Last month we learned that young Caleb has forty or more years before reaching traditional retirement age. Because he has a longer time horizon he can take slightly more investment risks than his older half-sister, and perhaps wind up with greater wealth.
One of the more reasonable risks he might take is borrowing money to help fund his purchases. Most (but not all) investment real estate can be at least partially financed. And particularly when investing in apartment buildings, well over half of the purchase price can usually be borrowed. High loan-to-value (LTV) mortgages are a major double-dog benefit, and make all the difference.
That doesn’t mean that he will always seek the biggest mortgages. There might come a time when Caleb would prefer to own his buildings free and clear, and we’ll talk about that in a moment. But right now let’s review why buying property with borrowed money makes so much sense for so much of the investor’s career.
Return on Investment
Everything else being equal, if a $100,000 building appreciates 10% over one year then its new value becomes $110,000. The owner’s assets grew $10,000 regardless of how much of his own money he had in the deal.
The important number for the owner is not the dollar amount of the annual gain, but his Return on Investment (ROI). And that is determined by his equity at the beginning of the period. The more of his own money it took to make that $10,000, the lower the ROI. Extreme example: If the building were mortgage-free, the owner’s equity would have increased 10% that year ($10,000 annualized gain divided $100,000 equity).
But the opposite is also true: the lesser of his own money invested, the higher the yield. That means interesting things start to happen when money is borrowed against the property, and it doesn’t make a bit of difference whether the new mortgage is to purchase the building or to refinance it and pull some money out. The only two relevant items are (1) annualized appreciation and (2) beginning equity. The math is simple: annualized gain divided by Beginning of Year (BOY) equity.
Here are some examples. They are all based on a $100,000 original value going up 10% by the end of the year. The only variable is the owner’s equity.
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Mortgage Equity ROI Math
Zero $100,000 10% $10,000 divided by $100,000 $25,000 $ 75,000 13% $10,000 divided by $ 75,000 $50,000 $ 50,000 20% $10,000 divided by $ 50,000 $75,000 $ 25,000 40% $10,000 divided by $ 25,000 $100,000 $ Zero Infinite $10,000 divided by $ Zero
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An investor can pretty much forget about the extremes, like buying an apartment with either no money down or, alternatively, buying it without any mortgage at all. If he absolutely will not borrow to fund his growth, he’ll have to save his pennies until he has the $400,000 or $800,000 or $1,200,000 or more to buy the building he wants. While he’s looking behind the couch cushions for spare change that $800,000 property is climbing to $900,000. The lesson here is it’s really hard to buy in an appreciating market without borrowing most of the money.
Most of an investor’s focus will probably be on putting a certain percentage down. As an example, a 35% down payment will generate a pretty good first year ROI. Using the figures in our example, 35% down on a $100,000 building that appreciates 10% in one year is a 29% ROI ($10,000 divided by $35,000).
As his equity increases the annualized ROI commonly declines simply because he has more of his own money invested. Referring to the examples above, at a 25% LTV (meaning the equity is 75%) the investor’s ROI has dropped to 13%. Over the long term, the difference between compounding your money at 13% or at 35% is huge.
One of the investor’s responsibilities is to properly manage the loans on his investment properties. At some point, usually when present loan is 50% or less of the property’s value, the careful investor refinances and uses the proceeds to purchase another building. This not only increases his units under management but it also reduces his equity in the building he refinanced, thereby (automatically) increasing his Return on Investment. When the investor moves for example, from a 50% equity position to a 25% position, his ROI doubles.
OK. So Caleb does all this. He buys his properties with someone else’s money. He monitors his ROI on each individual building he owns. When appropriate, he refinances one or two existing buildings to generate the down payment for a new purchase. Decades have passed, and Caleb has done this several times. He now has five buildings.
In a few years he’ll be eligible to retire under his company’s pension program. He faces the normal options someone in his position would reasonably have: (a) sell his buildings and put the money into wide spectrum stock and bond index funds; (b) don’t do anything, or (c) pay the buildings off and retire with a splendid income from properties he knows very well.
He knows that the stock and bond option is a possibility, but his wife doesn’t have a high comfort level with these investments. She’s a tire-kicker and every once in a while needs to drive past their investments and, well, kick the tires. On Caleb’s part, continuing the buy – appreciate – refinance – buy format that brought him his wealth isn’t really very interesting to him anymore. He’s BTDT (“Been There, Done That”) and the excitement is gone. He has reached the point where enough is enough. Caleb and his wife elect alternative (c): to keep their existing apartment buildings and pay off the underlying mortgages.
