Investors: Never Pay Off Your Mortgage.
I work with a lot of new real estate investors who want to get the most out of their hand-earned dollar by putting it to work for them in the lucrative income real estate market. Great idea! One thing I often hear though, is that these novice investors are keen to pay off their mortgage as soon as possible and run their realty portfolio ‘debt free’. Not such a great idea.
Surprised? You shouldn’t be if you’ve been a reader of the Monday Morning Memo for long. The concept here hearkens back to my 2009 article on leverage and is built around the same principle.
Here goes:
As you can see from the handy ‘Current Rates’ table published weekly in the MMM, the current lending rate for a variable mortgage is 1.95%. That means that on the financed portion of your investment (the part the bank lent you, also known as the mortgage), you would be paying an annual premium of 1.95%, and on the portion you put in, you would owe no interest. Simple right?
What it doesn’t tell you is that the market appreciation of your capital asset (rate at which the value of your home increases) is likely taking place at 5% or more per year in our market. Let’s analyze what this means for an investor with $200,000 of investable capital, by looking at two different scenarios (you can use whatever numbers you want; the theory holds true):
We invest the $200,000 in ONE triplex at St. Clair and Bathurst, at a purchase price of $500,000. Sweet! The mortgage therefore has a present value at closing of $300,000, which means your mortgage payments are around $990/mo at 2% on a 35 year amortization. We shall also say that the property makes $3,000 / month in income.
That means a total mortgage expense of $11,880 in the first year and a gross income of $36,000. Note: because your asset is appreciating at 5% per year in our scenario, you have also gained $25,000 dollars of wealth from the increased value of the building. For simplicity’s sake, we shall say you have therefore grossed $49,120 this year. Awesome! But I wonder if we can do any better?
Let’s try investing our same $200,000 into TWO similar triplexes in the same neighbourhood instead – with half of our funds going toward each. Note: this effectively means you will have LESS of your mortgage paid off on each property in your portfolio, contrary to the paying-off-the-mortgage ‘debt free’ approach. We now will have two $400,000 mortgages, for a total mortgage expense of around $31,680 in the first year. Ouch! But let’s keep going….
We know these buildings make $36,000 in rental income per year each, so with two buildings, we can expect $72,000. But also – and here is where the magic happens – we are holding $1 MILLION in assets versus the $500,000 in the previous example. At 5% appreciation, our two St. Clair and Bathurst triplexes can be expected to earn us $50,000 of unrealized capital appreciation this year.
When you add it all up, we see a return on the same amount of invested capital of $90,320. We nearly doubled the amount of return! In theory, therefore, you would benefit by refinancing your properties every time you’d paid down $100,000 of your mortgages and pulling that money out to by another triplex. And so go the astounding income possibilities of real estate.
One should take note that this does not always work out so nicely. For one thing, the lending rate plays a strong role in the functioning of the leverage mechanism, as does the market appreciation of the property. If the appreciation winds up being less than the lending rate, then your leveraged money starts to work against you to some degree. Not good! This is why it is always important to analyze the investment carefully and buy at a time and place where you believe you stand the best chance of using leverage to your advantage.
Want to learn more? Call me – I’m here to help. Oh – and if you’re wondering about buying a triplex or two as above… it’s one of the best and easiest ways to get started in real estate investment, and I highly recommend it. Let’s chat.
Until next time,
Shaun Nilsson
1-888-712-7888
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@ January 19, 2010 at 1:50 pm
Jake says:
Ahh I get it