So if I’m right the case you’re making is that if you take on $150/mth more in debt because of your $25k refi you can offset that by a rent increase of $150/mth on that property. That’s not being realistic. If you have a tenant paying $500/mth and you suddenly tell them rent is now going to be $650, a 30% increase, rest assured you’ll have a vacancy. Maybe I’m missing something here, if I am please tell me.
Propertymanager, are you going to chime in on this debate?!?!
I have ten properties with a positive cash flow. I am only refinancing one which adds $150 per month to my debt service. In the year that I refinance, just a nominal $25 rent increase in each property still adds $100 to my monthly cash flow after the $150 monthly increase in debt service.
I respect your right to your opinion. I don’t know what you have against gurus. If this system was created by a guru does that automatically make it invalid?
The “system” creates equity faster than debt. The system increases cash flow faster than debt service. I get an extra $25K in tax free cash each year to invest or spend as I see fit.
Please poke holes in the system, please show me how this is a recipe for disaster. So far, I don’t see it.
Propertymanager, are you going to chime in on this debate?!?!
Jbaldwin,
Yes. I think you are absolutely right about the rent increases. As I’ve said many times before, the “automatic” annual rent increases that the gurus talk about is simply BS. :bs Rents go up, down, and stay the same depending on the market conditions. As we have seen from many posts on the subject, many markets are now experiencing decreasing rents due to an abundance of homeowners who can’t sell and are therefore renting their property at ridiculously low rents (because they don’t understand operating expenses and are just trying to cover their mortgage payment).
In addition, the rents MUST go up over time just to keep the cash flow even, because expenses are almost always going UP! So, I’m not a big believer in this "make more money by raising the rents “theory”. Of course, you can improve the cash flow when you buy a building with below market rents and then you bring them up to market, but that’s a different story and not what we’re talking about here.
On the other hand, what Dave T is describing is certainly doable and realistic. You can refi a property every 10 years or so and reclaim some of your equity in the form of a tax free loan. Remember, you not only have any appreciation over that time, but you also have the principal paydown that has occurred. Of course, in doing so, you’re lowering your net worth (assuming you spend the money) and you’re incurring the debt. The key to doing this is to always maintain a level of equity (say 30% or so) in the property and to ensure that you have a positive cash flow after the refi. If you keep the 30% equity and have a positive cash flow, you’re still in a very safe position.
Personally, I’m hoping to pay off my rentals in the next 15-20 years (my loans are mostly 20 year terms) and enjoy the additional income. However, either plan is viable.
Mike
Mike,
Jbaldwin said that I would have a vacancy if I tried to impose a $150 rent increase. Yes, both you and he are right about that, but what Jbaldwin did not seem to understand is that this strategy is not designed for a single property portfolio. Over ten properties, a nominal rent increase in each property more than covers the extra $150 in new debt service. I have not had a tenant move out yet over a nominal rent increase even in a soft rental market.
Automatic rental increases do work for all my occupied units, even if the increase is just $10 on a $500 monthly rent. I always increase rents. I reinforce the tenants expectation that there will be rent increase with the annual lease renewal and I don’t disappoint them. My properties rent for $825 to $1130 per month, so a nominal rent increase for me is $25 per month on the annual renewal.
If you are only talking about turnover rents, then yes I agree with you. When you are trying to fill a vacancy, you have to set the rent at whatever the current market will bear – even if that means accepting less rent than your previous tenant paid. Turnovers are not unavoidable, but there are proactive things you can do to reduce your vacancy/turnover rate. Keep your tenants happy and they will gladly accept a nominal rent increase each year. Also, when I am filling a vacancy, I deliberately price my rents below the market top, so even with a nominal rent increase, my tenants are usually paying less rent than comparable units on the market.
Again, I emphasize that my scenario is premised on a ten property rental portfolio. Over the long run, you won’t have a turnover in every unit every year. In my oldest rental market, where I have half of my rental properties, I average a turnover every three years. Yes, every three years I may have to adjust the turnover rent to reflect market conditions, but once filled, I can usually get a nominal rent increase for the next three years, more in strong rental markets. I find that a good size rental portfolio tends to stabilize my rental income so filling a vacancy with a little lower rent than I had been receiving is mitigated by the rent increases I did get for all my lease renewals.
