Numbers

Inflation: The Great Mortgage Destroyer

May 8, 2016

If there is one thing people don’t have an intuition for, it’s Einstein’s Theory of Relativity.

So you’re telling me that the speed of light is the same no matter what speed I’m going? So if I’m standing still it’s X and if I’m traveling the exact same direction as the light, going X speed myself, somehow the light is still traveling away from me at speed X?

So you’re telling me that time itself changes based on the observer? So if you have two twins, and one leaves earth to travel around the galaxy for a while at the speed of light, when he comes back he is somehow younger than the other twin?

Ya sure … sounds a little fishy to me. But ok, whatever you say Mr. Genius.

If There’s One More Thing People Don’t Have an Intuition For, It Is Compound Interest

In fact, Einstein himself might have pontificated on this (or maybe not).

Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.
-Albert Einstein

Compound interest works both ways whether you are lending or borrowing. Another form of compound interest is inflation – something everyone is affected by whether you know it or not.

How can we get these powerful forces to work for us rather than against us?

I believe the best way is to have a mortgage balance that someone else pays off. Alternatively, people can look on websites such as https://www.housebuyersofamerica.com/how-to-get-out-of-a-mortgage for more information on mortgages. More on that soon.

Inflation Over 30 Years

It is hard to comprehend how inflation destroys the purchasing power of the dollar over a long time horizon. But let me try to put it in perspective.

The rule of 72 is a shorthand way to estimate how long it takes for compound interest to double. You just divide 72 by your interest rate and that is the number of years it will take to double.

If we estimate an inflation rate of 4.8%, then in 15 years the purchasing power is cut in half. In another 15 year it is cut in half again. So in 30 years, things would be 4 times more expensive.

In other words, in 30 years a ticket to Disneyland will be approaching $500! Hopefully your paycheck keeps up over those 30 years as everything else will be more expensive too…

Maybe 4.8% is a little high to forecast for inflation over the next 30 years, but that is a discussion for another day.

Let’s look at a more generally accepted inflation rate of 3% over the course of 15 years. I think 15 years is about as far as people are comfortable projecting – that could be your target retirement, or when your toddler will head off to college.

$1 in 15 Years Has the Purchasing Power of 64 Cents Today

Inflation slowly destroys the value of the dollar. Even at just 3% per year, with a pretty long time horizon and the compounding effect, it is significant.

Or put another way, you would have to invest 64 cents today at 3% interest to get a dollar 15 years from now.

Notice that I’m not using some wacky high inflation numbers or time horizons. Yet when we go through the numbers for a rental property it yields some impressive results.

Fixed Monthly Mortgage Payments

Let’s imagine I purchase a $100k property with 20% down at a 5% interest rate 30 year mortgage. It rents for $1000 a month – pretty much exactly the same as the two properties I currently own.

My monthly principle and interest payments on that mortgage will be $430. The real shocker is it will be the same $430 payment every month for 30 years.

It never goes up! Over time this payment will feel smaller and smaller. Let’s look at some numbers:

In the first year, this principle and interest payment is 43% of the rent collected. Every year inflation will tick up the monthly rent, taxes, insurance, repair expenses, and property management fees. Yet the principle and interest payment stays the same.

After 15 years the monthly rent is $1513. The principle and interest payment is now just 28% of the rent collected!

With every passing year, the mortgage payment is easier and easier to make. And since it is fixed while our rents are rising, you’ll notice in the far right column, our monthly cash flow goes up.

What About the Mortgage Balance?

The mortgage payments are fixed and over time the tenant is paying down the mortgage for you. Your cash flow is going up, the mortgage balance is going down, and the value of the dollar is going down as well.

Let’s look at the numbers year by year:

At the end of year 1, we receive $1,540 in cash flow. But the value of the dollar is 3% less due to inflation, so is equivalent to $1,495 at the beginning of the year.

The tenant has paid down the mortgage balance a little bit for us. It is now at $78,820. But here is the crazy thing – at the end of the year the mortgage balance is also easier to pay thanks to inflation. To help your intuition on this, we can translate that loan balance to what it would feel like at the beginning of year 1: $76,524.

Do this for 15 years and where do we stand?

