Real estate investment - Interest only vs capital repayment

[BeTheChange]

Discuss. Which do you prefer for your own investment portfolios and why.

 

[sazc]

First and foremost, look into a series LLC. Cost me $1k to set up. Protects each home independently. Keeps your main casa safe. Also DO NOT FORGET to get an umbrella policy! Assess your retirement needs, and what you currently have saved for retirement, and double that in an umbrella policy. Once your regular policy limits (car/home/rental) have been exhausted, your umbrella kicks in. Keeps your home equity and retirement saving safe. Legit, a $2mil policy cots about $400 (or less) a year. This is a must have.

All my homes have 15 year loans, that was a mistake. My primary home should have been the only 15 year loan. From were I sit now (on a ton of equity in a market that is cooling but still up there) My investment property loans should have been 30 year loans so that I could have pocketed the extra income and re invested in more property, sooner. As it stands now, I have to refi to get my equity. Not too terrible - because with investment property everything is a write off - but 15 year loans was probably not the best pick.

Also, dont pass on property that needs some work. Usually, once you do the work, you can write those costs off, refi and pull the equity out, and keep looking for more property. You will need liquid cash to do the work tho.

My best GF since 9th grade - her family has always done real estate (apartments, etc). They have a care free life. When I realized I was sitting on some real equity, I texted her dad. He called me, we chatted. He said "it's like monopoly, the more properties you have, the more likely you are to win"

My property manager told me "you need to be able to rent the property for 10% of what you are paying" (a few t-day ****tails later and I believe...) This translates into - if I buy at $150k I need to be able to rent at $1,500 a month to cover my costs. This is easy to figure out once you factor in mortgage payments, insurance and property taxes.

If you have a decent income on your own, dont be afraid of purchasing a property that will just pay for itself as a rental. You dont know the glorious-ness of depreciating an asset yet, and being able to write off repairs, all of them.

If the question really comes down to "I can get into a rental but the loan is going to be interest only, should I do that?" My short sighted answer is "yes" - monopoly, buy. buy, buy. My larger sighted answer is make sure you have 5-10k for any 'what if's'. I did replace an A/C for $5k (write off!) and am contemplating re-pipiing another home at a cost of $10k (write off!) And dont forget, property taxes and insurance need to be paid.

Good luck!

 

[Bible_Belt]

My family has had rentals all my life, mostly trailers. People who are new to the idea of being a landlord always want to buy the nicest units they can afford. But that's just vanity. The reality is that a $6,000 trailer and a $60,000 house will rent for the same $600 a month. I'd rather have ten trailers than one house. The lower the value of a unit, the greater percentage of its value that it will return in monthly rent. There is some downside in cheap units regarding higher maintenance and more troublesome tenants, but the return is so much higher that you come out ahead.

 

[sazc]

My family has had rentals all my life, mostly trailers. People who are new to the idea of being a landlord always want to buy the nicest units they can afford. But that's just vanity. The reality is that a $6,000 trailer and a $60,000 house will rent for the same $600 a month. I'd rather have ten trailers than one house. The lower the value of a unit, the greater percentage of its value that it will return in monthly rent. There is some downside in cheap units regarding higher maintenance and more troublesome tenants, but the return is so much higher that you come out ahead.

This strategy really depends on where you are located in the US.

 

[BeExcellent]

Interest only with private money. I like to maximize cash flow and an amortized note cuts into cash flow. I was taught the 1% rule like @sazc recommends but I typically get at least a 2% return per month because I agree with @Bible_Belt on purchase price and % return.

You bet its location based. I buy for cash flow. I do NOT buy where you are relying at all on appreciation. The highest returns are in the low end of the market. I search out target markets that are cheap, safe & stable. And interest only private money is what I prefer if I'm not an all cash buyer.

 

[BeTheChange]

I did the numbers of a recent acquisition prospect and interest only doesn't seem to make sense at all in this current climate where borrowing is so cheap, even accounting for zero capital appreciation.

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Here's a real life example:

Option A
Buy to rent at 4.39% full repayment. 25 year mortgage.

Borrowing £114k.
Total monthly payments of £624 made up of capital payments (£380) and interest (£244).

