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It’s Friday, and you know what that means: time for another reader case!
Now, I’ve just realized that it’s been a while since we did a housing-heavy case study. These are always a bitch to parse through because of the sheer volume of numbers involved, but what can I say? I like pain (just ask FIRECracker).
So I dug into my trusty pile of reader cases for a good housing-related one and as usual our readers did not disappoint.
Hi,
I first heard about your blog this evening and have spend the last 5 hours pouring through your posts, which has basically forced a ‘come to Jesus’ moment on me. I always thought my husband and I were great with money and had a perfect retirement plan, but now I think we’ve gone about this the completely wrong way.
I am 35, and my husband is 38. Our combined annual income is about $160k CAD (we get bonuses that can make that number go up a little). After taxes our income drops to $110k. We also have four houses in various stages of being paid off, since that has always been our retirement plan. House 1&2 are each worth about $100k (they’re actually condo apartments), and are paid off. House #3 is worth about $180k, and has $100k in debt left. House #4 is worth $300k, and has $230k in debt left. The interest rate for house #3 is 2.99%, and #4 is 2.89%.
With H#1, we rent it out for $850 a month. Our monthly expenses for this one include condo fees of $240 a month, and (average) property taxes of $105.00. H#2 has the same expenses, but we get $800 a month.
With H#3, we rent it out for $1200 a month. Our mortgage is $680, condo fees are $220, and average property taxes are $176. The mortgage is higher than what most calculators would predict because we have it set to be paid off quicker.
With H#4, we’re living in it. The mortgage is $1270, and total monthly spending, including utilities, taxes, food, and everything else comes to about $2000, but factor in another $10,000 a year for vacations. We have a car, but it’s paid off and should have 1-2 more years of driving in it with minimal repairs.
We only have about $40,000 in savings, and another $20,000 in RRSPs, but that’s because we’ve been paying off the mortgages as quickly as we can to minimize the interest we’re paying. With our current schedule, we should have all four paid off in 6.5 years.
Our plan has always been to have all our properties paid off, work for a few more years after that to save up as much as possible for a nest egg/safety net, and then use the rent money (approximately $3000) and savings to retire by our mid-40s.
However, after reading through all your posts about getting rid of mortgages and how investing is safer than having money tied up in property, I’m wondering if we’re going about this the wrong way. We’ve also recently had to dump about $8000 in repairs on one of our units, which makes me paranoid about what else could break next. With our income and the amounts we could get from selling our houses, do you think we could retire sooner than 10 years?
Thanks so much!
4Houses
You see what I mean? That’s a LOT of numbers. But we here at Millennial-Revolution don’t get intimidated by mere numbers, so without further ado, let’s MATH SHIT UP!
First of all, FOUR HOUSES? Yeesh. We debated for years about buying even a single house, but FOUR? I’m hyper-ventilating just thinking about it.
But aside from that, 4H made a totally rookie mistake when it came to how she dealt with her debt.
When you have as many mortgages as 4H does, your natural instinct would be to pay off as much of it as possible. That’s why she’s taken her considerable salary and basically thrown most of it towards paying off her debt. For most people, that’s the right thing to do.
However, 4H isn’t most people. She’s a real estate investor.
Now, I don’t write about real estate investing on this blog since I’ve never done it, and I don’t like recommending that people do things that I haven’t tried and tested myself, but there are real estate investing bloggers out there like Paula Pant from AffordAnything.com or Sam from FinancialSamurai.com that I enjoy reading and learning from.
And for real estate investors, you actually want to pay off the mortgage on investment property as slowly as possible. This is because the more debt you have on an income-producing property, the less of your own money you have tied up in that property. And since the formula for Return-on-equity or ROE is Income/Equity, it actually makes more sense to keep your Equity as low as possible to make your ROE as high as possible.
Of course, the less equity (and therefore, the more debt) you have on your property, the more likely a sudden drop in the property’s value will render you underwater, which puts you into a meat-grinder position of being unable to sell unless you cough up enough cash to cover the difference.
