Case Study – You wouldn't punch a girl with Glasses, would you?

[kingsbaker]

I have a question about reducing liabilities in order to pay down my stupendous mortgage. 
Some particulars...

Life Situation:
38 y.o. self-employed business owner with one child.  I plan to have a second in the next two-three years. 

Adjusted Gross Income: $189,000

Taxes: $66,150

Rental Income:
Rental Property #1 $700 net income
Rental Property #2  $600 net income

Current monthly expenses:
Mortgage on Primary Residence: $2,500 total (~$400 of that is T&I)
Fixed expenses (phone, internet, electricity and natural gas): $750
Variable expenses (groceries, alcohol, gasoline, restaurants, clothing, gifts, etc…) : $800
Gym: $140

Total:  $4200 / month

Rental Property #1:  $1,300  (T&I ~$300)
Rental Property #2   $1,100  (T&I ~$300)

Expected ER expenses: 
$1500-1600/month -no mortgage

Assets:
Primary residence: $459k
Combined rental properties :  $917k
401K/IRA:  $136K
Stocks:  $11K
HSA - $5.4K

Liabilities:
Primary residence:  $400K (issued Nov. 2016 in the amount of $405K).  Monthly payment is $2.5K
Rental Property #1: $117K (issued September 2006 in the amount of $282K). Monthly payment is $1.3K
Rental Property #2: $120K (issued August 2012 in the amount of $167K).  Monthly payment is 1.1K

Specific Question(s):
I have been reading ERE and MMM since the blog’s inceptions.  I have been taking notes. 

Things are great as they stand, if I wanted to work for another 20 years.  I have this whole other plan for my life that does not involve dedicating 10-12 hours including commute every day to a job that I am at best ambivalent about.  I have a great situation and even find my work enjoyable and rewarding but I also find it extremely limiting. 

Can I get feedback on my plan is to sell rental property #2 in order to crowbar myself much closer to early retirement.
The value of rp2 has risen dramatically in the past 4-5 years.  I want to capitalize on the upswing instead of cashing out my hard-earned money paid toward rp1. 
Also, let's just say that I can't refinance without bringing serious cash to the table.   

Here are the stats on the properties:
RP #1
purchased: 2006, $282K
value: 500K
balance: 120K
Interest:  7.8% adjustable
payment: ~1300/ month
Gross:  2100 / month

RP #2
purchased: 2011, $167K
value: 417k
balance: 120k
Interest: 6.5%
Payment: ~1100/month
Gross:  1750 / month

Primary
purchased:  2016, 459K
value: 460K
balance: 405K
interest: 5%
payment: ~2500/month
 

By applying the capital gains ($280K) toward the mortgage on my primary residence, I will reduce the principle to 120K, saving over $465K in interest plus the $280K in principle payments over time, and reduce my exposure to the vagaries of the housing market freeing up both time and money for other opportunities. 
 
So far, everyone I have discussed it with (family) says I should hang on to the rental property because it is paying for itself and it is “a good long-term investment.”  They also are planning to work until they keel over (parents) or have stay at home wives (brother). 

What do y’all think?  Am I missing out on some future opportunity to cash in and make a killing or to have someone else buy an asset for me?  I figure that if I really want to have a deeper hand in real-estate, I could always use my future earnings to fund real-estate purchases after I’ve taken care of my own living expenses and housing. 

[fell-like-rain]

Personally, I'm a lot less bullish on real estate than many FI-minded types seem to be- yes, you get cash flow and (potentially) better-than-market returns, but the flip side of that is a lot of risk, both in terms of potential damage to the property or a major drop in market prices, whether local or national. Also, in this particular case, it doesn't look like you're making out all that well- Property 1 brings in $25,200 annually on a value of $500k, which is just a 5% return, and that's before considering any of the other costs- maintenance, property taxes, what have you. Similar return rate for Property 2. It doesn't seem like these are highly performing assets, and that'd incline me to recommend selling.

[kingsbaker]

Thanks for the reply
The 5% return you calculated excludes property taxes as they are paid prior to net income calculation but not other expenses.  This kind of objective analysis is helpful.  I was operating off the feeling that it isn't the hot investment everybody seems to think it is and I also see a lot of the risks and want to mitigate them.
It definitely feels better to take care of my own shelter and living expenses first before pouring money into such a long-term investment.  My needs are immediate. 
 

[Calvawt]

I think you need to calculate the return on what you paid for the rentals, not the current value.  Have you looked at refi's for the rentals?  those rates are quite high and with the amount of equity, you might be able to unlock some cash AND increase monthly cash flow.