Option B
Same bank offering an interest only mortgage at 4.5% but as you aren't paying off any capital the loan does not reduce in value. Monthly interest expense is therefore £427.

Let's assess them both.

So on a "profit" basis repayment is the preferred choice due to the lower effective interest expense.

Now let's look at it from a cash flow perspective.

You are gaining a c.£200 p/m (£624 - £427) cash flow advantage using interest only, which amounts to c. £2400 extra cash a year. However the opportunity cost in choosing interest only rather than repayment is that you are forgoing annual equity of c. £460 (£380 x 12).

This seems like an incredibly short sighted exchange of value as you are essentially turning down £4,600 of equity a year just to save £2400 (nearly half the amount). I can see the benefit of it only if you really value your cash flow. However I fail to see how you could take that £2400 and create an additional £2,200 (£4600 - £2,400) of value annually - a return of 92%.

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This purchase is a distressed sale on a foreclosure. I am intending to adopt this strategy over the next 2 years with a view to buy, refurb and hold for rental purposes with minimum mortgage terms of 25 years.

The expectation is that after the refurb I can rent each of the three rooms out for c.£500 based on similar rental prices and local conversations. In my projections I'm discounting to £450 and then a further reduction in income by 10% and an increase in expected costs by 10% to adjust for margin of safety.

I've crunched the numbers and been reasonably conservative. My aim is to acquire an additional eight properties over the next two years using a similar strategy with the intention of putting down no more than £20k on each purchase.

 

[BeExcellent]

That is fine on a property that expensive. I prefer mine however because I create equity by purchasing well under market and also through improvement. Here is an example:

House costs 14K. Three beds 1 bath house. I put 0 down and lender carries at 9% interest. So a 100% interest only loan. Monthly payment is $105. Rent is $525. Annual income is $6300. Considering annual taxes and insurance of about 1K net income is $4040 (after lien payments, taxes & insurance).

This house pays me back for buying it using borrowed hard money in less than 4 years.

Additionally I have enough income to improve the property if needed to bring it up to retail market value...this one needed pet odor mitigated & paint & flooring.

The return is so high (3.7% using the 1% rule) that my strategy makes sense.

Could I rent a 140K house for 5250 a month? Nope. So I work my plan in the low end of the market where the strategy works.

I would not recommend interest only on a bank loan for a higher priced property for exactly the reasons @BeTheChange indicates.

Buying distressed (which I typically do) means I can build equity through improvement, so I can still build equity. Then I turn around and pay back my investor when I'm done using his money.

The investor is happy because he gets a great return with very low risk on the money he deploys to me (since it is backed by income producing real property worth above what he loans.). If I default he owns an income producing asset he can sell for above the note value.

I am happy because it gives me a tool to grab good deals at once and either refi out to standard bank money if it's a higher end property or pay them off quickly.

It allows me to buy even if my own money is fully deployed without having to equity strip something I own free and clear.

Basically I'm paying $1260 annually to earn $4040 in my pocket.

I do lots of little deals like this. I can increase net worth and grab more property this way, without reducing my net worth...in fact increasing it through improvements.

The management is a little more involved perhaps but even that can be mitigated through proper vetting. My favorite tenants are elderly people on fixed incomes. They are conscientious, pay on time, tell me if something needs repaired, and not prone to hook up, have babies, move or tear stuff up. They tend to have a pet or two. I can handle a pet or two for the income & stability I get in return.

 

[BeTheChange]

Bump. The sums I made above are wrong as I did not take into account the amortisation on the loan and therefore the fact that the interest is a significantly higher proportion of the total repayment at the beginning of the loan.

I would therefore argue that for business purposes interest only mortgages may in fact be the best option with cash flow being saved and utilised to expand. So agree with @BeExcellent. Ideally you want as long a loan as possible so I concur with @sazc.

More time to benefit from positive cash flow (and appreciation) without needing to worry about paying off the loan.

My main concern is that I would always utilise the additional cash flow as deposit for the next property rather than saving it towards paying back the mortgage (because if that's the case why not just go the capital repayment route right?). As such this could mean that once the mortgage comes to an end I may be forced to sell in a less than ideal market. How can this be mitigated?

