Long term plan for my real estate portfolio

[readandski]

I own 2 duplexes in a desirable location that have appreciated significantly.  My long term plan right now is to hold them until I die and then give them to my heirs.  I self manage them because I don't live far away and I have a good list of service providers, so there is not much hassle.  Since I still have a full time job, I invest 50% of net rental income into paying down the mortgages and the other 50% of net rental income into various investments, like i-Bonds and an index fund, but I'm getting burnt out with my job and I think I'll retire in the next 5 years and plan to use the net rental income to cover my expenses. 

Is this a good strategy for my real estate portfolio, or am I better off selling the duplexes and maximizing returns elsewhere?

Duplex One: 
Value: $1.1m
Mortgage: $330,000 @ 2.8%
Rental income: $5000/month (I could raise rents a little but they're close to market and I like the current tenants)
Monthly Mortgage Payment: $1700 (Plus I'm currently paying down an extra $1000 per month)
Monthly Expenses:  Average is $400/month between repairs and vacancy allotment.

Duplex Two: 
Value: $1m
Mortgage: $485,000 @ 3%
Rental income: $4,400/month (I need to raise rents this summer as it should be renting for at least $4,800 per month)
Monthly Mortgage Payment: $2500 (Plus I'm currently paying down an extra $1000 per month)
Monthly Expenses:  Average is $300/month between repairs and vacancy allotment.

So basically, if I raise rents in Duplex Two this summer, stop reinvesting net rental income in mortgage paydowns and other investments and spend it each year, I'll have annual net rental income of $58,800 on assets worth $2.1m with debt of $815,000, and in about 20 years the mortgages will be paid off and my net rental income will go up.  If I sell, I'll owe some significant capital gains taxes because my basis is low and I've been depreciating both properties for some time.   

[PMJL34]

Interesting case study and I'm in a similar boat as you.

I need a lot more info like....

Break down of other assets you own like index funds and bonds
Annual expenses
I'm assuming you have a primary home as well and what value that is
Does the monthly mortgage payment you mentioned include PITI and utilities?
Any major deferred maintenance

I would def stop paying 1k extra payments to both immediately and put them in index funds.

I'm personally comfortable generating 58k net on 1.3equity. it's really a lot less than 1.3 because of taxes of selling. But again, I'd want to see other assets before quitting.

[Dicey]

The advice covered in this thread applies to investment properties as well:

https://forum.mrmoneymustache.com/throw-down-the-gauntlet/dont-payoff-your-mortgage-club/

[uniwelder]

Something I learned on this forum was to never pay extra principal toward your mortgage. It’s equity that isn’t readily accessible and if foreclosed, you’ll never get back. Invest the money elsewhere until there’s enough to pay the mortgage off completely.

[SeattleCPA]

Something I learned on this forum was to never pay extra principal toward your mortgage. It’s equity that isn’t readily accessible and if foreclosed, you’ll never get back. Invest the money elsewhere until there’s enough to pay the mortgage off completely.

I kinda think paying off mortgages often makes sense.

If you've got any bonds in your portfolio, for example, seems like a lot better deal to use extra funds to avoid a 4% mortgage interest cost than to buy a treasury paying 2%... or less.

Another thing is, the tax treatment may further juice the effective return. E.g., if you're not getting a tax deduction on the 4% (because you're subject to passive loss limitation rules or because you're subject to mortgage interest limitations), that 4% interest cost you may save isn't like a 4% taxable bond. It's like a 4% muni bond.

A final comment: If you're looking at the next decade of stock market returns and, based on something like CAPE 10, think that stocks will deliver pretty modest returns, getting a guaranteed 4% return by prepaying a mortgage seems a compelling choice.

BTW, I do agree that you have to think about the illiquidity this causes.@uniwelder makes a really important point about that. But also think early prepayment can make sense.

[uniwelder]

Something I learned on this forum was to never pay extra principal toward your mortgage. It’s equity that isn’t readily accessible and if foreclosed, you’ll never get back. Invest the money elsewhere until there’s enough to pay the mortgage off completely.

I kinda think paying off mortgages often makes sense.

If someone were to pay down the mortgage, could we agree that they should at least decide on one property, rather than paying equal portions to both?  Whether it be the one with the lower balance or with the higher interest rate?

edited to add--- SeattleCPA, in your examples, an interest rate of 4% is used, but the OP has 2.8% and 3.0% rates on the mortgages.  Might not change your advice, but does make paying down the mortgages less advantageous versus putting the money elsewhere.

[SeattleCPA]

Something I learned on this forum was to never pay extra principal toward your mortgage. It’s equity that isn’t readily accessible and if foreclosed, you’ll never get back. Invest the money elsewhere until there’s enough to pay the mortgage off completely.

I kinda think paying off mortgages often makes sense.