[fell-like-rain]

I think you need to calculate the return on what you paid for the rentals, not the current value.  Have you looked at refi's for the rentals?  those rates are quite high and with the amount of equity, you might be able to unlock some cash AND increase monthly cash flow.

That doesn't quite make sense to me, because the current value is the only way to compare it to other assets. Let's say the price had doubled since purchase, so the return would be 10% as compared to the purchase price, instead of 5% as compared to current value. If he sold the house and bought $500k of stocks averaging 7%, that'd be $35,000 a year, which is significantly more than the rent of $25,200. You end up in this illogical situation where a 7% return is greater than the theoretical 10% return.

[Phoenix_Fire]

I calculate your ER expenses as being $2,090 based on what you have provided, assuming you do pay off the house.  I think in your stated 1500-1600 you left out the Taxes & Insurance on your home, unless you plan on reducing expenses elsewhere.  So, using $2,100 per month as your ER expenses you need to get to $630,000 invested. 

Assuming that $2,100 is accurate, and you are set on having the primary residence paid off when you retire, and your income stated above does not include your rental income, you could retire in less than two years if you sold the rentals and paid off your house now. 
http://networthify.com/calculator/earlyretirement?income=122850&initialBalance=424400&expenses=25200&annualPct=4&withdrawalRate=4

Could you sell your business as well?  If so, for how much?  Selling the houses and the business if it gets you to what you need could set you up to have that second child without the headaches of rentals or running your own business. 

Your fixed, variable, and gym expenses all seem high.  You might consider breaking them down for individual feedback.  Do you have a partner or are you raising the children on your own?  Have you factored in health insurance costs into your ER expenses?  Is moving to a lower COL area an option?  Reducing the price of your house could get you there even sooner, or give you more flexibility.  You also do not appear to have an emergency fund.  If that is the case, you really should build one up. 

[SwordGuy]

Get this book.  It will teach you how to correctly analyze a rental property investment.

https://www.amazon.com/Estate-Investor-Financial-Measures-Updated/dp/1259586189/ref=sr_1_1?ie=UTF8&qid=1527113480&sr=8-1&keywords=gallinelli+cash+flow

Then run the numbers, compare them to a 7% historical stock market return, then you'll know whether to keep them or not.

I didn't see an interest rate on the mortgage, so I can't recommend whether it's better to pay down the mortgage earlier or invest in the market.

As for PARTIALLY paying off your mortgage early, that doesn't make your financial situation "safer".  It just makes it easier for the bank to get their money back out when selling your ex-home on the foreclosure market.   Only a 100% paid off mortgage gets you the safer situation.

[kingsbaker]

Phoenix_Fire 
Thanks for pointing out my obvious omission of T&I on the primary residence. 
I even managed to overlook it in my own spreadsheets / calculations which are now all up to date. 

Here is the breakdown of my Fixed and Variable Expenses, averaged over the past 17 months I have been at my new address. 


I can't sell my business as I am my business.  I sell my time as an expert engineer.   

My partner and I have discussed having a child but this is not a sure thing.   A lot would need to happen between now and then.  Combining finances is a whole other enchilada.  In any case, I want to attain my own financial independence. 

Moving to a lower COL area is not option at this point.  My ex lives 4 blocks away and this is the best situation for my daughter.  Family is also in the same metro area and worth more than gold. 

Fixed expenses include both child support for my daughter although I have her 50% of the time as well as health insurance.  That is probably why the numbers seem high.  Variable expenses includes expenditures for piano and dance lessons for my daughter and upgrades to my yard, a 1/3 acre green desert (lawn) that is slowly being transformed into a food forest. 

Fixed      
Phone                    $90.00    
Electricity                    $-30.00   (solar to grid)
Gas                            $55.00    
Internet                    $55.00    
Health Ins.            $320.00    
Child Support            $200.00    
Water                    $25.00    
                            $715.00    
      
Variable      
Groceries                    $400.00    
Alcohol                    $40.00    
Kiddo                    $100.00    
Supplements            $70.00    
dental                    $16.67    
miscellaneous            $8.33    
haircuts                    $5.00    
pet/ vet                    $40.00    
auto expenses            $96.00    
hobbies (garden)    $33.00    
    $809.00    


Admittedly, $140/month for the gym is very high but it is worth it.  If that changes or is required to change then eliminating it is an easy way to slash spending.

I didn't list my cash accounts as assets but I keep $20k on hand as a personal emergency fund and the business has over $60K in it. 

SwordGuy
I have the book on reserve at the library and will check it out this week. 

I find it interesting how in the last 10 or so years the historical average of market returns has dropped by 4%.  When I first began looking at improving my financial situation (2006) and the historical average was 11%.   I assume there is much more volatility ahead but also a much larger market (expanding global middle class) so being positioned to take advantage of this might prove better than being stuck in real-estate.  I don't have a crystal ball, however, so we will all have to wait and see. 

