment loan more quickly you are losing that advantage.

The others have said it. Use that money to pay down your principal residence.

 

[TommyK]

Yes, THANK YOU YALL for the advice.

I am going to do bi-weekly pay down of $100. That way I will save more interest over a long period of time.

Yeah, once the mortgage on principle residence is paid down, then I can refinance HELOC for investment purpose (interest will be then tax deductible).

Thanks!

 

[Thomas Beyer]

QUOTE (TommyK @ Nov 22 2008, 12:12 AM) ... I do not need the extra $200 a month to live on. I have a 5-year plan ...

I would like to know what some of you are doing in your situation.
Tommy:

you appear very impatient with only $200 positive cash-flow .. pat yourself on the back with a big fat fancy meal .. then keep a FAT reserve for uncertain times ahead .. say 4-6 months of mortgage payments for each property you own .. minimum .. job picture is murky .. and no job is a given these days ..

Once you have accumulated thousands .. or better: tens of thousands of additional cash .. then (and only then) ask yourself: what to do with the cash !!

keep it liquid .. safe .. then invest again once you know we have reached the market bottom .. which we do not know as of late Nov. 2008 !

Also, a 5 year plan is fine .. but allow yourself to change it with changing facts such as :health, stock market, interest rates, available mortgage financing, family status .. many a happy Wall Street banker with a 5 year plan 3 months ago (2nd home in Florida or Arizona ? Jewelery for the wife or a new car for Christmas ? new job across the street with an even higher bonus ?) is now in the unemployment line ! Do not think that this could not happen here at home !!

next year will bring DRAMATIC world-wide changes so allow yourself a fat cash cushion and room in your plan for adjustments ..

I`d also not pay the mortgage down too fast .. keep a cash cushion first .. then pay the mortgage down .. or better: have a LOC .. why is there a mortgage anyway ?? .. related post here: http://myreinspace.com/public_forums/Real_Estate_Discussion/62-2302-What_is_better_a_mortgage_or_a_line-of-credit_.html

 

[Sherilynn]

Since we have older properties, we choose to reinvest our cashflow into improvements. This strategy helps increase the value of our investments and helps to maintain a higher renter profile.

Regards
Sherilynn

 

[TommyK]

Thanks again Thomas!

Ok, I will leave the $200 in the bank account for now in case things do happen. I won`t touch it unless I have 2 months of mortgage payment tuck away in the account. Then I will think of what to do with the money.

Thanks Sherilynn. My property is a 2006 built townhouse. Luckily there`s not much to improve for this property yet.
But it is a good suggestion nonetheless!

Tommy

 

[Thomas Beyer]

QUOTE (Sherilynn @ Nov 22 2008, 08:29 PM) Since we have older properties, we choose to reinvest our cashflow into improvements. This strategy helps increase the value of our investments and helps to maintain a higher renter profile.

Regards
Sherilynn
Indeed .. this is often a better investment than selling, paying taxes, realtor commissions and legal fees .. then spend time to buy similar assets !!

 

[Jack]

QUOTE One of the principals of real estate investing is the use of leverage... keeping a property as highly financed as possible... in order to maximize your ROI. When you pay down an investment loan more quickly you are losing that advantage.The problem with the word "leverage" is that it can be substituted for the word "risk". The more highly levered a property is, the more you`re at risk to lose your shirt. Dan`s right, in that, yes, the project will have a higher ROI if you`re more highly levered - but, this assumes that the real estate market is just going to go up, up, up! If it goes the other way, you`ll be introduced to the other side of leverage, and it`s not a kind one to investors. So is the double-edged sword of leverage; gains and losses will be magnified!

You`ve received some good advice in this thread. I`d agree that paying down your principle residence`s mortgage makes the most sense. And, well done - $200/mo. in PCF! Strong! There`s your REIN membership right there, boom!

 

[MonteDobson]

QUOTE (TommyK @ Nov 23 2008, 02:55 AM) Ok, I will leave the $200 in the bank account for now in case things do happen. I won`t touch it unless I have 2 months of mortgage payment tuck away in the account. Then I will think of what to do with the money.

Hi Tommy,

I agree that this money should be stashed away for "reserves" if required, but instead of just sitting in bank account doing nothing, why not set up a re-advanceable mortgage (ie. Scotia STEP) and pay down your principle residence mortgage. You are still achieving the same outcome, only faster and would still have access to the funds (as a LOC) if required. To me, the goal should be to reduce all bad or non-deductible debts to zero as fast as possible, while still having access to the funds (ie. LOC).