This decision is not for everybody and requires much thought. But Caleb expects interest rates to increase, and as that happens his mortgage payments will go up and his “spendable” will decline. Moreover, he wants the robust retirement income un-mortgaged buildings might provide. His prepayment penalties have expired, so that’s no longer a consideration. All in all, Caleb has reflected on the matter and concluded that there is more to be gained than lost in having paid-off buildings in retirement.
The following hypothetical example is simplified. Some but not all of the presumptions are that (1) the terms of any prepayment penalties have expired; (2) the loans are far enough along in their amortization schedules that principal reduction averages about 50% of the monthly payments, and (3) we take no notice of the growth of net operating income over time. These presumptions allow us to focus on the principle lesson: use cash flows to successively pay off the smallest loan, each in its turn.
Beginning of Year 1:
| Address
|
First Ave | Second Ave | Third Ave | Fourth Ave | Fifth Ave |
| Annual NOI | $60,000 | $100,000 | $120,000 | $120,000 | $140,000 |
| Annual Interest on Debt | (20,000) | (35,000) | (40,000) | (45,000) | (50,000) |
| Annual Principal Portion | (20,000) | (35,000) | (40,000) | (45,000) | (50,000) |
| Annual Cash Flow
(NOI minus Debt Service) |
$20,000 | $30,000 | $40,000 | $30,000 | $40,000 |
| Current Balance Owing | $550,000 | $650,000 | $700,000 | $725,000 | $950,000 |
Caleb owes $3,575,000. He got his most recent loan five years ago. If nothing changes, that loan will be paid off and his five properties will be debt free in 25 years. He wants that to happen well before the 25 years is up and is willing to make some sacrifices to that end.
With careful budgeting he and Eunice can live adequately on his corporate salary, permitting them the option of applying the entire NOI (minus interest costs) to paying off their portfolio. This is how they did it.
Step 1: Caleb begins with the mortgage with the lowest loan balance. In this example, that would be First Avenue. He continues to make the contracted debt payment, with $20,000 going towards the principal. But his portfolio provides an additional $160,000 of annual cash flow that is applied towards paying off the principal. At the End of Year 1 (EOY 1) First Ave’s mortgage has been paid down to $370,000 ($550,000 minus $20,000 minus $160,000)
Twelve months later (EOY 2), this property has been paid down another $180,000 (again, the principal portion of that year’s debt service plus the year’s cash flow from the entire portfolio) to $190,000. By the End of Year three yet another $180,000 is paid down and Caleb’s wife, Eunice, kicks in $10,000 from her mahjong winnings to completely retire the mortgage on First Ave.
It took three years to pay off First Ave. Caleb’s portfolio now looks like this (below). Notice that First Ave now generates $60,000 Cash Flow rather than the $20,000 in Chart 1. Additionally, his loans on the remaining four properties have been reduced by the accumulated principal pay-offs during the 3 years he was focused on First Ave. See “Current Balance Owing”.
End of Year 3:
| Address
|
First Ave | Second Ave | Third Ave | Fourth Ave | Fifth Ave |
| Annual NOI | $60,000 | $100,000 | $120,000 | $120,000 | $140,000 |
| Annual Interest on Debt | 0 | (35,000) | (40,000) | (45,000) | (50,000) |
| Annual Principal Portion | 0 | (35,000) | (40,000) | (45,000) | (50,000) |
| Annual Cash Flow
(NOI minus Debt Service) |
$60,000 | $30,000 | $40,000 | $30,000 | $40,000 |
| Current Balance Owing | 0 | $545,000 | $580,000 | $590,000 | $800,000 |
Step 2: Caleb again concentrates on the mortgage with the lowest loan balance: Second Ave. He continues to make the contracted debt payment, which includes $35,000 towards principal reduction. But his five properties now provide an additional $200,000 of annual cash flow that is applied towards paying off Second Ave’s mortgage. At the End of Year 4 (EOY 4) Second Ave’s balance owing has been paid down to $310,000 ($545,000 minus $35,000 minus $200,000)
Twelve months after that, at the End of Year 5, this property has been paid down another $235,000 (principal portion of that year’s debt service plus that year’s cash flow from the entire portfolio) to $75,000. And it’s totally paid off four months later. Caleb retired both First Ave and Second Ave mortgages in a total of 5 years and 4 months. The first three years were consumed by First Ave, but Second Ave only required an additional 2.33 years. Caleb’s portfolio now looks like this:
End of Year 5.33:
| Address
|
First Ave | Second Ave | Third Ave | Fourth Ave | Fifth Ave |
| Annual NOI | $60,000 | $100,000 | $120,000 | $120,000 | $140,000 |
| Annual Interest on Debt | 0 | 0 | (40,000) | (45,000) | (50,000) |
| Annual Principal Portion | 0 | 0 | (40,000) | (45,000) | (50,000) |
| Annual Cash Flow
(NOI minus Debt Service) |
$60,000 | $100,000 | $40,000 | $30,000 | $40,000 |
| Current Balance Owing | 0 | 0 | $487,000 | $485,000 | $683,500 |
Step 3: Now it’s time to pay off Third Ave. It’s not quite the “lowest”, but it’s close enough. Caleb continues to make the contracted debt payment, with $40,000 going towards the principal. While his five properties provide an additional $270,000 of annual cash flow, there are only 8 months remaining until the EOY 6. In this abbreviated period Caleb can pay only $206,500 towards Third Ave’s debt, bringing the new balance down to $280,500.