I also agree that the mortgage is a step function going from 0% home ownership to 100% home ownership *T&I not withstanding. 
A 74% paid-off mortgage (selling rental property) is all the same to the bank as a 9% paid off mortgage but it is moving in the right direction. 
I could pay off the mortgage within a year or two, which is better than 28 years on the amortization schedule.


fell-like-rain and vawt
I also initially fell into the logical fallacy of calculating return based on the purchase price.  In that case, I thought I was making out quite well.  However, feel-like-rain points out that assets need to be compared at their current value.  That was where I was headed in my thinking and fell-like-rain unlocked the door. 

[Laura33]

First, you are looking at the rental property "investment" wrong.  The primary value of rental property as an investment is the income stream it provides -- that income basically pays the mortgage for you AND provides you profit, which you can then use to plow into other rentals, until before you know it your portfolio is throwing off sufficient cash to cover your ongoing income needs.  If the value of the property grows over time, and you make money when you sell it, that's just an added bonus.  So your friends/family who are talking about your rentals as an "investment" are looking at it the wrong way round.  Do the full business analysis per the recommendations/book above and decide based off that.

Second, paying off your mortgage is likely the wrong call financially.  The value of your home will increase or decrease the same amount whether you own 100% of it or 1% of it, and your monthly obligations will remain exactly the same for the life of the mortgage no matter how much equity you have in it.  If you hit a rough patch, which is more helpful:  owning 90% of your home and having to pay $2500/mo, or owning 10% of your home, having $250K+ in the bank, and having to pay $2500/mo.?  But beyond that, you are focusing on the interest you will save -- and you're right, $450K+ is a lot of money, even over 28 years!  But if you take that $280K and put it in the market, and you get an average 7% return, in 28 years you'd have over $1M (even in a taxable account).  So your net worth would be over $500K higher.

Finally, you are also forgetting about capital gains taxes -- if you sell the rental and put the money in either your primary residence or investments, you will pay pretty significant capital gains taxes.  So since you have so much profit tied up in real estate, if the numbers suggest that either of your rentals is not returning what it should, you might want to do a Starker exchange into other rentals that are more profitable (assuming you can find some). 

If you want more flexibility in your ongoing housing costs, and you decide that one or the other of the rentals is not profitable enough to be worth hanging on to, then you may want to consider selling, taking as much of that profit as you need to do pay down your mortgage to the point where you can get a more favorable interest rate (e.g., 20% down), and then refinancing to another 30-year mortgage at a lower rate.  That will both reduce your interest paid and provide a little more flexibility in your monthly budget (even at 5%, your PI on an 80% loan would be under $2K/mo, and at 4% it would be around $1850).

[ChpBstrd]

RP1 nets $700/mo or $8400/y
RP2 nets $600/mo or $7200/y
Combined, they net $15,600.
Their value is $917k.

The annual net ROI is 15,600/917,000=1.7%, plus or minus appreciation. ONE POINT SEVEN PERCENT.

In other words, property values have risen so far beyond economic fundamentals in your market that real estate investments yield the same as online savings accounts or bank CDs. You picked a great time and place to invest in RE, but I'm afraid your returns from here are based on the expectation other people will pay even more for the properties in the future.

Maybe they will, but that expectation seems shaky to me, given rising interest rates and already very stretched affordability. Rather than invest nearly a million dollars into what might be a housing bubble, I'd switch to a diversified portfolio, but first I'd talk to a tax professional about the capital gains one would face in doing so.

If you sold both RP1 and RP2 you might be able to scratch together a liquid net worth of 800-900k after taxes. That's not too far from the $1.3-1.5M you could retire on. Best of all it could be diversified into a passive portfolio of bonds, equities, REITs, etc. rather than in homeowner enthusiasm for one neighborhood. Look what happened in Toronto!

https://www.millennial-revolution.com/rent/broke-ass-morons/

[kingsbaker]

looking at the net ROI makes things look dismal. 
What do you think about analyzing the properties based on cash flow prior to and during ER. 

RP#1 $700 net income making it worth approximately $210,000 net yield at 4% with inflation protection built in -regardless of changes in property valuation. 
Property values are quite steady in the city where this property is located.  It is a college town with a new crop of tenants every year. 
If I refi RP#1 to a better interest rate (4% instead of 7.9%), it could produce 1300 net monthly income replacing a $390,000 nest-egg in the basket. 