$1 in 15 years is equal in purchasing power to 64 cents today. Our yearly cash flow has gone all the way up to $4,974 (remember it increases due to the fixed principle and interest payments with rising rents and expenses) – or translated into today’s purchasing power it is $3,193. The purchasing power from the cash flow has more than doubled!

In 15 years the mortgage balance stands at $54,307, which the tenants have been kind enough to pay it down for us. But that $54k doesn’t seem as significant when inflation has raised the prices of everything. Translated into today’s purchasing power, it is equivalent to just $34,858!

Inflation is the Great Mortgage Destroyer

Prices keep rising, the mortgage payment stays the same. The mortgage payment is easier and easier to make and the mortgage balance feels less and less significant. Thus, if you feel like you should look for homes and would opt for a mortgage payment system for it, you could look at lenders similar to a Mortgage Broker Colorado who can help you out!

If you can master the concepts of compound interest and inflation, you can use them to your advantage.

There really aren’t any other opportunities where an average Joe has the ability to borrow money like this and return a cash flow. The fact that you can go get an extremely reasonable rate for an investment mortgage is frankly amazing, whether you get one to purchase a property in your own country or consult with someone like simon conn with a view to buying a property overseas to let to holidaymakers. It is a gift everyone should take advantage of. However, if you are simply a military veteran after an affordable mortgage so you can own your home then it might be worth using this mortgage calculator.

All you have to do is sit tight while the tenant pays down the mortgage for you and inflation does the rest.

What are your thoughts? Do you understand how powerful a mortgage destroyer inflation is? What’s holding you back from taking advantage of it?

If you are interested in playing around with the numbers yourself, here is the spreadsheet I used.

The Thing Most Investors Don’t Understand about Leverage

April 5, 2016

It can be frustrating when people just don’t get it.

Like when someone says they don’t like chocolate. Somehow logic just isn’t going to convince them how awesome it really is.

It’s sad because they will never understand and there is nothing you can do to share that joy with them.

A similar thing happens with leverage in rental property investing.

The Common Man’s Access to Leverage

Banks have all kinds of crazy access to loans. When they invest in something they only have to put up 6% of the price in actual money and borrow the rest.

Try walking into your local Scottrade office and doing that. “I’d like to buy 100 shares of Google. I know the price is $736, but I’ll give you $44 and finance the rest at 1% interest.”

Ya right.

Is it a rigged game? In some ways. But you know where the common man has access to leverage? Real estate investing.

20% down, 100% of the upside

The standard mortgage on a rental property right now is 20% down at a 4.5% interest rate. In fact, if you happen to ask around the jumbo mortgage wholesale lenders circle, they might agree to these statistics.

You get to own an asset by paying only one fifth of the price. Where else are you going to be able to do that?

Even better, it’s not like they require the rest of the money within a year or two. You pay the same amount every month for 30 years!

Since you own the rental, you get all of the upside. The bank doesn’t benefit if the house appreciates, you do.

Appreciation with Leverage

By now you know there are 5 different components that make up the overall return on a rental property.

Most people make the mistake of only focusing on one component and forget about the others. Right now we are just going to consider appreciation, but keep in mind this is just one aspect. Don’t forget the others.

The rentals I purchase are in somewhat boring midwest and southern United States cities. Most years they will appreciate at the rate of inflation – this isn’t a speculative beachfront Miami condo I’m hoping to run up 15% per year (as long as there is a greater fool to purchase it from me).

If the property appreciates 3% and inflation is 3%, did I actually make any money? This is where the leverage comes in.

Let’s Run Some Numbers

Over 15 years, what happens?

If you paid all cash, you won’t make anything on the appreciation in real dollar terms. The house goes up 3% per year, but is exactly canceled out by inflation. Your dollars are worth less. After 15 years at 3% inflation, $1 in year 0 has the same purchasing power as $1.56 in year 15.

If you use leverage? Let’s look at a hypothetical house where you put down 20% for a $100k property.

To keep it simple, we will just look at appreciation and assume you don’t pay down the mortgage at all over those 15 years. So in year 15 your mortgage balance is still $80k. This number will never go up, so this is the worst case scenario.