 

[TommyK]

Thank you Jack and Monte.

I have decided to put away the money until I have a comfortable emergency funds for rainy days.

Once I put away 2-month of rent in the savings, then I will start paying down my own residence to reduce bad-debt (non taxable interest).

Thank you for all the responses on here.

This is such a revelation to me as how $200 a month can do to further improve my ROI.

I paid $290,000, put 20% down (58,000down + 2,000 closing cost = 60,000). I generate $200 a month x 12 = 2400
2,400 / 60,000 = 4% cash on cash.
Yet the $200 a month can also be used to pay down my own residence and save more interest in the long-run. So my overall ROI is much greater than 4% at face value.

God, why didn`t I invest in real estate years ago! LOL

Tommy

 

[invst4profit]

As a investor that survives on positive cash flow I am always interested in knowing how other investors calculate there positive cash flow.

Your property as an example, with my calculations, having a purchase price of $290000 would need to rent out at approximately $2700/month to show a $200/month positive cash flow long term.
Are those numbers in the ball park of what you are seeing on this property.

 

[Thomas Beyer]

QUOTE (Jack @ Nov 23 2008, 08:59 PM) The problem with the word "leverage" is that it can be substituted for the word "risk". The more highly levered a property is, the more you`re at risk to lose your shirt. Dan`s right, in that, yes, the project will have a higher ROI if you`re more highly levered - but, this assumes that the real estate market is just going to go up, up, up!True to a point .. however you do not need an increase to make money levered ! Leverage is prudent if you can get money at 5% or 6% or so .. and the property yield is higher than that !Assuming a 25 year amortized mortgage, if you buy an asset with a 20% down-payment, and no positive cash-flow for 10 years, with:
a ) No appreciation (equity upside) you have DOUBLED your money as the mortgage has been paid down 20% !

b ) 20% price increase (less than 4% annually compounded, below Canada`s long term average !!), you would have TRIPLED your money ..

c ) 30% price increase (less than 6% annually compounded, about Canada`s long term average as house prices in Canada have doubled every 15 years in a normal economy !!) you would have made 250% on your money.

d ) 40% price increase (slightly higher than Canada`s long term average as house prices in Canada have doubled every 15 years in a normal economy, and AB has a better economy than the rest of Canada !!), you would have made 300% on your money, i.e. quadrupled it!

what about a decrease:

e) if you hold 25 years, with no cash-flow and a 25 year mortgage, and a 25% value decrease .. you`d still have have made over 250% on your money (from 40K down to now 150K in equity, up 110K, assuming a 200K condo)

f) if you hold 25 years, with no cash-flow and a 25 year mortgage, and a 50% value decrease .. you`d still have have made 150% on your money (from 40K down to now 100K in equity, up 60K, assuming a 200K condo)

==> Prudent leverage is KEY to make money .. ASSUMING a yield (net operating income / price) that allows at least 0 cash-flow (positive is better, of course !!) .. plus to my knowledge there is no market that will go down in 25 years where you should have invested in .. maybe war torn regions or places where people leave such as dieing BC forestry towns or NF fishery towns or PQ hinterland towns or AB or SK or BC mining towns where the mine is now closed .. or 3rd world countries .. but not any civilized place in NA, Europe or Asia !

So, the key is YIELD (or CAP rate if you wish) .. and true, in many markets the yield on a $400,000 house is perhaps 2.5% (rents for $2000 perhaps - taxes - upkeep - management cost - vacancies) .. well below a mortgage rate .. and as such it is very risky being levered ! That is why usually a big house makes a lot less sense than a small house, a cheaper condo or an apartment building ! The yield to mortgage rate relationship is key to cash-flow and long term hold .. and any equity upside is of course always appreciated and likely happening, but not required actually !!! So leverage is LOW RISK in the right circumstances or amounts !

Kinda` like drinking wine .. which is healthy and even Jesus didn`t condemn .. just getting drunk is unhealthy for you !

So, don`t get drunk on too high a leverage with a low yield property !

 

[ZanderRobertson]

as a wise man once said "why risk what you have and need for what you don`t have and don`t need"i agree that prudent leverage is key. we have to build a margin of safety into our investments. the three best ways i can think of to do this are to a)lever as little as is feasible, b) find the absolute best properties available (in terms of cash flow), and c) use that bit of cash flow to build substantial reserve funds.What are some other ways to increase our margin of safety?QUOTE (thomasbeyer2000 @ Nov 24 2008, 09:45 AM) True to a point .. however you do not need an increase to make money levered ! Leverage is prudent if you can get money at 5% or 6% or so .. and the property yield is higher than that !

