This article was posted on Thursday, Aug 01, 2013

Every once in a while it’s appropriate to devote a column to young people trying to get started. An adult grandchild reading this might be willing to engage in a conversation that needs to be started.

Review: Samantha, Part 1

Income property provides four sources of income: (a) appreciation; (b) equity build-up;

(c) depreciation, and (d) cash flow. They are not equal and do not manifest at the same times. However, income property, when suitably leveraged, can generate total returns greater than Warren Buffett’s Berkshire Hathaway.

Property consists of land and the improvements thereon. Land never wears out. Improvements are the things that wear out (dwellings, garages, fencing, etc).

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Things that wear out are not a durable source of wealth. If you had two identical improvements on widely separated pieces of land (imagine the pearl district of Portland, Oregon vs. the area south of the 7/11 in Pahrump, Nevada) you would not be surprised to find their net annual incomes to be widely different. The difference is not due to the improvements, because they are the same: it is due to the unique demographics of the different sites.

The best areas, the neighborhoods most likely to generate above average net income, consist of dense populations of rich people. These areas can be found by referencing on-line census data. It’s possible to determine the state where the prospective investment is desired, then (a) search for zips with greatest population and (b) a separate search for zips with high income. Cross reference (a) and (b) and the result should be a very useful map showing areas thick with rich people. We often refer to these areas as archipelagoes. To an investor, they are like bright little islands of promise.

Takeaway: The best locations have lots of people who can afford high rents. Duh.

Once a handful of archipelagoes have been identified the problem changes from “where” to buy to “which”. It becomes an issue of property selection. Given an attractive floor plan (public rooms are generously sized, contiguous, and separated from private rooms by a hall) the basic rule is that bigger is better than smaller, simply because folks accumulate stuff. The longer they stay the more stuff they get and the less likely they are to move for slight reasons. Big units are desirable because they take longer to fill up with stuff. Once they’re filled, they become an anchor.

It’s often the opposite with commodity properties located in common areas where it seems folks move much more frequently. Under these circumstances it’s more desirable to own small units because they are cheaper to freshen for the next tenant.

Takeaway: Buy big units in good areas; small units in commodity areas.

Even if it were convenient to pay cash for an income property it might not be best to do so because it materially reduces the total return on the investment. One of the huge benefits of income property ownership is the possibility of using Other People’s Money (OPM) to acquire personal investment assets that a third party – the tenants – will pay off for you. There may have been a time when mortgages weren’t available, so it’s appropriate to raise an occasional cup of tea to the man who first proposed the idea.

Mortgages, however, require management of two elements: (a) loan to value (LTV) and (b) fixed or floating.

Principle 1: The higher the loan to value,

the greater the landlord’s return on investment

Presume a property valued at $100 against which the buyer acquires a loan of $100. She has no personal investment in the property. The next year the property appreciates to $110. The owner gains $10 on an investment of . . . what? She has no investment: the property was purchased solely with borrowed money. Her Return on Investment (ROI) is infinite.

Had she used her own money to put $10 (10%) down against a $90 (90%) loan, and had the property gone up $10 (10%) the next year, she would have made a 100% annual return on her money. We have dropped from an infinite ROI to a mere 100%.

If she’d put $50 (50%) down and the property appreciated the same $10 (10%) the following year, her ROI the next year would have been 20% ($10 appreciation divided by $50 equity). Another huge drop in Return on Investment: we’ve gone from infinity to 20%.

The point here is that the more equity she has in her property, the lower her Return on Investment. A secondary point is that the equity a person has in property changes throughout the ownership period.  As demonstrated by the above examples, that change has an enormous impact on the returns received from the investment. The new owner’s equity may be increased immediately by a larger down payment (which, as we’ve seen, reduces ROI). Or equity may increase over time by (a) the tenants paying off the mortgage (increases equity / reduces her ROI) or (b) appreciation of the property (increases equity / reduces her ROI), or (c) both (a) and (b). These are insidious and pare away at Return on Investment in ways that are often not noticed.

Takeaway: To maximize Return on Investment, use as much OPM as you can.

Principle 2:  Whether the mortgage is fixed or floating has a material effect on the owner’s returns

For most of the term of the mortgage, the largest part of the monthly payment is interest. A 30 year loan at rates current as of the time of this writing only applies 20% of the first payment towards paying off the amount borrowed. That means that almost 80% of each early payment is . . . rent on the borrowed money. If your payment is five $1,000 bills, four of them go towards paying interest. It isn’t until 25 years into the loan that the relationship is reversed and 20% of the monthly payment goes towards interest with 80% applied towards principle reduction. The borrower pays a huge sum in interest over that 30 year span: total interest paid will be over 90% of the amount originally borrowed.

  • Total Interest Expense: Multiply the monthly payment by the term of the loan (in months) and subtract the original loan amount.
  • Example: Monthly payment of $5,368 x 360 month term = $1,932,000 minus original loan amount $1,000,000 means the total interest expense in this example is $932,000 (sums rounded). 

Obviously, the lower the total interest paid the greater the owner’s cash flow, so the point becomes how to minimize the total interest expense incurred during the ownership period, consistent with Principle 1 (above).

What is the macro-trend in interest rates? Do you see rates being higher or lower 5 or 10 years from now? During periods of rising interest rates, the landlord probably would benefit from having an interest rate lower than the prevailing. This almost always requires a refinance which permits the borrower to lock in an extended fixed rate period the first several years of the (new) loan. There’s no free lunch, however. The savings won’t come immediately because the “start” rate will reflect whatever the current mortgage market. But if the projection of higher interest rates in the future proves accurate, the net savings could be significant.

As long as rates are going up we generally want to be “fixed” as much as we can.

Notwithstanding the obvious benefits of serially refinancing to maximize Return on Investment and minimize interest costs, there are situations where it may not be the best thing to do. For example, if a person was 20 years or more into their loan and the portion of the payment going towards principle was high, it may not be the best thing to refinance.

Another example: if a review of the current loan’s documents showed that it’s interest rate would cap out at a reasonable number (in my mind that’s 10% or less, but your mileage may differ), it might not be the best thing to refinance.

Thirdly, if an owner expected to retire as soon as the current underlying loan was paid off and use the (greater) net income to fund retirement living, it might not be the best thing to refinance.

As appealing as maintaining a high ROI while minimizing interest expense might be, refinancing is a serious step. It should not be a hasty decision and it’s not right for everybody.

Serially refinancing, even when it’s done just to minimize total interest expense, is not forever. When rates begin to decline, and eventually they always do, most people should stop refinancing and allow their mortgages to flip to adjustable rates. Adjustable loans follow rates down automatically, so interest expense is minimized without the need to refi.

Well, there is one reason to refi even if rates were declining, and that’s to harvest equity to buy another building, but that’s got more to do with asset accumulation than mortgage management.

Takeaway: When rates are going up, lock the interest rates at current levels. When rates are declining, stop refinancing. Allow mortgages flip into their adjustable period and ride the rates down. Mortgage management is especially important if you’re using a lot of OPM. 

In last month’s column we talked about why income properties can make a splendid long term investment and we discussed how to find the money to buy the first entry level property. In this column we addressed where to buy, what type of units to buy, and how to manage one of the biggest single costs of property ownership: interest expense. An understanding of these elements is useful in our type of investing.

If you’ve missed some of the prior articles, basic “beginner” guidelines on successful investing are in my book “Stairway to Wealth” available at

Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].





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