That’s why a successful real estate investor has to be able to:
- Find good tenants that will pay the rent on time
- Be able to keep maintenance costs low by fixing shit themselves
- Be able to delicately balance the opposing forces of debt and equity to keep their ROE high while keeping the risk of going underwater at bay
That’s why I don’t invest in real estate. I am good at precisely none of these things. And judging by 4H’s email, she shouldn’t be investing in real estate either. She seems to have figured out #1. But based on the fact that unexpected repairs cost her $8000, she doesn’t appear to be good at #2. And based on her decision to pay off her investment property’s debt first, she’s not good at #3 either.
Instead, the correct thing for her to do was to direct her money towards paying off her own mortgage (since that’s not an investment property) while keeping her 3 rental units leveraged.
But whatever. Mistake already made, let’s see what we can do about the situation.
First, let’s look at her current trajectory. 4H projects being debt free in 6.5 years. Super. Good for her.
At that time, her rental income per month will be $850 + $800 + $1200 = $2850. And her condo-related expenses per month will be $240 + $105 + $240 + $105 + $220 + $176 = $1086. That makes her net rental income $2850 – $1086 = $1765.
That’s not quite enough to cover her living expenses of $2000, so she’ll have to keep saving until she builds up a portfolio large enough to cover the difference. And of course, if she keeps getting hit with random $8000 repair costs, who knows when that’s going to happen.
But what if she were to sell everything? If 4H sells the 3 investment properties, she’ll get $100k + $100k + $180k = $380k. After real estate commissions, that becomes $361k. And after paying off the $100k mortgage on House #3, that leaves $261k.
Now hidden in that number is the capital gains tax she’d have to pay on that. That’s a number I don’t have enough information to calculate, since I don’t know her buy prices. But let’s assume she slowly sells these things off over a number of years so she doesn’t spike her yearly income too badly, and after taxes she nets enough to cover the $230k mortgage remaining on her primary residence.
Now she’s got a paid off house, no mortgage, and monthly spending of $2000. That mean she’ll need $2000 x 12 x 25 = $600k to retire. She’s got $60k now. How long will it take?
| Year | Balance | Savings | ROI | Total |
|---|---|---|---|---|
| 1 | $60,000.00 | $76,000.00 | $3,600.00 | $139,600.00 |
| 2 | $139,600.00 | $76,000.00 | $8,376.00 | $223,976.00 |
| 3 | $223,976.00 | $76,000.00 | $13,438.56 | $313,414.56 |
| 4 | $313,414.56 | $76,000.00 | $18,804.87 | $408,219.43 |
| 5 | $408,219.43 | $76,000.00 | $24,493.17 | $508,712.60 |
| 6 | $508,712.60 | $76,000.00 | $30,522.76 | $615,235.36 |
6 years.
Also known as, less than the amount of time it would have taken her to just pay off her existing debt. In just 6 years, she could be retired. And not have to deal with the hassle of managing 3 properties.
So while 4H hasn’t done poorly by any means investing in real estate, for all the extra trouble she has to put up with she still trails investing in good ol’ index funds. All while putting up with the financial risk of a bad tenant, a leaky pipe, or a busted roof. If she’s really in love with real estate, she could buy REITs, yielding 5% or more without the hassle.
So I would posit this question to 4H. In 6 years, would you rather be a real estate investor and still struggling to pay off debt? Or an index investor and retired?
What do y’all think? Should 4H become 1H? Let’s hear it in the comments below!
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Good analysis Wanderer. Another way to frame this is around capital allocation. An unlevered investment property often has terrible returns compared to other investments.
While realestate is great for diversifying, it’s frequently not the best return for your dollar *unless* those dollars are significantly leveraged.
Do they have HELOC’s in Canada? That might be one way to get the equity out and increase returns.
Personally I don’t like a ton of leverage myself, so I prefer to own REITs for my real estate investments.
The best return on a dollar frequently isn’t in buildings however, it’s in businesses.
Allocating more capital into businesses (aka stocks) will likely result higher total returns.