For example if I buy a house for $100k with an interest only loan and in 30 years time it's still worth $100k (unrealistic but necessary for this example) is it possible for me to remortgage or pay back the existing mortgage with a new one or if I lack the cash would I need to sell?

 

[BeExcellent]

Bump. The sums I made above are wrong as I did not take into account the amortisation on the loan and therefore the fact that the interest is a significantly higher proportion of the total repayment at the beginning of the loan.

I would therefore argue that for business purposes interest only mortgages may in fact be the best option with cash flow being saved and utilised to expand. So agree with @BeExcellent. Ideally you want as long a loan as possible so I concur with @sazc.

More time to benefit from positive cash flow (and appreciation) without needing to worry about paying off the loan.

My main concern is that I would always utilise the additional cash flow as deposit for the next property rather than saving it towards paying back the mortgage (because if that's the case why not just go the capital repayment route right?). As such this could mean that once the mortgage comes to an end I may be forced to sell in a less than ideal market. How can this be mitigated?

For example if I buy a house for $100k with an interest only loan and in 30 years time it's still worth $100k (unrealistic but necessary for this example) is it possible for me to remortgage or pay back the existing mortgage with a new one or if I lack the cash would I need to sell?

Interest only notes are a very razor edged weapon to build wealth. Here is why.

1. You cannot assume appreciation. Many investors get gutted by banking on (hoping for or assuming) appreciation. An interest only loan can substantially compound this risk.

2. In your 100K house it would be foolishness to pay 100K if that is full market value. You would have no hedge against downward market movement, which is real and it the number 1 way people go broke in property. Over leverage combined with downward market movement is what causes people to go broke and end up with bankruptcies & foreclosures. My investor will only invest a maximum of 70% percent market value and he prefers 60% or LESS. Why? If he has a 60K note pledged against a 100K property there is a 40% equity position to start with, and therefore there is a 40% cushion protecting his note. So the trick is to buy a 100K property for a 40% discount, purchase at 60K. Those are the sort of conditions under which I obtain a 100% interest only loan: NOT 100% loan to value...rather 100% loan to capital invested. Big difference.

3. As noted elsewhere I invest for cash flow. It is not the only real estate investment strategy but it is the one I favor. Returns are to a degree inversely related to value concerning cash flow. That means generally speaking that the lower socioeconomic strata (lower priced) produce higher % returns, and higher socioeconomic strata (higher priced) produce lower % returns. Now. Once you get into high volume multi unit properties the cash flow, even though the return are not the same, the gross amount trumps volume.

Think of a developer who wants to build a 100 unit complex. Ten buildings, Ten units of 1000 sqft each. Current commercial construction costs run about 70 dollars per square foot.

That means the complex would cost 7 million to build. Let's say market rents average $800 a month. That is 80K per month X 12 = 960K. Almost a million dollars annually. A 13.7% return. At an 85% vacancy rate would equate to 816K annual income which is still an 11.6% return.

So the volume begins to work to your advantage with lots and lots of units.

My plan is to eventually transition to this model.

For now I'll stick with my 20% to 40% returns in the low end of the market where I purchase well below market value at 100% interest only loans, where the lack of amortization accelerates cash flow & cash accumulation.

At my returns my properties can generate enough income to pay themselves off in the short term.

Now. Not all my properties are like that. I've bought some for cash outright. Others have bank loans that are amortized. I've had some properties gain value, some lose value, and many are strictly sideways. But they all create cash flow. Therefore I don't care about appreciation...Which I like...but it's gravy.

4. Cash flow is income. It means your property is self sustaining. That means you have an infinite holding period, not withstanding vacancy rate.

5. You protect yourself against vacancy loss through volume. If you have 1 unit and you have 1 vacancy you have a vacancy rate of 100%. If you have 10 units and you have 1 vacancy you have a vacancy rate of 10%. Giant difference. Strength in numbers.

 

[sazc]

@BeExcellent I've LONG thought purchasing a multi unit situation to be a better decision than purchasing one off single homes, which is what I am doing now. So am I hearing you correctly in that you purchase in less desirable areas in an effort to get a lower purchase price but higher returns?