See What’s Going on Here?

The investment just keeps up with inflation, but since you used leverage, you made $44,637!

Had you paid cash, the appreciation is exactly zero.

This is powerful stuff people. You took 1 of the 5 components of rental property return from $0 to $44,637, just by taking advantage of leverage.

With Great Power Comes Great Responsibility

That’s a Spider-Man quote, but it is true – leverage can provide huge returns even when the house appreciates at the same rate of inflation.

Don’t take this to mean you should buy a Miami condo which “projects” for even more appreciation. Instead look for the most boring, predictable, steady growth markets – you’ll still get a great return without needing to resort to gambling.

How Much is Too Much?

Leverage is a powerful tool that most people are brainwashed into thinking is bad. You now know better – this isn’t credit card debt, it’s strategic leverage.

The lending limits right now are 1:5 ratio for your first 4 investment properties (20% down). For properties 5-10 it is a 1:4 ratio (25% down). Remember banks are gambling at a 1:16 ratio backed by the FDIC and our tax dollars!

But is there a point where even with boring and predictable rentals, you can have too much leverage? Sure.

If you have 10 conservative cash-flowing properties at a 1:3 ratio, I would argue that is not over-leveraged, even if you have a one million dollar loan balance.

The leverage ratio and loan balance is less important to me. What matters more is how predictable the markets are (not gambling on appreciation, which comes with huge crashes) and if there is enough cash flow to provide a comfortable cushion if things don’t go as well as planned.

What are you comfortable with?

How Do You Know When to Refinance Your Investment Properties?

March 17, 2016

Oops, I did it. I upset the internet masses last week.

I asked if it made sense to refinance my investment property in Atlanta to use the money, combined with a little of my own, to purchase a new rental (see Let’s Double Down! Cash Out Refinance on a Rental Property for the analysis).

The reader comments include “I would not refinance for a measly 17k” and “I would be very concerned about needing to borrow $15k to make a purchase”.

Both true. Valid points. I asked for opinions and that’s what I got.

However this isn’t where the analysis ends. Let’s dig a little bit deeper.

Reviewing Investment Property Refinance Basics

Imagine a property with a $45k mortgage that is worth $100k. It has $55k of equity, or 55%.

The return on investment doesn’t really change if I have 20%, 55%, or 85% equity. Either way it has the same cash flow and appreciation benefit.

A cash out refinance is basically starting a brand new mortgage with only 25% equity. There is a fee to do the refinance and you get the difference in cash.

For the example with $55k in equity on a $100k house, the new mortgage balance would be $25k. If the fee is $3k, you would get to pocket $27k. Untaxed. Lump sum.

This is why it is important for people to do their research into mortgage refinancing from websites like sebastianfriedman.com so that they are equipped to move onto this stage at the right time to align correctly with their finances. That said, besides gaining knowledge regarding mortgage refinancing from websites, it would also be a good idea to talk to a certified mortgage broker who might have more in-depth knowledge regarding the same. Wondering how to find them? For instance, if you are from Etobicoke, Canada, then looking up keywords like CMB Etobicoke on the Web can help you find them easily.

The Power of the Cash Out Refi

The cash out refinance can be a powerful way to more quickly build up your portfolio of rentals. You can take that $27k and use it as a down payment on a new investment property.

Just like that, Property 1 clones itself and creates Property 2. Then seven years down the line, after slowly building equity, perhaps you do it again: Property 1 clones itself and creates Property 3. Property 2 clones itself and creates Property 4.

Same initial investment, but after 7 years it has turned into four properties!

The Patient Alternative Approach

Rather than doing a cash out refinance, you can certainly leave the equity in the house. Once the equity gets to 100%, you no longer have a mortgage to pay and the cash flow is much greater.

If you want to buy more rental properties with this approach, you have to do it the old fashioned way – save your money for a down payment!

There’s nothing wrong with this approach, but it will take much much longer to get to 4 properties (or whatever number of rentals you are shooting for).

More importantly, it will also take much longer to hit whatever cash flow goal you have to be financially independent.

Viewing My Rental Properties as a Portfolio

I want to go about rental property investing as would a portfolio manager. All proceeds are reinvested to grow the portfolio. I also contribute an additional $1000 a month to save up for more investments.

