To Keep Or Not To Keep - Equity In Investment Properties?
I think I have heard that an investors should not keep massive equity in rental homes. I disagree with my parents who are a "pay cash" and when you don't, only take a "10 year mortgage" on rent property. Is this the way to go? I think you should mortgage every property to the maximum until you have a specific goal amount in the bank, (let's say 100K) and then maybe start holding equity and trying to keep your mortgage payments low. Anyone else have any ideas?
Mortgage= leverage and higher potential for high yield (at the cost of more risk). Able to invest in many properties and take advantage of appreciation and tax benefits. Income is reduced by mortgage payments.
Cash= lower potential for high yields (at least in % terms) and lower risk. Also cannot invest in many properties. Rent is your income and repair budget, no mortgage payment. Less tax benefits.
My choice would be mortgage. Put down as little as you can and still get a positive income flow on the property. My bank will give me a 85% LTV at 6% with about 2-3 K in closing costs. Watch out for high LTV loans and closing costs. I was quoted 5-6K closing costs on a 95% LTV. As far as I am concerned closing costs are wasted money as you have to pay someone else extra to use their money.
The answer is simple- you need a crystal ball.
If you don't expect any appreciation in your area, then the tenant's rental payments will go to pay your mortgages and you will not have any cash flow or appreciation. Paper depreciation would offset up to $25,000 per year in your JOB income, providing you don't have an extremely high paying job. If you don't want to count on any appreciation, pay cash. Just realize that if property values go up, you missed a big opportunity by not having any leverage.
If you think your area is going to appreciate, then use loans. The leverage will magnify your return.
Don't leverage to the point where you can't make your payments if rents drop 20% in your area, as they recently have in the interior of the U.S.
The long standing loan to value that banks like for apartments is 70%.
clevincc,
You are correct in stating that closing costs are a waste of money. I don't like charging them to clients, but it costs money to get money. In your example of 85%LTV with $2-3K in closing costs vs. 95% LTV with $5-6K in closing costs. If you used the extra 10% saved from the 95% LTV and used it to buy two more properties you would make a better “cash on cash” return basis. Sure your closings costs are higher initially, but your returns by owning the additional properties will pay for the difference several times over the difference. This does not give you the right to go out and buy properties just to make $50-$100 a month profit. If you are going to buy a property, make it worth your time.
Phil
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[ Edited by Pherrejon on Date 12/10/2003 ]
I like to think of equity in a property as a no interest, savings account. Of course there is a certain peace-of-mind in knowing the money is there and a nice bufffer if expenses\rental decreases hit but this cash is completly non-performing. As an investor, I'm out to make the most of my money. Loans are cheap right now and any money I can invest in real estate will net me much more than interest and loan fees.
Just my 2 cents.
cygnus
It all depends on your personal goals.
Years ago when I was a tax accountant, I had several clients that retired young on just a handful of rentals that they owned free and clear.
They weren't dependent on appreciation, interest rates or even the rental market as they never raised the rents for existing tenants and therefore usually kept them for a long time.
That is probably the way your parents are thinking.
[addsig]
I like to ask see how much equity I can take from each property without causing a to much of a mortgage increase. As long as my rental income on each property STILL covers all the costs involved with that property. Than I will take that equity out. If you have 5-10 investment properties and they have been purchased every 3-5 months apart. In time you can live off the borrowed equity without causing the rental property any harm (if you had a good cash flow prior) meaning....money out of pocket to pay back the equity loan.
Most of my property has good cash flow where I can afford to take out a little equity every so many years and my renters pay that for me (the $1200.00 a month rent check covers both loans!!!)
Again, loaned money is tax free. Just do the math on each property you own to see if it will work.
It boils down to your personal Risk tollerance and the opportunity cost of dumping money into a mortgage. That's it. If It's going to go to a savings account instead of your mortgage, by all means, pay down your mortgage. If you're comfortable with highly leveraged properties, and you can take the same money and use it to buy another highly leveraged property and you realize the risks (ie, you could loose everything if market rents drop by, say, $80 per unit....which happens) then run out and buy another.
I think high leverage is good when you're beginning RE. It gets you into properties, gaining both equity and experience. Once you're Making good money, and have more to loose, I'd probably try to maintain lower LTV's (say 40-60% rather than 75-90%).
I have recently done spread sheet calculations using various investment strategies under various appreciation on other economic conditions. With gross monthly income at 1%, expenses at 25% of gross income, the long range result favors leverage investing over all cash buying even with no appreciation. All leveraged investing was 80% LTV at 7% fully amortized over 30 years. With appreciation at 5% per year (close to national average) the performance differences are very dramatic. By the way, all of the investments resulted in positive cash flow.
Hope this helps.
Regards,
Ed