For RP#2,  $600 net income translates into 180000 net yield at 4% w/ inflation protection. 
This property is in a "hot" market.  Rents are high right now and will definitely be stable over the short-term (3-5 years) but I am not so sure about the long term as a bubble may burst.  Hence my desire to capitalize on high property values before the bubble bursts. 

[Phoenix_Fire]

Kingsbaker,

That break down and explanation makes more sense.  Those look reasonable for the most part (phone should be lower if only one line).  I would challenge you still on the gym expense.  Consider that you could spend $1,680 to purchase your own equipment for a home gym, and that would cover 1 year’s expense of going to the gym.  The other thing that stands out are supplements, but that is also going to be a personal choice based on your health requirements. If you could somehow eliminate both of those, that reduces your amount needed to FIRE by $63,000.  Those are just points to consider.  Your expenses are so low that if you consider that part of your happiness I'm not going to fault you for it.

Your net worth not counting primary residence:
401k/IRA: $136k
Stocks: $11k
HSA: $5.4k
Emergency Fund: $20k
Business Fund: $60k
Equity in Rentals if sold: $677k

Total without Paying off Mortgage: $909,400
Total after Paying off Mortgage: $504,400

That doesn’t take into account the taxes/realtor fees for selling the rentals.

Based on your expenses, your Stash needs to be:
Sell Rentals, Do not pay down mortgage: $1,260,000
Sell Rentals, Pay down Mortgage:  $630,000

How much is needed to hit those goals?
Sell Rentals, Do not pay down mortgage: $1,260,000 – $909,400 = $350,600
Sell Rentals, Pay down Mortgage:  $630,000 – 504,400 = $125,600

Your P&I is literally half of your expenses.  I think it actually makes sense to pay off your house in this case, all in one shot by selling the rentals.  Assuming you are looking to FIRE ASAP.  I understand the argument for normally not paying off the house, but in your case you can actually FIRE much sooner with a paid off house as opposed to keeping the cash and paying it down slowly.

---

One other thing I noticed.  When you first posted, your variable expenses mentioned restaurants as part of them.  Your detailed version does not.  Is that missing and making your expenses lower?  Do you pay for Netflix or Amazon? 

You’re in a great situation.  You could sell the rentals, pay down the mortgage, and work the two to three years you mentioned before having a kid and save a lot extra, nearly $300k more. 

All, if I’m looking at those numbers above incorrectly in regards to the difference between paying down the mortgage vs investing it, please feel free to point it out.  I know it goes against the grain of the normal advice here, and it makes me think I’m missing something.

[ShoulderThingThatGoesUp]

How about selling all three properties and moving somewhere where a house for a small family doesn’t cost half a million dollars?

[kingsbaker]

Thanks everyone for the feedback and information. Based on my amateur analysis, I think I would do best to sell one rental property, plow that money into my home and keep the second and refinance it to get a better rate (4% vs. 8%). 
Refinancing RP#1, I can pull in the same amount of rental income from a single property, improving my ROI to at least 3%. 
Selling both RPs requires the largest amount of cash to be stashed to cover living expenses and as the majority of my 'wealth' is tied up in real estate, that means a lot longer working.  (3 years, 4 months at 70% savings rate)
Selling one RP, dumping that money into my primary residence and refinancing the other could generate the same amount of net income from a single property.  This reduces my required nest egg by ~1/2 since net rent covers over half of my expenses.  (2 years, 2 months at 80% savings rate)
Keeping both rental properties and paying off the primary residence takes the longest to reach FI but would also leave me sitting on a pile of extra cash... until the next crash. (5 @ a 50% savings rate)


Phoenix_Fire
Thanks for the feedback.   

Restaurant fees are spread between the grocery and alcohol categories.  At the moment, I much prefer to eat at home but there are always times when it is more fun to enjoy a beer and appetizer with friends at a restaurant.
 
Supplements are high for sure but it is probably only temporary.  I had a health issue as a result of overworking myself after my daughter was born.  I am working through it and hopeful that the damage can be repaired.  Gym fees are along the same lines... a pilates reformer machine costs 3-4K and even then, it would be difficult to workout alone. 


ShoulderThingThatGoesUp;
I always thought that if I bought a half-million dollar home, it would be a monument to luxury and include a bevy of servants, stables with horses and Robin Leach would come to breakfast and rave about how fabulous it was.  However, this is a modest home, a 3-bedroom ranch...in a crazy market.  I have considered selling out and moving in with family or renting a tiny ass apartment but keeping stability for my daughter and the yard/garden keep me here. 


Overall: 
The gym membership, supplements, the house and even my $400 grocery bill for 1.5 people are crazy-ass luxuries but in the end, it is worth it to me to pay those prices for all the other benefits I receive regarding health, happiness, and family.