The next year (Year 7) sees that $280,500 retired at the rate of just under $26,000 per month. Third Ave is paid off ten months into Year 7 (rounded to End of Year 7). Caleb has paid off three of his five properties in 7 years. The first property took three years; the second took 2.335 years, and the third took just under two years. Eunice has begun kicking tires furiously.
End of Year 7:
| Address
|
First Ave | Second Ave | Third Ave | Fourth Ave | Fifth Ave |
| Annual NOI | $60,000 | $100,000 | $120,000 | $120,000 | $140,000 |
| Annual Interest on Debt | 0 | 0 | 0 | (45,000) | (50,000) |
| Annual Principal Portion | 0 | 0 | 0 | (45,000) | (50,000) |
| Annual Cash Flow
(NOI minus Debt Service) |
$60,000 | $100,000 | $120,000 | $30,000 | $40,000 |
| Current Balance Owing | 0 | 0 | 0 | $395,000 | $583,500 |
Step 4: We’re working on Fourth Ave now. Of the two remaining properties, it has the lower loan balance. Caleb continues to make the contracted debt payment. The principal portion is $45,000 to which he adds the $350,000 annual cash flow. The total principal reduction payment is $395,000 that last year. He only owes $399,000 on the property, so Caleb pays that property off in exactly one year.
End of Year 8:
| Address
|
First Ave | Second Ave | Third Ave | Fourth Ave | Fifth Ave |
| Annual NOI | $60,000 | $100,000 | $120,000 | $120,000 | $140,000 |
| Annual Interest on Debt | 0 | 0 | 0 | 0 | (50,000) |
| Annual Principal Portion | 0 | 0 | 0 | 0 | (50,000) |
| Projected Cash Flow
(NOI minus Debt Service) |
$60,000 | $100,000 | $120,000 | $120,000 | $40,000 |
| Current Balance Owing | 0 | 0 | 0 | 0 | $533,500 |
Step 5: There is only one property remaining: Fifth Ave. The normal mortgage payment provides for $50,000 towards the principal and Caleb adds $440,000 of cash flow, for a total of $490,000. He owes $538,000 so it takes another year and one month to retire the last mortgage Caleb and Eunice have.
End of Year 9 :
| Address
|
First Ave | Second Ave | Third Ave | Fourth Ave | Fifth Ave |
| Annual NOI | $60,000 | $100,000 | $120,000 | $120,000 | $140,000 |
| Annual Interest on Debt | 0 | 0 | 0 | 0 | 0 |
| Annual Principal Portion | 0 | 0 | 0 | 0 | 0 |
| Projected Cash Flow
(NOI minus Debt Service) |
$60,000 | $100,000 | $120,000 | $120,000 | $140,000 |
| Current Balance Owing | 0 | 0 | 0 | 0 | 0 |
Take Away: When Caleb and Eunice began paying off their five properties they generated $160,000 of annual cash flow against a debt of $3,575,000. Caleb and Eunice used the accumulated cash flows to retire their investment debts. About 9 years later the five properties were churning out $540,000 annual cash flow and were mortgage free. Eunice is pleased and expects to resume her mahjong.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional. 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]
If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com