If someone were to pay down the mortgage, could we agree that they should at least decide on one property, rather than paying equal portions to both?  Whether it be the one with the lower balance or with the higher interest rate?

edited to add--- SeattleCPA, in your examples, an interest rate of 4% is used, but the OP has 2.8% and 3.0% rates on the mortgages.  Might not change your advice, but does make paying down the mortgages less advantageous versus putting the money elsewhere.

Agree it'd make sense to pay only one of mortgages at a time. Also, I missed interest rate, so absolutely use 3% versus whatever the bonds someone holds pays... I'm holding intermediate treasuries paying 1.6% I think... so 3% while low is nearly twice that rate I'm paid on what I'm loaning the government.

As noted, I think you want to tweak these pre tax numbers for any tax effect.

And then I'd think you compare the 3% to what you expect your stocks to do. BTW, I sort of buy into Vanguard's expectation, which is 2% to 4%... so 3% guaranteed doesn't sound that bad.

Final comment: I'm not really presenting any of this as a rule of thumb or a general principle. Rather, I'm thinking you want to do the math and try to compare the after tax return on the mortgage prepayment with what you think your other options are. It seems like different investors would do the math and then come to different but correct answers.

[waltworks]

What's the bigger picture here? If I have a million+ bucks in extractable equity and nothing invested elsewhere and I'm a healthy 35 year old, I'd sell at least one of them and diversify.

If I have $10 million in index funds and terminal cancer and I'm passing the properties to my heirs imminently, different story, obviously.

The reality I'm guessing is somewhere in the middle so the answer's not super obvious.

I personally would not count on the inheritance cost basis reset for investment property lasting too much longer. It's inherently pretty stupid and regressive. That said we have a lot of stupid/regressive tax policies, so who knows.

-W

[waltworks]

And then I'd think you compare the 3% to what you expect your stocks to do. BTW, I sort of buy into Vanguard's expectation, which is 2% to 4%... so 3% guaranteed doesn't sound that bad.

I believe the Vanguard prediction is a real-returns prediction (AFAIK) whereas your 3% mortgage is fixed and hence effectively likely to be around zero percent real (but guaranteed!) return in a historically average inflation environment.

-W

[SeattleCPA]

And then I'd think you compare the 3% to what you expect your stocks to do. BTW, I sort of buy into Vanguard's expectation, which is 2% to 4%... so 3% guaranteed doesn't sound that bad.

I believe the Vanguard prediction is a real-returns prediction (AFAIK) whereas your 3% mortgage is fixed and hence effectively likely to be around zero percent real (but guaranteed!) return in a historically average inflation environment.

-W

Here's quote with percentages used and which look to me like nominal returns, based on that '21 return:


Over the next decade, investors should expect 2% to 4% U.S. equity market returns annually, the Vanguard panel said. That's far below last year, when “we had a return in the S&P 500 of close to 28%,” said chief investment officer Greg Davis, who joined Buckley.Jan 13, 2022.

Source: https://www.google.com/amp/s/www.inquirer.com/news/vanguard-stock-bond-market-forecasts-2022-time-buckley-greg-davis-sara-20220113.html%3foutputType=amp

[waltworks]

You are correct, it appears they are forecasting zero or even maybe *negative* real returns over the next decade (roughly the same as the 3% mortgage).

That prediction explicitly includes another prediction - that inflation will return to it's historical 2.5% or so (something I tend to agree with but many do not). If you're more concerned about inflation, investing rather than paying the mortgage might be a more attractive option.

I'm in a position to write off mortgage interest (as is OP, I assume) so there's still an advantage there, but it's a small one.

-W

[SeattleCPA]

You are correct, it appears they are forecasting zero or even maybe *negative* real returns over the next decade (roughly the same as the 3% mortgage).

-W

Perhaps it would be more accurate to say "It appears you might be correct..." Because this all seems pretty murky to me. I grant you, the numbers don't quite make sense.

BTW on a totally different topic, this perspective from a tax accountant about the Section 1014 step-up in basis...

I think as someone who deals with estate tax returns--the threshold for estate tax is relatively low in Washington state--that the step-up makes quite a bit of sense.

The practical issue it addresses is how can the executor know what grandpa paid for those assets in his estate once he's dead. Also remember that he and grandma would have never known they needed to keep cost basis info in the 1960s or 1970s.

BTW, what does seem likely or likelier to me? That some future Congress allows the estate tax limit to ratchet back down to roughly $5M-ish. And that as President Biden proposed, that laws change about valuation rules for estates.

Also note that once people do the math, the big estates get tagged pretty good if existing laws applied and loopholes closed. Nearly 50% tax at a federal level. In Washington state where I live, after $2M-ish, rates start at 10% and pretty quickly rise to 20%. So the policy impact here may be less than one initially assumes.