Author Topic: Why not include principal paydown in rental calculations?  (Read 3915 times)

mulescent

  • Stubble
  • **
  • Posts: 114
Why not include principal paydown in rental calculations?
« on: September 01, 2014, 03:08:06 PM »
Hi all,

I'm considering buying another house and am stuck on the familiar "rent or sell" dilemma for my current house.  Before I get to my question, here are the details:

Market Value: ~500k
Original Purchase price: 425k
Original Mortgage Amount: 382k
Interest Rate: 3.25
Mortgage Term: 30 yr
Term remaining: 28 yr
Amount remaining on mortgage: ~369k
Gross Rents: 2400 (estimated with comps)
Principal and Interest (the P&I of your PITI - should match with the above info): 1.6k
Taxes and Insurance (the T&I of your PITI): 522
HOA costs: 0
Deferred maintenance notes: None

Obviously, this property breaks all the regular rules of thumb.  Here is my question, though.  The principal paydown is ~7.5k a year currently.  The total equity (after paying for a realtor, etc) I could extract by selling is ~100k.  So, I'm getting a 7.5% return assuming the rent covers expenses.  This assumes 1) prices will at least track with inflation and 2) I am OK with this highly illiquid asset.  Traditional RE investing focuses on cash flow, which I get because people are trying to build an income stream.  However, I'd take a 7.5% inflation-adjusted return even if I can access the returns for a long time.  What am I missing?
« Last Edit: September 01, 2014, 03:32:28 PM by mulescent »

Another Reader

  • Walrus Stache
  • *******
  • Posts: 5109
Re: Why not include principal paydown in rental calculations?
« Reply #1 on: September 01, 2014, 03:46:22 PM »
That the $7,500 is not return ON your $100k of equity.  The return on your equity is the appreciation plus or minus the net cash flow to the equity position.  The $7,500 is an injection of additional equity and belongs in the denominator, not the numerator.

arebelspy

  • Administrator
  • Senior Mustachian
  • *****
  • Posts: 28103
  • Age: -999
  • Location: Seattle, WA
Re: Why not include principal paydown in rental calculations?
« Reply #2 on: September 01, 2014, 10:55:14 PM »
That the $7,500 is not return ON your $100k of equity.  The return on your equity is the appreciation plus or minus the net cash flow to the equity position.

I'm not sure I agree.  (I think I may not fully understand what you're getting at though.)

The $7,500 is an injection of additional equity and belongs in the denominator, not the numerator.

It's only an injection of additional equity if it's coming out of your pocket.  If it's paid out of the rents, then it's part of your return.

I'd calculate one's total return as "however much your net worth increased" divided by the equity you could have extracted.

Things that increase the net worth are appreciation, cash flow, principal paydown, and tax benefits.

I count principal paydown in my total return, but I don't in the real number I'm interested in - cash on cash return.  I want cash flow, and principal paydown and appreciation to happen on top.  Why just take appreciation and principal paydown when you can have cash flow also?

The problem is your assumption of "the rent covering the expenses" - the rent would have to cover all expenses plus the P&I for it to count as return.  Otherwise you're in AR's scenario of where you're injecting capital, and then it's not return on equity.

In this scenario, you're cash flow negative.  It's not going to cover the expenses and mortgage payment.  Sure, you could say "once you count in appreciation and principal paydown I'm slightly net worth positive" - but what could you do with that 100k of equity instead?

What if you put that as a downpayment on a property that would also get the same principal paydown and appreciation as this property, but also cash flowed a decent return as well?

Either way this doesn't seem like a dilemma, but a clear sell.
We are two former teachers who accumulated a bunch of real estate, retired at 29, spent some time traveling the world full time and are now settled with three kids.
If you want to know more about us, or how we did that, or see lots of pictures, this Business Insider profile tells our story pretty well.
We (rarely) blog at AdventuringAlong.com. Check out our Now page to see what we're up to currently.

mulescent

  • Stubble
  • **
  • Posts: 114
Re: Why not include principal paydown in rental calculations?
« Reply #3 on: September 02, 2014, 12:51:33 PM »
That the $7,500 is not return ON your $100k of equity.  The return on your equity is the appreciation plus or minus the net cash flow to the equity position.

I'm not sure I agree.  (I think I may not fully understand what you're getting at though.)

The $7,500 is an injection of additional equity and belongs in the denominator, not the numerator.

It's only an injection of additional equity if it's coming out of your pocket.  If it's paid out of the rents, then it's part of your return.

I'd calculate one's total return as "however much your net worth increased" divided by the equity you could have extracted.

Things that increase the net worth are appreciation, cash flow, principal paydown, and tax benefits.

I count principal paydown in my total return, but I don't in the real number I'm interested in - cash on cash return.  I want cash flow, and principal paydown and appreciation to happen on top.  Why just take appreciation and principal paydown when you can have cash flow also?

The problem is your assumption of "the rent covering the expenses" - the rent would have to cover all expenses plus the P&I for it to count as return.  Otherwise you're in AR's scenario of where you're injecting capital, and then it's not return on equity.

In this scenario, you're cash flow negative.  It's not going to cover the expenses and mortgage payment.  Sure, you could say "once you count in appreciation and principal paydown I'm slightly net worth positive" - but what could you do with that 100k of equity instead?

What if you put that as a downpayment on a property that would also get the same principal paydown and appreciation as this property, but also cash flowed a decent return as well?

Either way this doesn't seem like a dilemma, but a clear sell.

I agree with you about the ultimate conclusion.  It just happens to be the house I currently occupy, a notoriously bad starting point for landlording.  I guess I was just curious about how people counted principal paydown on rentals.  It seems like for some, it's either completely irrelevant or considered a nice bit of icing on the cake.  To me, it seems like a meaty source of extra dollars.  Anyway, thanks for your thoughts.

waltworks

  • Magnum Stache
  • ******
  • Posts: 3393
Re: Why not include principal paydown in rental calculations?
« Reply #4 on: September 02, 2014, 01:59:21 PM »
I include it in my future planning (I do not plan to hold my properties indefinitely as they have appreciated beyond the point where they make sense as rentals - one down this year, two to go next year) but with the caveat that the end selling price of the property isn't 100% predictable and there are going to be significant costs associated with liquidating.

IMO, it's fine to ignore the equity in the property for the purposes of rentals you'll hold for long periods of time, since the value for you is in the cash flow. If you are not going to hold onto them forever, obviously any reduction in liabilities will increase the amount you receive in the end, hence affecting your return on investment.

In the OP's specific case, I think the 50% rule (maybe make it 40% since it's a higher end place) still says it's cash flow negative by a decent amount so probably better to sell.

-W

hardworkingpenguin

  • 5 O'Clock Shadow
  • *
  • Posts: 11
  • Location: Las Vegas
  • Real estate investor in Las Vegas
    • Hardworking Penguin
Re: Why not include principal paydown in rental calculations?
« Reply #5 on: September 06, 2014, 04:48:27 PM »
Although this house is not that great on cash flow, but a 3.25% (fixed right?) mortgage rate is insanely awesome to have. It really depends on the rest of your financial situation. This house has a very low risk in the sense that your payments are going to be this low for 28 years. If you sold the house and get a 4.25% financing on a new house, to have the same payment you can only borrow 338k. I'd stick it out for the long run if I can afford it financially. Vacancies do hurt when the rent is around $2400.