Pay down rental property principal or invest in index funds?

[BrianT]

A little background about why I am asking the community for help: We just had our little baby boy earlier this year, and we've decided that my wife will stay at home to look after him after my paternity leave is complete. This means we'll be transitioning from a dual to single income household. Now, I've already prepared for this in that I rent out 4 homes for residual income to help supplement. Based on current expenses, and thankfully there aren't too many, it's very possible for us to live off only my salary and still put some away. The rental income will in most cases not need to be tapped unless we run into a huge expense; and in addition we also have a reasonable amount of savings to work with that will last for approximately 8 months.

My question now is...instead of leaving the net rental income in checking or savings, should I use the proceeds to proactively pay off the principal or invest in a total market index fund (whether in Roth IRA or regular brokerage account)?

Here are some stats on the properties, which show current principal balance and monthly payment:

• $273,084.95 @ $1506.81/month, 3.99% APR
• $91,598.00 @ $508.88/month, 4.125% APR
• $85,046.77 @ $527.43/month, 5.00% APR
• $64,112.44 @ $420.62/month, 5.125% APR

After all expenses and contingencies factored in, my monthly net income is $1822; again assuming no major catastrophes. Each year the income does go up because rents have been increasing steadily at about 8% per annum.

Any suggestions on where I should park the $1822 earned each month? At first I thought paying down the properties so that I can have access to extra cash flow much earlier. My mind wouldn't allow me to stop there, so I thought maybe I should invest the money in a total market index fund instead. Now I can't decide.

Thoughts? I realize some extra data points that I am not aware of may need to be stated here. Please let me know what else might help. Thanks in advance...I appreciate everyone's input on this.

Just an FYI, I'm not worried about a retirement account. I have enough money socked away in 401k and IRA that will give me plenty to retire if I so happen am forced to work full time until 60 (which I don't plan to).

[Kierun]

What are the interest rates?

[feelingroovy]

There is a risk in paying off a mortgage part way. The cash is tied up but you still have to make the payment.

What about option 3: putting the money in stocks until you have enough to fully pay off a mortgage?

Also, when do you want to retire? Would these properties cash flow enough to cover your expenses if you did pay them off?

[BrianT]

What are the interest rates?

Thanks for bring it up. I updated OP.

[BrianT]

There is a risk in paying off a mortgage part way. The cash is tied up but you still have to make the payment.

What about option 3: putting the money in stocks until you have enough to fully pay off a mortgage?

Also, when do you want to retire? Would these properties cash flow enough to cover your expenses if you did pay them off?

That risk is what kept me from moving so quick on just throwing it into the homes. If I ever needed cash really fast that wasn't from credit, then I could be stuck.

Option 3 did cross my mind...basically a hybrid.

Yes, the income is good enough. If the properties were owned free and clear today, my monthly net cash flow would be $4,548. We are frugal, and most likely I'd be working part time just because I feel like it. If I needed a lot more cash at once, I could always sell the homes (total value of the homes is about $1.3 million). And this only would only need to last until I'm 60. By then my retirement accounts will be well into the millions and then there'll be some social security for supplement when I'm 65 (although mathematically it's not necessary for me). Right now I am 37.

Thanks for the input!

[BrianT]

Also, when do you want to retire?

Sometime between 45 to 50 years old. I am 37 right now.

[Laura33]

Why not use the profits to buy yet another income-producing property?  That's generally the way real-estate investors succeed:  use the profits or equity from one property to fund others.

I would not pay off the mortgages.  You do not appear to need the extra cash flow right now, and there are significant tax benefits to being able to write off the mortgage interest against the rental income (particularly while you are still working and so your income is higher than it is likely to be in the future).  More to the point, those rental properties are going to continue to throw off the same amount of rent regardless of how much of your capital you have locked up in them -- you could have 0% equity or 100% equity, and those properties are still going to provide $4548/mo. income.  But your rate of return is going to be dramatically higher if you have very little money tied up in the house than if you have the properties fully paid off.

Now, I wouldn't necessarily recommend you refinance to take out even more equity (though that is what some RE investors do as a way to finance additional properties).  But I also wouldn't recommend tying up more money in your existing properties to get the exact same return you're getting now.  Take that money and put it into something else that is going to generate even more income, whether that's stocks or another rental property.  Then, when you're ready to pull the plug on your day job, you can take a hard look at your whole portfolio and tax situation and decide whether it's worth paying off the mortgages so you can live on that higher net income.  But no reason at all to jump to that while you're still in the accumulation phase. 

[frugal_c]

Great post Laura, I don't know if I can add too much.  If it were me, I would want to shield as much of that income as possible from taxes.  If there is room in a tax free account that shifts things even further towards investing, in my opinion.  Cut that current and future tax bill down.  I am guessing your incremental tax rate is fairly high if you are working full-time so even more reason to focus on it.

You don't really get into the details but I would consider the ratio of stock equity to real estate equity.    For instance, if I had 500k equity in real estate and 200k in stocks it is even more tempting to focus on the markets.  If it is the other way around, then I could start to see why you might want to focus on properties.

If you still think you really want to pursue real estate, it might make sense to look at saving up your cash flow to purchase another property.