We do have HELOCs, so you’re right that would be one way to get your equity back out. I didn’t really want to recommend that since HELOCs have their own risks (like the bank calling it at any moment).
That was shorter and sweeter than I thought it’d be. I’m a bit amazed that with 4 rental properties, it wouldn’t be enough to cover their monthly expenses. I think this was a good reflection point for 4H… sometimes things sound like they should work but when you do the math as seen above… the numbers don’t actually work out. Just as a casual observer I would think sweet… 4 rental properties..yeah that should work out.
Curious what was the motivation on paying off a rental property before paying off your own home?
Just for funsies, was the $8,000 in repairs something to do with a leak? It seems like these houses are always leaking!
Wow, Wanderer, that critique was a bit harsh, eh? I mean these stupid real estate investors get their arse kicked hard by you! To be fair I think 4H has outperformed a high percentage of general population in terms of savings, leveraging other people’s money, investing, and goal planning. If you think about it they could potentially retire with relatively stable income by early 40’s which is awesome.
$8k repair bill sounds nasty but no details provided and sometimes just a part alone can cost close to that much if it was a new furnace or hot water tank, etc even if you were a handy man.
But for real estate investing they actually did quite well by purchasing relatively affordable properties with very favourable cap rates, judging by its rental income relative to property value/purchase price. Where do these folks live, like in Winnipeg(?), for such crazy low prices in Canada?!!
I think they could liquidate one or two properties but still continue renting out but just diversify their investments with the freed up proceeds elsewhere such as stocks or bonds, etc.l
ohh i think you’d be surprised at how expensive even winnipeg is now. My guess is maritimes.
I did say she hasn’t done too badly with these properties. I’d still argue it’s way more stress and work than it’s worth though.
I know what’s done is done, but why did they pay off their rental mortgages before their own? As you say, there is no value in paying off a rental mortgage faster. Actually if you calculate your ROE annually, there will be a point where your ROE is no longer as good as what you would get by investing in stock/ETF. But it’s great when you use the bank’s money! As long as you don’t mind the leveraging and the headache of being a landlord!
Would they consider using segment mortgages on unit 1& 2 (maybe even 3) to apply towards their home? That way they could at least write off the interest. Timing would be critical to avoid any penalty.
They own three condos so at least their expenses are somewhat limited. Curious about the 8K?
Also, they need to make sure they increase the rent annually as allowed by the province.
A ton of assumptions need to be made to make this kind of analysis. Personally, I’d not be comfortable making those assumptions to come up with a simplistic answer.
I am both a real estate investor and a stock investor, and have been very successful with both. I don’t approach the investments as which one will do better, but they are both cornerstones of my foundation. Even if stock markets crash, I can still enjoy cash flow from rent. Generally, stock markets are much more volatile than real estate.
Some of the big assumptions made here are:
1. Stock markets will continue to go up as they have been for another 6 years. BIG BIG ASSUMPTION.
2. Real estate in her area will not appreciate. What area is she in? My condos have appreciated 200+% in the past 6 years.
3. Rents will not increase. Again, what area is she in? Rents in my area have appreciated over 50% in the past 6 years. Properties that initially had a cap rate of 9% now have a cap rate of 16%.
I agree with the number crunching, but the results are totally dependent on the assumptions of a rising stock market with a flat real estate market.
I have invested in REITs and real estate partnerships as well as my own rentals. I much prefer my own rentals due to visibility, predictability, and control of profit/loss. Owning REITs and real estate partnerships, you have to accept bad decisions made my management. Many REITs imploded during the financial crisis due to selling properties at the bottom, or over-leverage, my rental made it through just fine. My most profitable real estate partnership decided to sell a property during a very high income year for me, the partners decided against 1031 exchange, and I ended paying half the profit to taxes; that’s turned me off to real estate partnerships. Not everyone in the partnership has the same aligned interests and priorities.
It actually doesn’t matter if her rentals appreciate, since the rental income wouldn’t increase with it. In fact, that would DECREASE her ROE, wouldn’t it. Though in that case, she might be able to use the higher appraised value to HELOC more equity back out.