I once had a property manager tell me that her mother had purchased several units, with cash, that had foundation issues, for $40k each but she didn't care. Know why? Because she could rent these units for $1k each (more now) and live well off the income, and she planned on keeping the units forever (no plans to sell) so there was no need to worry about resale value.

With units that need foundation work, there is always pipe issues to consider. Aside from that, it's general and typical maintenance, which really doesn't amount to much per year.

So your strategy is to purchase less desirable units and charge market rate? So the less-than-desirable-people-issue of "sorry, im out and you are not getting your rent" is handled by the other units you hold - they make up for the differences. It's a pooling of resources, which I get...but the OCD in me likes to hold each house in it's own account so I know how well it is doing individually. And the OCD in me really works to my advantage when I refi or purchase a new property. Lenders love organization.

 

[BeExcellent]

One other thought. When you hold long enough with amortized properties you do see accelerating equity on the back end. I've got several properties that I could pay off right now, but the equity is going to pay them down anyway without me siphoning off cash. This allows me to store up cash to pay off interest only notes.

Happiness all around

 

[sazc]

@BeExcellent so you do, or do not, invest in property in the less desirable areas in order to capitalize and make a larger profit?

 

[BeExcellent]

@BeExcellent I've LONG thought purchasing a multi unit situation to be a better decision than purchasing one off single homes, which is what I am doing now. So am I hearing you correctly in that you purchase in less desirable areas in an effort to get a lower purchase price but higher returns?

I once had a property manager tell me that her mother had purchased several units, with cash, that had foundation issues, for $40k each but she didn't care. Know why? Because she could rent these units for $1k each (more now) and live well off the income, and she planned on keeping the units forever (no plans to sell) so there was no need to worry about resale value.

With units that need foundation work, there is always pipe issues to consider. Aside from that, it's general and typical maintenance, which really doesn't amount to much per year.

So your strategy is to purchase less desirable units and charge market rate? So the less-than-desirable-people-issue of "sorry, im out and you are not getting your rent" is handled by the other units you hold - they make up for the differences. It's a pooling of resources, which I get...but the OCD in me likes to hold each house in it's own account so I know how well it is doing individually. And the OCD in me really works to my advantage when I refi or purchase a new property. Lenders love organization.

If you want great renters you must be patient, screen properly and provide good customer service.

I am very organized also. I purchase in small markets. I have my own algorithm I apply in finding new markets. Places where markets don't radically cycle up & down the way a major metro can. Places where acquisition is cheap, rental demand high but prices are relatively flat. I own in stable neighborhoods and buy structurally sound properties. I also use the income for non recurring improvements that maximize values and I meticulously maintain my units. I have many multi year tenants. I do not raise rents on existing tenants. Over time this does mean I give up some income. It also means I have very low vacancy rates. My tenants know if they need a repair it is done quickly and correctly. I reward long term renters with upgrades as part of routine repairs from time to time. I get referrals from current tenants, former tenants and from business people in town because I cultivate a good & fair business reputation. But I am no softie.

 

[BeExcellent]

Small markets are a key to my strategy.

I do not invest in marginal areas. If I do not feel safe walking outside at 3am (yes I actually cruise neighborhoods at 3am) then I won't buy there.

If I don't feel safe neither will good renters.

 

[BeExcellent]

The other thing I'll do is buy houses with problems that scare off most buyers. While I always buy structurally sound properties I'm not scared of a hole in the tub surround, a bunch of weird paint or even an incomplete remodel. I buy, fix & rent.

 

[sazc]

@BeExcellent what type of upgrades do you do for your tenants and what state, states, are you renting in?

 

[BeExcellent]

Upgrades might be new more powerful window ACs, bathroom upgrade, new paint, outdoor landscaping, upgraded window treatments, fancier light fixtures, stone counter tops if I think they can keep them up (so far so good, knock wood), nicer front door, nice front storm door, etc.

Things that maximize market value or curb appeal that also are an extra something for the renters.