The goal is to optimize the portfolio so it makes the most money in the long-run. How do I do it?

I actually sat down and ran some numbers over 10 years.

Here is the complete spreadsheet with all the calculations. Disclaimer: this is a rough model

The Inputs

Start with my portfolio now (a property in Atlanta purchased in 2011 and a property in Memphis purchased in 2014) and $10k in cash. Contribute $1k per month to the portfolio for the first 5 years. Assume the cash flow from each property is $167 per month, principle pay down is $100 per month, and appreciation is 3% per year.

Each new property purchased will be 20% down for a $100k property. With $3k in closing costs and $2k added to cash reserves for unexpected repairs, let’s assume each new property requires $25k in cash. A refinance will cost $3k.

The calculations also won’t go beyond 10 properties (although the spreadsheet includes notes when additional properties can be added).

The Scenarios

Even though the model isn’t perfect, it should help compare different strategies – the relative numbers is what matters, not that it is a perfect calculation.

Scenario 1: Never Refinance

This approach is to just use the cash flow and $1k per month contribution to build the portfolio.

Scenario 2: Refinance only for a full property

This approach is to wait until a property has enough equity built up that it can be used to purchase a complete new property. With the assumptions, it takes 53% equity in order to get the $28k required ($20k down payment, $6k fees for refi + new mortgage, $2k in reserves). It takes almost 8 years to build up that much equity.

Scenario 3: Refinance now and for a full property

This is the approach I was asking about in last week’s article. Refinance now when Property 1 is at 44% equity, then from now on, wait until each property has 53% equity to refinance.

Scenario 4: Refinance aggressively at 40% equity

Rather than waiting to get to 53% equity, what if I refinanced every time a property reached 40% equity? With the given assumptions, it takes just under 6 years to get to the refinance rather than 8.

The Results

It should come as no surprise that doing cash out refinances will significantly improve the results.

Scenario 1: Never Refinance

Purchase 5th property after 3 years 8 months
Will have 9 properties after 10 years
After 10 years, the portfolio value is $434,750

Scenario 2: Refinance only for a full property

Purchase 5th property after 2 years 5 months
Purchase 10th property after 7 years 5 months
After 10 years and stopping at 10 properties, the portfolio value is $509,067
Could purchase another 5 properties if I wanted, or put $53,667 in cash to work in another way

Scenario 3: Refinance now and for a full property

Purchase 5th property after 2 years 9 months
Purchase 10th property after 6 years 10 months
After 10 years and stopping at 10 properties, the portfolio value is $505,217
Could purchase another 4 properties if I wanted, or put $70,167 in cash to work in another way

Scenario 4: Refinance aggressively at 40% equity

Purchase 5th property after 2 years 9 months
Purchase 10th property after 5 years 10 months
After 10 years and stopping at 10 properties, the portfolio value is $542,950
Could purchase another 7 properties if I wanted, or put $97,300 in cash to work in another way

Interpreting the Data

It should come as no surprise that doing cash out refinances will drastically improve the results over 10 years.

The ending portfolio value is very similar in Scenario 2 and 3. The only difference between those scenarios is whether or not to refinance Property 1 now, so perhaps it doesn’t matter either way.

However, if I were to continually refinance at 40% equity, it would lead to a substantially better result. This jump is comparable to the jump from not refinancing at all to refinancing at 53% equity.

So in conclusion…

I still don’t know that there is a conclusion yet.

If I have a set number of properties I would like to get to, it is a good idea to refinance aggressively.

If I want to keep adding properties past 10, it is a good idea to refinance aggressively.

If using this for an actual long term plan, I would have to build a more complex model and possibly look to get more info about software that could help me with scenario analysis. We can draw some simple conclusions from the data above, but shouldn’t read too far into it.

Also, with new blockchain companies (if unclear, check what is a block chain company) introducing tools for new market overviews, neighbourhood insights, property analysis, I do have other options to consider. It’s nice to have choices. Let’s see.

What do you think?

Are these results surprising?

Does it change your opinion of refinancing now?