Assuming a 25 year amortized mortgage, if you buy an asset with a 20% down-payment, and no positive cash-flow for 10 years, with:

a ) No appreciation (equity upside) you have DOUBLED your money as the mortgage has been paid down 20% !

b ) 20% price increase (less than 4% annually compounded, below Canada`s long term average !!), you would have TRIPLED your money ..

c ) 30% price increase (less than 6% annually compounded, about Canada`s long term average as house prices in Canada have doubled every 15 years in a normal economy !!) you would have made 250% on your money.

d ) 40% price increase (slightly higher than Canada`s long term average as house prices in Canada have doubled every 15 years in a normal economy, and AB has a better economy than the rest of Canada !!), you would have made 300% on your money, i.e. quadrupled it!

what about a decrease:

e) if you hold 25 years, with no cash-flow and a 25 year mortgage, and a 25% value decrease .. you`d still have have made over 250% on your money (from 40K down to now 150K in equity, up 110K, assuming a 200K condo)

f) if you hold 25 years, with no cash-flow and a 25 year mortgage, and a 50% value decrease .. you`d still have have made 150% on your money (from 40K down to now 100K in equity, up 60K, assuming a 200K condo)

==> Prudent leverage is KEY to make money .. ASSUMING a yield (net operating income / price) that allows at least 0 cash-flow (positive is better, of course !!) .. plus to my knowledge there is no market that will go down in 25 years where you should have invested in .. maybe war torn regions or places where people leave such as dieing BC forestry towns or NF fishery towns or PQ hinterland towns or AB or SK or BC mining towns where the mine is now closed .. or 3rd world countries .. but not any civilized place in NA, Europe or Asia !

So, the key is YIELD (or CAP rate if you wish) .. and true, in many markets the yield on a $400,000 house is perhaps 2.5% (rents for $2000 perhaps - taxes - upkeep - management cost - vacancies) .. well below a mortgage rate .. and as such it is very risky being levered ! That is why usually a big house makes a lot less sense than a small house, a cheaper condo or an apartment building ! The yield to mortgage rate relationship is key to cash-flow and long term hold .. and any equity upside is of course always appreciated and likely happening, but not required actually !!! So leverage is LOW RISK in the right circumstances or amounts !

Kinda` like drinking wine .. which is healthy and even Jesus didn`t condemn .. just getting drunk is unhealthy for you !

So, don`t get drunk on too high a leverage with a low yield property !

 

[Thomas Beyer]

QUOTE (ZanderRobertson @ Nov 24 2008, 06:48 PM) What are some other ways to increase our margin of safety?

1) don`t overpay

2) sell when prices have gone up "irrationally high" .. like into 2007 ..

3) make prudent assumptions about rent levels, costs, vacancies, values, interest rates

4) buy only in growing economies / cities / areas (a key REIN philosophy)

5) buy with enough cash-flow (or price to rent ratio aka 8-10% rule) so you can hold during bumps like 2008 / 2009 ...

6) seek advice / help

7) hire a decent property manager even if it costs you $100/month or 5% of rent collected !

8) have the right partners: marriage, investors, business teams (realtors, lawyers, mortgage brokers, educators, property managers, ...)

9) have a prudent cash reserve

10 have low expenses that are in line with business goals

 

[Jack]

QUOTE So, the key is YIELD (or CAP rate if you wish) .. and true, in many markets the yield on a $400,000 house is perhaps 2.5% (rents for $2000 perhaps - taxes - upkeep - management cost - vacancies) .. well below a mortgage rate .. and as such it is very risky being levered ! That is why usually a big house makes a lot less sense than a small house, a cheaper condo or an apartment building ! The yield to mortgage rate relationship is key to cash-flow and long term hold ..

Yield:Mortgage Rate...interesting. Is there a target that you keep in mind when analyzing acquisitions? Where do you go to find historical information on yields by region/property type?

QUOTE Kinda` like drinking wine .. which is healthy and even Jesus didn`t condemn .. just getting drunk is unhealthy for you !

So, don`t get drunk on too high a leverage with a low yield property !

Awesome - and after an all-day stag for a good pal of mine on Saturday, I can attest that getting drunk is unhealthy (but oh, so fun!).