Hi - I’m new to this forum but I have read through some of the threads and am completely impressed by the quality of the info posted.
I just started with a duplex last year in the Seattle area. I have a RE broker suggesting to me that I should try to leverage as much equity as possible in my rental and primary residence to get more rental property (the Missed Fortune 101 model). In the central core area of Seattle, it seems very hard (impossible?) to me to positive cash flow with 10-20% down payments (remember - I’m new at this…) but the property appreciation is very good (consistent 8-10%+). So as a long term strategy, this seems reasonable(?).
My questions are:
Is this strategy workable or are these real estate and mortgage brokers just trying to get me to buy more and refinance more?
Although I now benefit from the negative cash flow and depreciation in offsetting my regular wages, I will start hitting the limits (both $25K and modified gross income) in the next few years or so or faster if I get another property with negative cash flow. Does it make any sense to keep piling up passive losses that I can’t use now?
I like the idea of pulling out equity with a refinance or HELOC but how does one get the cash to pay the loans, especially with the tax deductions phasing out? It seems scary to pull out of the line of credit to pay interest on the existing line of credit.
You should be very careful here. I would never recommend refinancing and pulling cash out of your primary residence for rental property, especially if it will not cash flow. I have seen way too many clients play the leverage game and put more into rental property only to come crashing down with way too many foreclosures when values start falling.
Hi Mark and William -
Thanks much for your advice. Based on your thoughts, would you then suggest putting larger cash down payments and/or using interest-only financing to get positive cash flow? (I suppose a better plan is finding positive cash flowing properties - but for the sake of my example, let’s assume this is not the case.) Is this better than financing a greater amount and keeping a large cash side account for contingencies, vacancies, etc?
gaining positive cashflow from interest only financing is risky: 1) these are usually ARMS and 2) when are you going to ever pay it off?
if it’s that close to the “edge” it’s probably not a good deal.
for me a good rental is 70% of market value, doesn’t require much repairs, can be 100% financed from the rents on a regular 30 year amort, and will still cashflow something each month.
I agree with Mark. Interest only financing adds risk to the investment in most situations. I personally like to put 65% to 75% debt on the property and always make sure that I have cash reserves sufficient to hold me through the down cycles. Those who finance their portfolio too tightly with no cash reserve will probably not make it through the nasty down turns.
If you can’t answer this question, then you have a major pitfall with your strategy. Equity credit lines on your investment property can work as long as you have a positive cash flow to begin with and your new debt service keeps you positive.
I agree with the others, don’t put your family home at risk of foreclosure if your investment goes bad. Those interest only loans that were originated a few years ago had negative amortization features and are the loans that are defaulting now, leading the way to higher foreclosure rates all across the country.
Thanks for the good advice. Based on the consensus, it seems like I should keep my personal residence out of it.
If I did something like an 80% 40 year amortized loan on a rental with some or most of the down payment covered by an equity loan on the other property, but I keep liquid cash reserve sufficient to pay off the equity loan plus some additional for vacancies and capital repairs - does this generally seem about right as far as risk management? Thanks again for your insights. - DK
I will make sure it has positive cash flow by either choosing the right property or adjusting the loan amount to do so.
Did you have any thoughts on passive losses that cannot be taken in the present year’s tax return?
Also it is my understanding that loan interest is completely deductible for investment real estate. So a HELOC on another rental property that exceeds $100,000 of the acquisition debt amount is not subject to this limit if it is used on another rental. Is this right?
Passive losses that can not be used this year are carried forward for future use.
My understanding of the $100K HEL limit on the deductible interest is that this applies only to your primary residence. The interest on a primary residence HEL is deductible as home mortgage interest on your Schedule A regardless of how the money is used.
For your rental property, the proceeds of a HEL must be used for a valid investment purpose to be deductible. Using the money to buy a new car, to take a vacation, or just putting it in the bank until you figure out what to do is not a valid investment purpose and the interest on that loan would not be deductible. I am not aware of any limit on interest deductions when your investment property secures the HEL.
I think that you should stop listing to anybody that does not have 10 times the amount of money that you do. Judging by the advice of your real estate broker and mortgage broker I do not think that this is the case. Your broker is proposing in my understanding that you take out equity of your personal residence to use to put 10 to 20 percent down payment on rental property and sign personally for a loan for 80 to 90 percent of the value of the property that does not cash flow. And as time goes on and your rental property goes up, refinance down the road and take out as much equity as possible and buy more. One the surface this seems like a good idea. However I think it is a recipe for disaster. What are you gong to have down the road if you implement this strategy? Lots of rentals yes, but all rentals and a personal residence with NO EQUITY. Lets say you get 8 rentals this way and each has a negative cash flow just like the duplex that you won own, and lets say that each property “eats” $200 a month. If you have 8 properties that’s 1,600 a month that you have to pay from the income you produce with your own labor from your job. Can you afford to support your self and 8 properties that eat 1,600 a month? You don’t work at a job to pay money to own investments, you work at a job while you collect investments that pay you money so that you don’t have to go to that job. What is one of the ways you can have positive cash flow? Have lower debt on the property so you have more coming in than going out. Well how do you pay down debt if you keep refinancing to take out more money to buy more properties that will eat more money? This doesn’t make sense.
