Cash Flows From Operating Activities To Net Profit After Tax Should You Pay Off Your Rental Properties Early?

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Should You Pay Off Your Rental Properties Early?

When I started buying rental properties a few years ago, I financed everything with 30-year mortgages. I wanted to generate as much cash flow as possible so that I could continue to purchase more rental properties. If I financed the property with a 15 year mortgage it would eat into the cash flow and not give me the money I wanted to buy the next deal. When I was buying real estate in Denver four years ago, I used a hard money and refinance strategy to buy properties that were flowing $700 a month with 30-year bonds; in most cases with less than $5,000 out of pocket. This meant that every few months I could use the cash flow to buy another property. Prices were low, finding renters was easy and my cash flow increased with each purchase, life was good! While I was doing my taxes this year, I was reviewing mortgage statements for rental properties and found that my monthly average principal was about $125 per door. I currently have 10 properties so payment is slow. When I bought properties with 100% financing with 30-year mortgages, I didn’t expect to pay off the principal overnight, nor did I expect to be making the same mortgage payments at age 60.

When the cash flow of the property is flowing so well, I start to think about what it would be like to start investing all the cash flow into rent-to-own mortgages and whether that would be a good investment strategy. Considering that all of these mortgages have interest rates between 3-5.5%, most investors immediately think, “why would I invest my money at 5.5%?”

Each answer to this question is different, depending on your personal situation. Let’s look at a typical investor with four properties; the details are below, as well as some questions that might provoke thought.

Here is an example of a landlord.

  • 4 rental properties; all balances to $100,000

  • Mortgage Payments ($100,000, 30 years, 5%, $125 per month for taxes and insurance) $625 per month

  • All rented for $1250 per month

  • Gross monthly cash flow: $625

  • Cost at 25%, $315 per month, per property

  • TOTAL NET CASH FLOW: $1,240

What are your goals?

Create a cash flow for income today. In the example given, the net rents would add $1,240 to your monthly bottom line. You can use it to pay your mortgage, fund a few nice vacations a year, or send your kid to college.

Use cash flow now to generate more cash flow in the future. Pay off your mortgages and get one free and clear lease in just 6 years. Add the $500 per month payment you have been paying on this property to make $1,740 per month and the next one will be paid off in 4 years and the next two in just 6 years. Payout acceleration provides 4 free and clear rental properties in just 16 years, with a monthly cash flow of $3,240 (no rent increases).

Other investment opportunities: If you are looking for multiple deals, it makes sense to save that cash flow to invest in another business. In the case of $1,240 net per month, that’s about $15,000 a year or $30,000 over two years to buy another business or two. It’s harder than ever to find deals in the Denver market, so you may have to work harder to put that money to good use. Some of our clients in Minnesota are buying homes for $30,000, making it pretty easy to incorporate cash flow into your next deal.

Debt Tolerance: Your personal debt tolerance may be your deciding factor. Some buy-and-hold investors buy with cash only, while others prefer financing. Each has its advantages. When paying cash, a change in the market or an increase in vacancies is unlikely to cause you to lose any sleep. Financing allows an investor to buy more properties with less money. While an investor might be uncomfortable looking at their balance sheet and seeing $400,000 in mortgage debt, for others it’s just part of the deal.

Time horizon: In my opinion, this is the second most important decision you need to make when considering a rent-to-own mortgage. Your time horizon can be critical to your decision. If the investor is 30 years old, he may not be in a hurry to pay off the rents, as there could be more opportunities for further property acquisition on the horizon. Although based on the example in “what are your goals?” this investor could be 46 years old with a nice monthly rental income.

A 45-year-old investor may or may not want to carry this debt until age 75. That investor wouldn’t have as much time to enjoy the cash flow he generated. However, if the intention was to use it as a retirement home, it would be an excellent choice.

Income Needed: How much do you need to survive? This is the most important question to ask yourself. Some investors use the rental income as a supplement or all of their income. If you’re using your cash flow to pay bills, using it to pay your mortgage is obviously out of the question. Although if you don’t need cash flow; it could be easy to use the allowance to pay the rents.

What makes sense to you? Have you ever stopped to think 30 years out while shopping for a rental property? Will you hand over your wealth to your family, donate it to Alma Mater, or liquidate everything and live off the profits? Sometimes as real estate investors we spend so much time looking for the next deal and not why we are actually chasing those deals.

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