I'm in the Midwest & Southwest

 

[ubercat]

@BeExcellent would you mind sharing some tips for buying under market value. I ve got 70k to invest and I d like to buy 2 regional properties. But market s high in Australia and NZ. 250 - 320 k for a house. If I have to pay market value I won't be able to buy 2.

 

[BeTheChange]

@BeExcellent

So you pay 70% below market value? What do you define as market value? Its list price? Is value based on a multiple of expected net income? A dcf model?

 

[BeExcellent]

If you guys read my posts over again I think you may have misread them. I often can get 20-30% below, the best deal I've ever made was at 70% below market value & it was very lucky that I got it. I only have 1 of those & I paid cash for it. I can get property at 40-50% market value from time to time now that I am known as an investor in my markets. To do this I have to be willing to fix whatever issues I'm buying (it's discounted for a reason), & be able to reliably close the sale (which I am known to do), and close fast. I get told of "pocket listings" before they hit the market often now, something I didn't believe was really true reading a gazillion real estate books when I first got started. Once you have a bit of a name for yourself deals do start to find you.

To find such properties? Look at stale listings, sales that are happening due to poor condition or acute financial need (death/divorce/relocation/foreclosure, etc). There are plenty of books on how to identify such properties. A favorite author of mine is Robert Irwin. He has written many books, I find them practical & pragmatic & you can get them inexpensively.

@ubercat what can a 250 - 320k house rent for in your area? Buy and hold is a harder strategy where market prices are much higher because the costs to purchase as well as recurrent costs to hold make accumulation of volume (getting more units) more expensive & take longer. Can you buy one & Air B&B it? You might be able to maximize income that way. Can you buy a distressed property & solve its problems? Are you willing to focus on your chosen market & really get to know it? Network with real estate people, bankers, local folk (both residents & business people)? I like to know a target area block by block if I'm serious about buying there. I drive it at 3am during the week, 3am on the weekend, after work, I watch the online portals like a hawk (My 70% off market value popped up on Realtor . Com one day. I called my broker IMMEDIATELY and said "put a contract on that house...NOW"), I have bought via live auction & online auction. But I already have done the research that allows me to pull the trigger so quickly. My networks of people are also established. But I built people networks before I bought. I think that is key.

I know a very successful investor in San Diego, CA. He and his wife are now in their 70s. They own free & clear their own home as well as 6 rental homes in the San Diego area. Each house is worth around 500-700K now, so his net worth is several million, and he gets roughly $2500-$3000 a month in rents per unit which is good and provides them a great income stream between 12K to 18K per month (less if they have a vacancy, which they rarely have & are usually short lived) but he has owned these houses for decades and paid less than 100K for each one.

It's very hard to find great undervalued properties in major markets with high property values. There are so many more experienced people with more money scouring the area that you almost have to know the right people (or find & get to know them), or be very lucky or very creative. I tried for a while to get into Las Vegas' market. I was always a day late on deals I wanted and wasn't on the inside track there as an out of state investor. I wasn't willing to move there to really learn the players in that market. Yet.

That's not to say it can't be done. It can. You have to have the same IDGAF attitude TRP teaches (there is ALWAYS another equivalent or better deal), and you need to be sure it's the right deal before you commit money.

If you look at my friend's San Diego portfolio you'll notice that buying those same houses at today's prices for today's market rents would not be a wise financial move if using leverage. The rents would not justify the values, but it's SoCA, a very high demand,very expensive area.

One thing I have done with success is get out of major metro. Prices are substantially lower and there are still people who need to live & work there. Many of whom can't afford or don't qualify to purchase but they can rent something. It's a sacrifice one way or another in that you either have to manage property remotely (not something I'd advise for a novice, although not impossible) or move to the area & become a locally known presence. Moving to a small market is a big sacrifice socially. I did it while married so my family life was stable & I wasn't worried about social opportunities at the time.

@BeTheChange I define market value very simply. By recent comps. On income producing property you can do cap rates and all sorts of fancy financial calculations about returns to set value but in my humble opinion market value is only as much as you can sell it for today & nothing more. Recent comps are the most reliable indicator for that. Market value is sometimes less than what income or income potential would suggest.

That can be great news as a buyer, dismal news as a seller. Depends on your perspective.