I agree with you that minimal rental increases tend to offset increases in ownership and operating costs so that your cash flow tends to stay the same year over year. I am just pointing out that there is a way to get an extra $25K in tax free cash out of a 10 property rental portfolio every year without sacrificing cash flow.
Having a free and clear rental portfolio is an achievable goal. Buy a cash flowing property, your tenants rent pay the mortgage, and in 20 years (30 in my case) I own the property free and clear.
Let’s use your 2% rule for a $50K property, bought with $40K financing at around 6% fixed for 20 years. Lets say that this property is purchased at retail and is move in ready (no rehab needed) just to simplify the illustration. As I understand your 2% rule, this property should gross $1000 per month. You will spend 50% on ownership and operating expenses and another 25% on debt service, leaving $250 per month for our cash flow.
Let’s also ignore closing costs and just use your $10K downpayment as your initial investment. On the day you purchase, you have just $10K equity in this property, With a $3000 annual cash flow, the return on your investment is 30%. If you agree that over time, annual rent increases are offset by inflationary increases in your operating costs, then you should expect your cash flow to remain roughly the same over the life of your loan. Once the loan is paid off and your debt service goes away, your monthly recurring cash flow becomes $500 per month.
In the end of 20 years of ownership, at an average 7% rate of appreciation, your $50K property will be worth $193,484. If this is the end of the discussion, we would all agree that you have made a good investment, turning $10K out of your pocket into $193,484 in 20 years.
With the mortgage paid off, your annual income from this property is $6000 per year. If you repeat this nine more times, you have a rental portfolio of ten free and clear properties worth nearly $2 million, generating $60K in free cash flow per year, and for which you only paid $100K out of pocket.
For many rental property investors, this is the end goal, and it is an admirable one at that. A certain amount of free and clear properties in my own rental portfolio is in my own long range financial plan.
You don’t have to work at all and you still have a $60K income to support your lifestyle. My concern with stopping here is that your money is not working an efficiently as it could be. The $60K income you get from your $2 million rental portfolio is just a 3% return on your equity. A $2 million stock portfolio with an average yield of just 8% would generate $160K in annual income.
Real estate and the leverage possible with financing is an inexpensive way to accumulate great wealth, hands down. I am just planting the seed, that maybe free and clear property is not the most productive vehicle to generate income. Once you have this free and clear real estate portfolio, you probably don’t want to sell all your rental properties to invest the entire nestegg in the stock market, so why not leverage a portion of your equity to invest in higher yielding assets?
Dave,
I agree with everything you said. Another consideration against holding paid-off rentals is that you are more of a target for lawsuits. It’s all a trade-off and a person just needs to decide what is best for their personal tastes. I don’t have a strong opinion one way or the other on this subject. As I said, my biggest concern would be after each refi, that I still had significant equity and positive cash flow (which is what I believe you are saying also).
Mike
How about this one? You purchase say one property each year and try like hell to pay them off in 15 yrs. Let’s assume you manage to pay off 5 properties after 15 yrs. If they’re worth $200,000 each. You can refinance them at 50% LTV and have $500,000 tax free cash and still have very good cash flow. You can even use the extra cash flow to accelerate the payoff of the other properties. Then keep doing the same thing or reinvest the money into more properties. There sems to be a lot ways to use rental properties as a way of retirement and college education costs. I do like the idea of taking out $500,000 tax free. Does this sound too good to be true? It seems legal and very doable to me. Any thoughts?
Well, I suppose if you start with a $67500 property and get an average 7% annual appreciation, your property will be worth $200K at the end of 15 years.
If you paid $67500 and used 80% financiing at 6% fixed for 30 years, just adding an extra $132 per month to the mortgage payment will retire your $54K loan in 15 years.
Certainly doable, absolutely legal.
Can you do it for five properties all at the same time, all acquired at the same time? Perhaps, provided you have the excess cash flow or other discretionary income to apply to debt reduction. `
The question to answer is whether your properties will still generate a positive cash flow when you are making an extra $132 principal payment. If your properties will still cash flow if you do this for one property, will they still cash flow if you do this for five properties?
If the answer to this question is yes, then you have to look at the new debt service from refinancing. The monthly loan payment to retire your old loan in 15 years is $455. If you refinance one of your properties for $100K, your new debt service will be $600 per month – another $145 higher than before. Will your properties still generate a positive cash flow with this new debt service? How about if you are refinancing five properties and adding another $725 per month to your old debt service? Will you still cash flow?