Let’s Double Down! Cash Out Refinance on a Rental Property

March 10, 2016

Vegas baby! I avoid gambling in risky investments outside of my control, but have you ever played blackjack? Or roulette on a gambling website for that matter?

The thrill when you push all your chips in and get an 11 against the dealer’s 7. You gotta double down!

When you double down, you are betting more of your own money – it would be so much better if your chips just multiplied on their own. Or split like a cell and all of a sudden you had two identical copies. [Mitosis for you science nerds out there]

Did you know rental properties can clone themselves?

Silently Building Equity

For four and a half years I have been cashing rent checks and paying expenses for my Atlanta property. Well, I guess my property manager does most the work – but I read the reports and keep an eye on things!

I’m definitely aware of the cash added to my bank account every month, as well as the tax benefits at the end of the year. Combined they are a cool $7,627 – averaging $1,700 a year from this one property.

This whole time equity has been secretly building without any effort required! Most investors don’t realize the 5 Components of Rental Property Return.

Every year the tenant has been slowly paying down the mortgage for me (1.5% to 2% a year in the first several years of a 30 year mortgage). And the property has appreciated 30% (better than the expected 15%, pretty much due to lucky timing).

When I purchased the property I only had 20% equity. Fast forward four and a half years and I now have 42% equity.

Put Your Money to Work

If you haven’t noticed yet, the focus of this entire website is how to make your money work for you. Passive income. Rental properties.

Equity is a nice cushion, but it doesn’t earn any additional money. Whether my equity is 20% or 75%, the rent is still the same.

The expenses are pretty much the same, such as basic maintenance costs, repairs, some new installations such as chain link fences in Edmonton (or another location), advanced gate systems or CCTV for increased security.

There is something we can do to put that equity to work…

The Cash Out Refinance

You can refinance an investment property up to 75% of the loan value. Basically trading that equity for cash.

That cash is not taxed – it’s already your money, you are just accessing it.

Doubling Down – When A Rental Property Clones Itself

You can take that lump sum of cash and plow it directly into another investment property. You still own the original and will now have another that is producing cash flow, tax benefits, and building equity. Double your pleasure, double your fun!

Pay attention, this is where the compound returns come in. My rental property 1 will clone itself and purchase rental property 3. It won’t require me to save another $20k for a down payment.

Can you imagine if every property cloned itself after 5 to 8 years? Boom!

Any Downsides?

Yes, of course. Most obvious – you have to pay to do it. In my case, the estimate is $3,200.

You will also have a larger loan, likely with a larger payment depending on the interest rates. If you are at a point where you have enough loans and want to start paying them down, a cash out refinance might not be right for you.

You are resetting the 30 year repayment schedule, so if you want to live off the cash flow of your rentals soon, a cash out refinance might not be right for you.

If you are young and still building up your portfolio, go for it!

A Closer Look at My Decision

Let’s examine the details and see if it makes sense for me to do right now.

The current mortgage is at 5.5% and has a balance of $60,655. The monthly payments of principle and interest are $370.

The new mortgage would be at 4.625%. If the property appraises at $105k, the mortgage will be for $78,750 with monthly payments of principle and interest of $405.

Thanks to the interest rate going down, the increase in monthly payments is just $35. It will hurt the cash flow numbers for this property, but the gains in cash flow from a new property will be at least $150 a month.

So it makes sense from a straight cash flow perspective. When you look at the other components of rental property return (appreciation, paying down mortgage, taxes) it becomes a home run.

Feels a Little Tight Though…

Refinancing this loan would be a gain of $18,200. But it will also cost $3,200 to do. So the net is $15k that I can use to purchase another property. I would have to contribute another $6-8k to get a property in my preferred price range.

This is also largely dependent upon the appraisal of the property. If it appraises at $98k I will only pocket $13k. If it appraises at $113k I will pocket $17k.

At what appraisal number does this no longer make sense?

Now or Later?

Now:

Double down sooner to have twice as many properties providing cash flow and building equity
Lock in the low interest rate now in case things change (unlikely, but even a .1% change is $5 more a month)

Later:

Let the property build more equity so when I take it out, the fee isn’t as significant a portion

What do you think, what should I do?

Photo: Images Money