How to Structure Accelerated Mortgage Payoff with CF from Rentals

[Tr10av]

I wanted to get the board's opinion on a couple different strategies for paying off my rental properties sooner than 30 years and see if there was one strategy that made more sense that the other. Each of these strategies assumes I have ample reserves for vacancy, repairs, and other problems on hand and that I do not require the cash flow generated for any other purposes. At the moment I have 2 properties with the goal to add an average of 1 per year. My philosophy is that I fund my real estate purchases through my own savings and then treat the properties as a stand-alone investment that should not require additional capital outside of what each property produces. I also do not want to take money out of the "business" as I want each branch of my investment strategy to stand on it's own.

Strategy A - Treat each property as it's own business
In this strategy I would apply the excess monthly cash flow from each property to it's respective mortgage. This allows the better performing properties to pay for themselves quicker and also provides additional equity in the event I needed to sell for an unexpected reason. This also allows for "hiccups" so if a property goes from over-performing to under-performing due to economy, neighborhood deterioration etc each property would stand on its own and not have all my equity tied into a property on the downward swing.

Strategy B - Treat all properties as a giant business
In this strategy I would apply the excess monthly cash flow from all properties to one mortgage at a time with the goal of paying them off as quickly as possible. This allows me to have a smaller number of mortgages outstanding and reduces my risk as a borrower. I would order the mortgages based on interest rate, current balance, projected income, etc. However, with this strategy there is the potential that the property I place all my cash flow in becomes undesirable (trashed by tenants, and issues from Strategy A) and all my eggs are in one basket instead of spread evenly.

if you are an investor working to pay down mortgages which do you prefer and why? 

[SuperMex]

You should put all effort into paying down the mortgage with the highest interest if that is your goal.

Mathematically you would make more money by using the extra cash flow to keep buying more cash positive rentals and selling those that don't make a profit.

Eventually you could sell them all and buy a multi-unit property for easier management when you are ready to hang it up.

[Drifterrider]

To the OP:

Are you trying to own real estate or make "cash flow".

The answer to my question will give you the answer to your question.

[Secretly Saving]

We are using a hybrid method of what has been suggested.  We are using excess business cash flow to pay down the house with the highest interest rate. 
We are also buying new properties when the numbers make sense. 

[Tr10av]

You should put all effort into paying down the mortgage with the highest interest if that is your goal.

Mathematically you would make more money by using the extra cash flow to keep buying more cash positive rentals and selling those that don't make a profit.

Eventually you could sell them all and buy a multi-unit property for easier management when you are ready to hang it up.

I definitely understand that paying the highest interest rate down makes the most sense mathematically. However, when you factor in risk my question is basically "Does it make more sense to have 2 mortgages 50% paid off or one that is nearly paid off and one that has 80% of payments to go"?

[Another Reader]

The range of my interest rates is about 1.75 percent.  I'm using the hybrid method of paying down mortgages and saving cash for new purchases where (or should I say when) the purchases make sense.  If the rate is under 5 percent, I'm ignoring accelerated payments.  I'm paying off the lowest balance over 5 percent first.  Once that loan is paid off, I will focus on the next lowest balance.  Although I will pay a little more interest in the long term, I'm reducing my risk by removing the mortgage liens. A cash flow/liquidity crunch will not affect me if most of the properties are free and clear. Every property that is paid off is removed from the mortgage risk pool. 

I am also taking advantage of a better market to unload a couple of the weaker properties  I will use the proceeds to pay off other mortgages, further reducing my debt risk.

[MetalCap]

I think your end game and timeline are critical to seeing the answer for you.

We're in our first 2 years of real estate investing and are focused on acquisition and scaling as fast as smartly possible.  Any additional cash flows after reserves etc go toward the next property but our time horizon is 10+ years.  We also view appreciation as a key wealth generator and rank that above cash flow. A cash flowing property already covers mortgage payments but additional mortgage payments do not increase your wealth beyond the value of the loan.

This question is very similar to the questions being asked on these boards for years about whether or not paying off your primary mortgage is fiscally correct.  I personally disagree that removing the mortgage liens does anything to reduce your risk.  Having a mortgage spreads the risk on the property between you and the bank, if you have reserves and a rentable property then your risk of foreclosure is very very small.

[Another Reader]

We're in our first 2 years of real estate investing...

I personally disagree that removing the mortgage liens does anything to reduce your risk.  Having a mortgage spreads the risk on the property between you and the bank, if you have reserves and a rentable property then your risk of foreclosure is very very small.

Two years investing in a rising market does not give you much experience or perspective.  After 35 years in real estate, my experience leads me to a different conclusion.    Watched a lot of investors crash and burn over the years.  When you have been through a severe down market like 2008-2012, you may change your opinion. 

[Tr10av]

We're in our first 2 years of real estate investing...

I personally disagree that removing the mortgage liens does anything to reduce your risk.  Having a mortgage spreads the risk on the property between you and the bank, if you have reserves and a rentable property then your risk of foreclosure is very very small.

Two years investing in a rising market does not give you much experience or perspective.  After 35 years in real estate, my experience leads me to a different conclusion.    Watched a lot of investors crash and burn over the years.  When you have been through a severe down market like 2008-2012, you may change your opinion.

This is what I am most nervous about. I don't want to be 5 properties in and have an unforeseeable event come in and wipe out all my progress of the past 3-5 years from having $100k in student loans to having no personal debt at all and 2 (mortgaged) rental properties. I would rather scale slowly and safely than take on unwanted risk.

[MetalCap]

That is exactly my point, you've been doing this for 35 years so your end game and horizon are very different from mine and OP's.  I assume that OP has a similar horizon as I do based on a similar number of properties.

If that is correct, your advice may be stunting their acquisition phase.  I lived through the Recession as well, working at a Commercial General Contractor and scraping by, I'm well aware of what happens.

[MetalCap]

This is what I am most nervous about. I don't want to be 5 properties in and have an unforeseeable event come in and wipe out all my progress of the past 3-5 years from having $100k in student loans to having no personal debt at all and 2 (mortgaged) rental properties. I would rather scale slowly and safely than take on unwanted risk.

Your market and your individual properties will determine that more than what the overall market does.  Take a look at Austin which boomed through the Recession or Detroit which died during the run up before.  Real Estate is more local and if your properties are cash flowing and have reserves, your renters won't disappear in a day.  Additionally, if a recession hits, the difference between a 50% paid off mortgage and a 75% paid off mortgage won't matter in terms of foreclosure, keeping renters and getting you through the tough years.

If you do as you say and do a house a year and make sure its set up before going after the next, it seems like you are scaling safely and thoughtfully.

[Another Reader]

"Stunting" the acquisition phase might avoid disaster.  Ramping up when the market is distressed and buying good properties is easy, except you need cash. Don't know what you are buying in the DC market, but that market is also cyclical.  Don't get lulled by the long run up in prices. Buying possibly at the top of the market and calling a few percent off retail a good deal is not a good plan.  Focus on buying properties that make sense and build a wide moat between you and the lenders.