You mentioned saving up to 20% for a down payment for each property, I don’t know how high your income is, but how long do you think it’s going to take you to build up a substantial portfolio of rental properties if you have to WORK AT A JOB TO SAVE 20% TO PUT DOWN. A very long time indeed. I do not know what your outcome for real estate investing is, but if it is to quit your job and live off positive cash flow from your properties, if you keep going down the path that you are on, you will never get there. NEVER, not going to happen unless your going to live to be 300. Here’s another way to illustrate what I’m saying, you go down to the store and you buy two gooses. Yes gooses. And the first it lays a golden egg each month for you which contains $200, and the second goose goes thru your wallet and removes $300 each month. How long can you afford to have a goose that steals $300 form you each month? Not very long! Especially if you have 7 or 8 stealing gooses! How long can you afford to have a goose that lays $200 dollar eggs each month? Forever right? What if some one came to your door and wanted to buy one of your gooses? Which one would you sell? The stealing goose right?! Exactly. Each property ie the duplex that you have in Seattle is a stealing goose! You don’t need anymore of those now do you!!! Not to mention this stealing goose is taking up your time and energy!!! It’s no fun spending time and energy on losing money! It’s much more fun to loose money thru gambling, shopping, takeing up a highly expensive sport, buying high priced items. All these are much more fun ways to have money leave your life, dealing with tenants is not a fun way to loose money. Now anybody that suggest that you LOSE money each month for tax write offs IS NOT SOMEBODY YOU NEED TO BE LISTING TO. They are NOT richer than you.
About refinancing with the bank. Ok you sign personally for a loan at the bank. Do you know how to get out of that agreement? You either pay it off, or you die. Those are your choices. (and when you die you estate still has to pay it) Lets say that you signed personally for a loan on property that is worth 100,000. and the loan you have to pay back is 90,000. And lets say that a couple years goes by and it goes down in value and your property is not only worth 92,000. Lets say YOU HAVE TO MOVE, you lose, your job, or get a better one or what ever, buy you have to move and sell it. Do you think you can sell it for what you owe? Maybe, maybe not. Definitely not if you have to sell the “traditional way” and pay closing cost, and a realtor commission. Your going to be in a tough situation. Remember that the loan hardly has an principal pay down for a long long very long time. And an interest only loan is even worse!
What am I trying to tell you here:
don’t go to the bank and sign personally on loans ever again for the rest of your life, in fact, if I were you, I would sell anything that I had where I had signed personally on a note and get somebody else to pay it off so that I had no loans in existance that I personally signed for. Remember if you sign, they can go after you. They can foreclose on you. How do you avoid that? Don’t put your self in that position in the first place.
Do not ever purchase any geese that steal money from you! If the property does not have a positive cash flow after ALL EXPENSES, and not just any positive cash flow, a cash flow of at least $200 per unit, don’t buy it. DO NOT BUY IT. From now on, anything that takes money from you every month is not acceptable in your life, and anything that gives you money every month (without your labor being involved either at all, or very mildly) is ok.
Do not refinance your house to take out any equity. Sell it and buy something else using all cash, or take over somebody else’s loan. (by the way any property with no equity limits your exit strategies and back you into a corner should anything but roses circumstances come about, and we all know life has storms followed by sun followed by storms followed by sun. Think about how to protect yourself from the rain and take preventative action when it’s sunny.)
Do not take any advice from people that are not 10 richer than you are. My guess is your broker is not. You know your brokers advice is not right, that is why you wrote on this forum. Trust you instincts. You know something is wrong.
What should I do?
Buy properties at 70% or less or do not buy. IF it doesn’t give you $200 a month cashflow, do not buy. If you have to sign personally for a debt, do not buy. If you cannot do this in your city, learn how to find people who will sell you houses for 70% or less, (they exist) or move to a depressed area of the country were there is cashflow (although this is where you should choose carefully because these parts of the country are depressed for a reason). Learn more, invest in your education, because it could seriously affect where you are and what your doing down the road. I hope did not offend, I can be blunt sometimes. I hope you succeed.
Erma in Kentukcy
A slightly better metric is the Debt Coverage Ratio,
Debt Coverage Ratio = Net Operating Income / Annual Debt Service
If the DCR is 1.25 or better, then the property is usually self supporting. You have enough cash flow to cover those unplanned repairs. Depending upon the size of your debt service (principal and interest only), $200 cash flow may be more that enough, or just barely adequate.
Have you considered investing out of state? I’m invested in multiple states and it has worked well for me. Some markets are good for appreciation, others are good for cash flow. Having diversity in different markets is a good thing. If one market sours, another might be booming. The trick is having property managment you can trust. Feel free to PM me if you should want any recommendations.
Thanks much for taking the time to write your detailed reply. I have a couple of questions for you:
I’m not sure how one goes about not personally signing for a loan. With a “starting out” LLC, will any lender write a mortgage without me personally guaranteeing the loan? Is this a big issue? It would never be my intention to default on a loan.
I’m pretty convinced by you and others to go with positive cash flow. I wasn’t quite clear whether you are saying to buy properties at 70% of market value or 70% financed. If you mean 70% financed, my question is that if I am looking at 70% loans and properties making $200/mo, how do I ever build up the 30% down for my next purchase without pulling out equity? Maybe I’m not thinking about this right… or not patient enough…
If you are saying 70% of market value - ugh - now I’m depressed! (and definitely not skilled or patient enough…)
To Dave T - Thanks for the info on the debt coverage ratio. This seems like a great guideline. (Though maybe a little challenging.)
To PREO - Thanks for the suggestion about out of state properties but since I’m just starting out, I feel like I want to stay local to keep things managed.