Absolutely legal. Doable for one property, probably. Doable for five properties, perhaps, but you have to run the numbers to tell.
The strategy that we have with our apartment complex is that at the time that the depreciation expense will no longer shelter your tax flow, you 1031 into a larger property(of multiple properties). This starts you over again with a larger depreciation schedule and eventually higher cash flow. Theoretically you can do this over and over and over. The taxes only start to catch you when you quit, and especially if you sell the last property without moving into something new, because your tax basis in it will be near zero, so you pay the capital gains rate on almost the entire value.
DB
There may be a flaw in your strategy concerning your assumption about the depreciation basis of your 1031 exchange replacement property. Let’s say you purchased a property quite some time ago for $100K. The value of the land at the time of your purchase was $20K, which left you a depreciation basis of $80K. During your holding period, you made no capital improvements and you have depreciated the property fully, making your adjusted cost basis in this property equal to the land value – $20K.
Also, during this period of time, your property has appreciated to $400K. You decide to do a delayed 1031 exchange into a property also worth $400K. Because your replacement property is at least equal in value to your relinquished property, there is no income tax consequence.
As a result of your exchange, however, the cost basis in your replacement property is still $20K, which is allocated to the cost basis for the land under your replacement property. You have no new basis in the replacement property to depreciate.
If instead, your replacement property had an acquisition cost of $500K, then you have $100K in new basis (minus the portion of your new basis allocated to the land value) to depreciate over 27.5 years.
If you did the exchange while you still had some time remaining on the relinquished property depreciation schedule, then your adjusted depreciation basis becomes the depreciation basis for the replacement property which is depreciated over the remaining life of the original depreciation schedule. Only new basis created by trading up is depreciated on a new 27.5 year depreciation schedule.
For example. Let’s say you have a property with $25K in depreciation basis still left on the relinquished property and 9 years still left before the property is fully depreciated. You sell the relinquished property for $150K and purchase a replacement property for $200K. To keep things simple, lets assume that the cost basis for the land is equal for both properties. Because your basis in the old property becomes the basis for the replacement property, the $25K in depreciation basis you still had in the old property becomes the depreciation basis for the new property and it is still depreciated over the 9 years you still had remaining in the original depreciation schedule. Since you did add $50K in new basis to the replacement property, you can depreciate that $50K separately on a new 27.5 year depreciation schedule.
Please consult your tax advisor for specific details.
The taxes only start to catch you when you quit, and especially if you sell the last property without moving into something new, because your tax basis in it will be near zero, so you pay the capital gains rate on almost the entire value.
If you do have a taxable sale, the portion of your capital gain that is due to depreciation is taxed at 25%. The portion of your capital gain due to appreciation is taxed at the applicable long term capital gains rate in effect at the time of the sale. Under current law, the maximum long term capital gains tax rate is scheduled to increase from 15% to 20% in 2011.
Dave T,
I have always enjoyed reading your advice here in the forums, thanks for sharing with us.
The details of our situation are as follows
We invested 300,000 in building an apartment complex. It is worth now that it is full about 1.5 million. That minus the land cost is our depreciable value. Some improvements can be depreciated faster than others according to my accountant, I am not sure exactly which. We are projecting that in about 8 years the depreciation will no longer cover income. At that point we will have equity of 300,000 plus principle that has been paid down, plus appreciation of around 5% (This is a projection, obviously ). This should be roughly greater than 1 million dollars in equity. We would then sell and 1031 exchange into 3 or 4 of the same size deals or a single larger (5 million dollar) apartment complex with comparable amounts of 80% leverage. You now have a much larger asset to depreciate, and by expansion, keep your income down as you start to pay off a much larger asset. Do this several times and then go ahead and pay off the assets. The income produced as they pay off will be very adequate, and at that point you will have to start paying income taxes. You will only have to pay the depreciation recapture and capital gains if you sell the assets in the end.
This is the way I understand how it works, if I made it make sense.
Thanks,
DB
I am not clear on your numbers. You invested $300K to build an apartment complex. Did that include the cost of the land, or did you spend $300K to build a structure on land you already owned or purchased separately?
