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SHOW NOTES FOR EPISODE 560: DON’T FORGET THE PRINCIPAL PAYDOWN
As we say in every podcast episode of the Old Dawg’s REI Network, “Cash flow is King!” But we don’t just buy for cash flow. We buy in emerging markets where prices are going up. In today’s podcast, Bill looks at the benefits of buying for both cash flow and equity on all your rental properties.
Tip of the Week – Just do it!
- The McKissacks in Texas
- Linda McKissack was a guest on the Old Dawg’s REI Network: 143: From $600,000 in Debt to Real Estate Mogul
- Owned a restaurant and nightclub
- Lost the business
- $600,000 in debt
- They became real estate agents and did very well
- They wanted to save but had difficulty
- People encouraged them to invest in real estate as their “forced savings” account
- Had a plan to buy a property a year
- They set specific criteria
- 20% down
- Had to be 10% below market value
- Had to produce $200 cash flow minimum
- They ended up buying more than just one property a year
- Today they have:
- 100 single family homes
- 16 vacation rentals
- A commercial ranch
- Multifamily properties
- 6 commercial buildings
- Linda said her biggest mistake was that she didn’t start investing in real estate sooner
Don’t Forget Principal Paydown
As we say in every podcast episode of the Old Dawg’s REI Network, “Cash flow is King!” And that we believe is the major focus of our investment efforts. However, we don’t always just buy for cashflow. We also buy in emerging markets where real estate prices are going up and, with that (rents are increasing as well – which helps cash flow).
But, one of the key reasons we buy in emerging markets is that we also want our properties to increase in value. Value goes up, equity goes up, leverage opportunities increase and your net worth increases as well. I, personally, would rather invest in a property that has both benefits – cashflow and increasing equity.
However, with housing prices skyrocketing as they currently are, it’s understandable that many real estate investors are fixated on price appreciation over everything else. That’s why flippers are having such a hay day right now!
Both cashflow and equity are advantages of real estate, of course, but the price appreciation we are seeing today is an aberration. Cashflow should be a standard that you can always depend on.
Historically speaking, house appreciation has been just slightly higher than inflation. This is nice and when you add in leverage, it’s even nicer (four percent appreciation on a property with an 80 percent loan turns into a 20 percent gain). While there’s no way to predict when the housing market will cool off, correct or even collapse, we can say for certain that the 10 to 15 percent annual price appreciation rates we have been seeing will not last forever.
As far as cashflow goes, with houses in particular, you need to make sure you buy right. Because, you may make $200/month in cashflow, but then, you have a bad move out and turnover and you could lose all of that profit. Capital improvements such as replacing the roof, HVAC, siding, etc. can also eat up a lot of your cashflow it you don’t have a good cash reserve fund to cover those things.
But don’t feel disheartened.
I am still convinced that real estate is still the best way for someone of modest means to become independently wealthy. But it’s through all the advantages of real estate that people gain wealth, not just appreciation and not just cashflow. This includes things such as the tax advantages you get from depreciation, mortgage interest and other deductions, as well as the ability to use leverage while also being able to buy undervalued properties — because real estate is an inefficient market.
But one advantage that gets way too little attention is principal paydown.
The Power of Principal Paydown
As a good friend and fellow apartment syndicator Joe Fairless emphasizes, there are “Three Immutable Laws” of real estate investing:
- Buy for cashflow[i.e., do not speculate on assets that will eat up cash]
- Secure long-term, low-leveraged debt[lower interest rate than private money PLUS principal paydown]
- Have adequate cash reserves.[i.e., save for a rainy day and have the flexibility to jump on opportunities quickly]
The first law isn’t as much about making so much through cashflow that you become rich. It’s mostly about making sure the asset is sustainable, doesn’t eat away at your cash reserves (Law 3) and can sell at its top in the market price. But when you add Law 1 to Law 2 (cashflow, plus principal paydown) your return is substantially more than just the cash coming in.
This is because each bank loan is amortized. You pay both interest and principal each month. And each payment going to the principal reduces the amount of debt attached to the property.
While this doesn’t come back to you as hard cash, it does increase your net worth. And any real estate investor knows that a key number to look at is net worth.
To illustrate this point, I performed a simple calculation to show what the internal rate of return would be with just principal paydown. (Internal rate of return or IRR is superior to a simple Return on Investment or ROI because it accounts for WHEN money is received; earlier is better.)
Of course, this is not actually a “return” since there’s no cash here, just equity. But the point should suffice. Here are the assumptions:
- Purchase Price: $100,000
- Down Payment: $20,000
- Loan: $80,000
- Amortization: 20 Years
- Net Cash Flow: $0
- Appreciation: 0%
The last assumption is borderline ludicrous. Of course you shouldn’t even buy it if it doesn’t have cash flow. Also, during the last 20 years, only one of the 500 biggest cities in the United States has failed to appreciate in value (Flint, MI). And the 2008 Housing Crisis occurred during that time.
Even still, if you were simply to hold a property with a 20-year loan for the entire 20 years with no cash flow (the rent paying only for all property-related expenses) and no appreciation, the rate of return is pretty good. Using the CCIM Financial Calculator,(I’ll have a link in the show notes, we see the following:
7.18 percent may not sound incredible, but it’s not bad at all. Indeed, as Nerd Wallet reports, the average return in the stock market is just 10 percent. So the stock market barely beats principal paydown with none of the other real estate-related advantages!
There are some caveats here. For one, early in a loan, most of the payment goes to interest and then, as you , deeper into the loan, it switches and most of each payment goes to the principal. I have a graph in the show notes that illustrates this. This example illustrates the point:
Therefore, if you pay off the loan early, the IRR will be less. In addition, if the loan is a 30-year amortization as many are, the IRR will be less too (although the cashflow will be higher).
But remember, this is a 7.18 percent return with no cashflow, no appreciation, no tax benefits and settling to buy at market prices. Add those other benefits in and the rate of return goes up and up significantly.
If you can find a good off-market, below market deal, a good interest rate and buy it in the RIGHT market (which, by the way many investors are still doing), you will see
I mean, great investors like Warren Buffet, Peter Lynch, Peter Teal, Jacob Astor, and Benjamin Graham go by the philosophy where Time IN the market beats TIMING the market
The power of principal paydown is another reason why maybe it’s not such a good idea to sit on the sidelines and wait for a correction just because you think (rightly or wrongly) the market is near its peak. Sure, it’s important to be careful in a hot market like this one. And sure, I, personally tend to lean more toward the conservative approach, which in today’s market means not to buy at all. But there are so many advantages to real estate outside of appreciation (principal paydown being one of them and the least discussed) that maybe (I’m talking to myself here) you shouldn’t just twiddle your thumbs and wait for a crash that may or may not come at a time no one can really predict.
Well, that’s the show for today!
References:
https://thinkrealty.com/principal-paydown/
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