Is it financially intelligent to pay off bank loans on investment property or rentals as fast as possible? Is a 15 year or 30 year amortized loan better? Should your goal be to own all your real estate holdings debt free? For that matter, if you could, would it be better to pay cash for long term holds? Far too many real estate investors answer these questions wrong. In this insightful training, you'll discover when it makes sense to pay off bank loans and when it is actually better to perpetually have bank loans against real property. If you own real estate, this is a must watch training on real estate finance.
Should You Pay Off Bank Loans on Investment Property?
The Concept of Arbitrage
The word arbitrage can come across intimidating to many people, but it shouldn't because you are probably doing it every day. For example, if you hire someone to clean your house or mow your lawn, you would typically pay 10 to 15 dollars an hour. If you are earning 20 to 50 dollars an hour, it makes sense to hire someone else to do he work, because you make more money per an hour doing what you do best, as opposed to what they do best. That is the definition of arbitrage, and financial arbitrage is the idea that you can earn more interest on your money when you invest than the prevailing interest rates for you to borrow money
Paying Cash For a House
I understand that not everyone is capable of purchasing a house in all cash, but for illustration purposes, we will assume this example can. If a house is being sold for $300,00 with a 10% cap rate; this means you would receive a 10% return on your investment after all expenses are paid. Your return on investment would be $30,000 a year, which means you could borrow the money at a 5% interest rate.
The Big Question:
If you can bring in 10% and it costs you 5%, does it make financial sense?
The answer is yes. You do not need to have a degree in calculus or advanced mathematics to understand that this is an example of a 5% arbitrage. You are receiving a 10% return on investment and paying 5% in the form of interest. This is the concept of arbitrage and why it can make sense to have a bank loan when you have a rental property, long term investment property.
You're going to have what's called the NOI, which is your net operating income and that's going to be divided by the purchase price. The NOI is your absolute income cash flow minus any expenses that are acquired when you purchase a piece of real estate, such as: taxes, insurance, maintenance, and management fees. The NOI does not include the cost of the mortgage because in this example you have paid cash for the property.
A Cap rate number is a percentage number, and in this example a 10 cap would be a .10 percentage number. In order to receive a 10 cap on the property with the $300,000 purchase price, the income after expenses would need to be $30,000 a year.
Financial arbitrage is just the beginning of the benefits of bank loans against rental real estate.
If a property sold for $300,000 with a 20% down payment, how long would it take to pay off the $60,000 down payment?
In the original example there was an ROI of $30,000 coming in per year, but now instead of paying cash, we are paying a loan of $240,00 which changes the total amount of income coming in. I did a quick analysis on the Zillow mortgage calculator for a 5% interest rate loan. According to the calculator, about $20,000 a year goes to "debt service", so we would end up with a cash flow of $10,000. Our cash-on-cash return is 10 into 60, but that is still a lot better than our original example.
Bank Loan Benefits
By using a bank loan, you're not only using arbitrage and getting a higher cash-on-cash return; you're also able to purchase more real estate because you're not putting as much cash in. You will also receive the power of depreciation. Depreciation allows you to pay less in income taxes because it's considered an expense. Even though it is not technically an expense taken out of your bank account, it is still considered an expense for tax purposes.
For single family homes the depreciation is 27 1/2 years. To figure out what your depreciation tax cut will be, you take the cost basis, which is the cost to purchase the property minus the land value. But because land doesn't depreciate based on the IRS rules, you divide the purchase price by 27 1/2 years.
If we use the original example, and the value of the land is $60,000, then the cost basis is $240,000 divided by 27 1/2 years. If you round out the number you wind up with $8700. This means that out of the $10,000 cash flow, $8,700 is considered expenses, so you are only paying taxes on $1,300.
On the other hand, if you paid cash for the property and had the $8700 depreciation amount with a $30,000 ROI you will be paying taxes on more money because depreciation is based on the cost basis, so the more money you pay for a property, the more the depreciation would be. A bank loan allows you to pay a deposit separately, which lowers your purchase price, hence lowering your taxes.
Drawbacks of Bank Loans
- Personal Guarantee
The first big problem with a bank loan is the requirement of a "personal guarantee". This means that if something goes wrong, and the loan does not get paid off, you are personally held liable and have to pay.
- Mortgage Length
Loan terms are very important because a low interest rate is what helps make a deal a great deal. There is also the amortization length, which is typically 15-30 years for residential or 15-20 years for commercial real estate. If a lender requires you to agree to a 15 year loan, it could hurt your overall profitability, bcause a 15 year loan would require you to put out a lot of money towards paying the loan off in time.