For the sake of discussion, let’s say that you spent $300K to build a dwelling structure on land you purchased separately for $100K. Your depreciation basis is $300K. It does not matter what the value of the property is today. You can only depreciate what you actually spent on the structure.
Sorry for not being clear. The 300,000 was used mainly to purchase the land. With that much money invested, the balance of the 1.5 million (80%) was obtained in a loan in order to build out the apartments. This leaves us with 1.2 mill roughly to depreciate, and an asset that is not producing a great amount of income because of a fairly high debt load. In essence, the project is “paying” some of my other income taxes at this point, because the depreciation is higher than my income from this asset.
When the income becomes greater than the depreciation we can sell with 1031 exchange and move our equity, from the initial investment, appreciation, and principle paydown, into multiples and start over again. As I said, we are projecting that equity at that time to be around 1 million. Using that as the 20% needed to go into a new project or set of projects makes the next round total price somewhere in the 5,000,000 range. Again, about 80% will be depreciable, and income will not be very high at first because we are leveraging back up to 80%.
Hope that clears it up. I would love to hear your opinion on the strategy if I can be clear enough to make it understandable.
DB
l Just want to make sure that you are aware how the depreciation basis for the replacement property is calculated.
Just to make sure we are starting from the same point, the adjusted cost basis in your relinquished property is your $1.5 million investment cost, plus the cost of capital improvements, and minus the depreciation allowed during your holding period.
If you are trading equal in value, then the adjusted basis you had in the relinquished property becomes the basis of the new property. If you still had remaining depreciation basis in the relinquished property, it becomes the depreciation basis for the replacement property and it is depreciated over the remainder of the time left on the depreciation schedule in the relinquished property.
If you are trading up in value, then you have to supplement the equity in the relinquished property with new cash and debt to complete the replacement property acquisitiion. The adjusted basis in your old property is the initial cost basis in the replacment property. Let’s call this basis the OLD basis. The amount of new cash and new debt you add to the replacement property acquisition is added to the OLD basis to arrive at the new cost basis for your replacement property. Let’s call this amount of new cash and new debt your NEW basis.
If you want an example for the calculations to this point, let’s assume that you sold your relinquiched property for $2.25 million and purchased your replacement property for $5 million. Let’s also say that the adjusted cost basis in your relinquished property is $1.15 million after taking $350K in depreciation during your holding period and you have 20 years left on the depreciation schedule.
The first $2.25 million – the amount equal to the value of your relinquished property – has an adjusted cost basis of $1.15 million because the OLD basis becomes the basis in your replacement property. The NEW basis in your replacement property is the amount of new cash and debt you had to add to the deal to complete the purchase, or $2.75 million in this case. Adding the OLD basis and the NEW basis together, you determine that the cost basis for your $5 million replacement property is $3.85 million.
The depreciation basis only needs a couple more calculations. First, the depreciation basis remaining in the relinquished property becomes the depreciation basis for the OLD basis in your replacement property. So, the first $2.25 million of your replacement property’s cost has an adjusted cost basis of $1.15 million. Because the relinquished property had an original depreciation basis of $1.2 million, and you had taken $350K in depreciation, the remaining depreciation basis for the relinquished property is $850K. The depreciation basis for the OLD basis in your replacement property is $850K over the 20 years that still remained on the old depreciation schedule.
The NEW basis is $2.75 million. If the land comprised 20% of the replacement property purchase, then reducing the NEW basis by 20% gives us a depreciation basis of $2.2 million. This amount is depreciated as a new asset over the next 27.5 years.
Now for the big question. If you are only able to take $42.5K in annual depreciation expense for your OLD basis, and another $80K in annual depreciation expense for your NEW basis, will your net rental income from a $5 million multi-plex still be fully sheltered by your depreciation? I suspect it won’t, but you will have to run your own numbers to know for sure.
Dave T,
As far as I can tell, your explanation is right on. I have come to respect the way you get your hands around and understand these issues. I didn’t check all of the calculations, but the principles are the way I understand them.
To answer your question at the end, I think it is based on two things. One is deciding how much leverage to use. A larger purchase with more leverage and therefore more interest and less income brings the income side of the equation down while paying off a larger asset. The other side is whether some improvements can be depreciated on an accelerated schedule. I know that is the case with some things in new construction, I was assuming that it would also work with a purchase, but I need to check on that.
DB