[waltworks]

If the properties were owned free and clear today, my monthly net cash flow would be $4,548...(total value of the homes is about $1.3 million).

Wow, that's pretty horrible. You're getting <4% (assuming no "catastrophes")?

Sell the houses, 1031 into better properties. Or put the money into boring index funds.

-W

[BrianT]

Why not use the profits to buy yet another income-producing property?  That's generally the way real-estate investors succeed:  use the profits or equity from one property to fund others.

I would not pay off the mortgages.  You do not appear to need the extra cash flow right now, and there are significant tax benefits to being able to write off the mortgage interest against the rental income (particularly while you are still working and so your income is higher than it is likely to be in the future).  More to the point, those rental properties are going to continue to throw off the same amount of rent regardless of how much of your capital you have locked up in them -- you could have 0% equity or 100% equity, and those properties are still going to provide $4548/mo. income.  But your rate of return is going to be dramatically higher if you have very little money tied up in the house than if you have the properties fully paid off.

Now, I wouldn't necessarily recommend you refinance to take out even more equity (though that is what some RE investors do as a way to finance additional properties).  But I also wouldn't recommend tying up more money in your existing properties to get the exact same return you're getting now.  Take that money and put it into something else that is going to generate even more income, whether that's stocks or another rental property.  Then, when you're ready to pull the plug on your day job, you can take a hard look at your whole portfolio and tax situation and decide whether it's worth paying off the mortgages so you can live on that higher net income.  But no reason at all to jump to that while you're still in the accumulation phase.

I been watching the thread all day on my phone and been wanting to reply since seeing this response. I sooooo much appreciate your insight.

Originally when I thought of this idea, the monthly cash flow of $4548 is what I wanted to achieve by paying down the properties. I wanted to change my monthly cash flow from $1822 to $4548, just so that we'd be more comfortable. But then I had also thought about how I wouldn't have easy access to any cash that I put down on the house. This idea caught my attention when I read blogs from people that primarily focused on RE for FIRE, and they used monthly rent as a way to get there. It's neither right or wrong to me...it's just one of the methods.

So then I thought it would make more sense to put more money into stocks. Across 401k and IRA, I have about $260,000 invested in an index fund, Costco, and Berkshire Hathaway. I also have a Roth IRA with about $15,000 in it. But I don't have any money in a regular brokerage account. That's when I thought maybe it would make more sense for me to take my rental earnings and park it in a total market index fund.

[BrianT]

You don't really get into the details but I would consider the ratio of stock equity to real estate equity.    For instance, if I had 500k equity in real estate and 200k in stocks it is even more tempting to focus on the markets.  If it is the other way around, then I could start to see why you might want to focus on properties.

Your guess is actually about right. The net equity of my rentals is about $800,000; my stock portfolio is less than half of that. I decided to put the residual into the market instead.

I live in Los Angeles County, and generally speaking finding profitable cash flow rentals is much harder these days. I bought the bulk of my rentals during the housing recession between 2010 and 2012. Since then those specific properties have either doubled or tripled in value. It's nearly impossible, but not impossible, to find properties around here that have that kind of return. I don't have any desire or energy to buy and manage break even or negative cash flow properties just for the sake of speculating on equity. I also don't have any plans to branch out and look at property in other states. It makes much more sense in this situation to put the money into index funds, I think.

[BrianT]

If the properties were owned free and clear today, my monthly net cash flow would be $4,548...(total value of the homes is about $1.3 million).

Wow, that's pretty horrible. You're getting <4% (assuming no "catastrophes")?

How did you calculate this?

[waltworks]

Easy, you have $1.3 million earning about $50k/year (I'm assuming you've carefully accounted for maintenance/capex, vacancy, management, etc, etc).

50k/1300k=.038. Hence, a bit less than 4% return if you completely paid off the properties.

Now I'm not being completely accurate there, since you'll pay some significant capital gains to sell the places if you don't 1031 them. But they are horrible, horrible rentals at this point. You should be looking to extract your equity and put it to use elsewhere.

-W

[BrianT]

Easy, you have $1.3 million earning about $50k/year (I'm assuming you've carefully accounted for maintenance/capex, vacancy, management, etc, etc).

50k/1300k=.038. Hence, a bit less than 4% return if you completely paid off the properties.

Now I'm not being completely accurate there, since you'll pay some significant capital gains to sell the places if you don't 1031 them. But they are horrible, horrible rentals at this point. You should be looking to extract your equity and put it to use elsewhere.

-W

Thanks for clarifying! The properties are worth 1.3 million, but I definitely didn't pay that much for them. The purchase price combined is about $800,000, so I've had an equity gain of about $500,000 so far. I suppose it depends how you want to look at it. In terms of my own money in the initial investment, I only put in $215,000 of my own cash to buy the 4 properties. After that rents have covered all the expenses.

[waltworks]

It does depend on how you look at it, but you have to analyze the situation going forward using their current value (if you paid them off, as you proposed, you'd have $1.3 million in equity making very little profit, right?)

If I bought a shack in San Francisco in 1910 for $50, and that land is now worth a million, the original purchase price isn't very relevant anymore, right?

-W

[BrianT]

I decided to take the residual income and put it in my brokerage account for index fund investing. Thanks everyone for your input!