- Fixed Rate Length
Most commercial lenders offer a 15 year or a 20 year amortized loan, but it's not going to stay fixed for 20 years. It's going to stay fixed for maybe 5 years and then it's going to go back to whatever the prevalent interest rates are at the time 5 years from now. This can be a huge drawback. When you're planning out all of the details, it might make sense for the first 5 years, but then all of a sudden after 5 years you don't know what's going to happen with the interest rates. That's why it's so exciting in the United States, with residential real estate, you can get a 30 year fixed rate loan.
In 30 years your rental rates will probably be a lot higher and some inflation on the dollar will have taken place. That is what makes a fixed rate mortgage, such a great idea, but it comes with some drawbacks.
- Lack of Anonymity
A huge drawback for myself and many others is the lack of anonymity. When you are granted a loan, they want you to personally be the buyer, so it's going to show you as the owner on record. You can try to transfer the property to an LLC after the deal has closed, but then you would be breaking the deed of trust or mortgage due on sell clause. You might get away with it, but it will void your title policy and it's still on public records that at some point you were the owner. There's not much anonymity involved when you receive a bank loan. If you are high profile or do not want people to know what kind of assets you have, bank loans might be a problem.
My 2 Commandments of Bank Loans:
- Number 1: 30% in equity.
Most banks are only going to require a 20% down payment for most investment loans. My first rule of thumb is to not only put 20% down but you must also buy it 10% below value. This 30% in equity is important because if things go wrong and you need to sell the investment property quickly, you can drop the price low enough to get rid of it quickly, but still pay off your bank loan and even make a small profit.
- Number 2: You Need Reserves.
My second commandment is to always have at least four mortgage payments worth of reserves. This saved up money can be used to pay the mortgage payments if something goes wrong. It gives you the time to fix the problem, whether it's that a tenant moved out, the property needs major maintenance, or anything else thrown your way.
Having equity and reserves gives you the ability to take full advantage of the power of a bank loan. It allows you to use the bank loan to your benefit instead of putting yourself in a potential financial bind by trying to use the power of leverage
Benefits to Owning a Rental Property All Cash
- Anonymity When you Buy
If you purchase a property with all cash, you can buyt it with an LLC trust. YOu are able to purchase the property with complete anonymity; which is huge for people that do not want their assets on public record.
If you recently went through a divorce, and have now come into some money, you might not want your ex-spouse to know about it, because then you could end up back in court with changes in your alimony and child support. If for some reason, you want to hide your assets, then purchasing with all cash can be a huge benefit.
- No Interest
When you purchase a house with all cash, you are not paying any interest on the property. Now paying interest, is not a bad thing as long as your cap rate is a lot higher then your interest rate, but if the cap rate is about the same or just slightly higher then your interest rate, there is no benefit to having interest on a home.
Property Ownership Myth When Paying with All Cash
Just because you pay cash on a property, does not mean that you outright own the property. You must pay your property taxes or the government can take your property. Also, if it is in an HOA, Homeowners Association, you have to pay your dues, or they can also take your property. The idea that paying cash for a property means you own it free and clear is a myth. The government owns the property, the HOA owns the property, and you must pay house insurance.
Loan VS Pay Off/Cash
If you can apply a winning arbitrage game on a property with a fixed interest rate, no questions, the loan will always win. But if the cap rate is really high, it can make sense to pay off the loan, even if you're winning the arbitrage game, because there's no other place to put your money to get that high of a return on investment.
If you plan on owning the property for generations to come, but are unable to acquire any sort of fixed rate loan, it might be a good idea to pay all cash, so that you don't have to worry about the cap rates increasing dramatically in the future.
If you need anonymity you have to pay cash upfront to get that anonymity, but either way what you see here is paying off bank loans makes sense when the cap rate's huge.
Creative financing helps combine the best of a bank loan and the best of all cash, so you can have your cake and eat it too. If you do not want to worry about your fixed interest rate becoming an issue in the future, and you want to remain anonymous in the deal, then creative financing is for you. With creative financing, whether it be Subject 2, or owner financing, you can buy the property in whatever entity, LLC trust you'd like.
You also wouldn't have to stake your own personal guarantee on the property, because with owner financing you can structure it so that your entity has the guarantee, not you personally. Creative financing allows you to get the best of both worlds, without all of the hassles and headaches involved. For more information on the subject of creative financing and how to structure creative deals, you can view my video How To Turn a Little Into A Lot Part 2.