For real estate investors, appreciation of their investment does matter. When real estate rises so do rents, of course here in Ontario we are limited to how much we can increase the rent year over year of our tenants, but when they move out we are free to boost the rent. For example, I have a tenant moving out in the fall, great tenant sad to see her go, but because of the increase in property value, I’ll be earning 150$ month more. But even in my houses without tenant turnover, I’m still very interested in property values rising. It’s like having a dividend fund. Sure it pays u every month, but don’t you also like to see it rise in value? Why? Because your net worth is growing.
Well, I don’t know how long ago 4H sent his email out. My advice for them would be to SLOW DOWN.
You only stumbled on this FI blog 5 hours ago and you already want to change your whole strategy 180 degrees.
RE investment is a totally good and valid FIRE strategy. Spend some time on RE investment blogs and learn how to do it better before you decide on such a transformational change of direction.
Maybe you will decide to change course. That’s fine, but do it because you have deep knowledge and awesome spreadsheets, not because you read a blog for 5 hours and are all excited.
Post this same question to some RE investors and see what they think. I love this blog and personally like passive portfolios as a mean to FI, but truth be told, as much as FC and Wanderer are super un-biased, they really aren’t into RE (and openly admit it). Wanderer gave you his analysis, from his POV. It is a good one IF you chose passive portfolio as a financial match for you. Your financial strategy needs to also match your personality. Index investing requires a steady course over many years with nauseating boredem, ignoring the news and not reacting to anything that captures your attention. If you are the kind of person willing to go 180 after an evening on a blog, that might not be for you. Will you change strategy when you read about dividend growth investing? Will you change again when you hear about some other strategy? That’s not coming as criticism of your character, but as a point to consider before changing course.
With your level of income you can toally keep the properties AND build a portfolio.
There are also many personal things to consider. Are you planning to travel the world when you retire? Than maybe not having RE is easier. Do you plan on having kids and putting some roots down? In which case having RE close by is not much of a hassle, and can be a great thing to have for when the kids grow up. (They can move in there, learn practical skills of home maintenance, learn to manage it etc).
What is your risk tolerance? The last 10 years were great for investors. Things are a bit more scary now…
Another note regarding Wanderer point on underwater mortgages: this isn’t an issue if the property is cash-flow positive. If anything, by having 3 investment units they have some diversification and can withstand a shock like a unit going unrented for a month.
So, my take on it is stay the course while you learn more about index investment, investment accounts, taxation, deepen your knowledge of RE investment and pick up some home-fixing skills. Spend a year following the investment workshop on this blog and see if you are built for the patience and strady-hand that index investing requires. And then decide when you have experienced both strategies. You are already in a very fortunate position and can probably enjoy both strategies.
I like the fact that even at low interest rates, you believe in paying off your home, rates can reset much higher in the future, and probably will, and with the Markets hitting a high point, you have to wonder in the next 5 years, would you get a 6% return on that money? Or am I betting paying off debt?
cheers
I totally agree. Many people say that low interest rates climate is good for borrowing.
I think it is the best climate for getting rid of debt.
I think real estate investing works well if you are investing in properties in foreclosure or auction at sufficient discount to the initial price. I think problems happen much likelier if you buy a brand new unit selling at premium price due to all the marketing and hype.
This is awesome! Having absolutely no interest in real estate (at least currently in the atrocious housing market of Los Angeles) makes me always interested people’s decisions to own multiple properties. Love your breakdown and will continue to enjoy not having to deal with tenants or unexpected expenses.
H4 is doing pretty well overall even if the RE investing hasn’t been optimized. My partner and I have the same before and after-tax income and comparable expenses. We’re also mid 30s, in Canada and on track to FIRE. So if H4 wants to compare to a likeminded peer…..they might be interested to know that we’ve focused on index investing and we have approximately the same NW (if you tally up their equity). We plan to FIRE in our early 40s….in about 6 years. The reason I haven’t gone the RE route is because I don’t like dealing with tenents and I don’t like home repairs. The biggest factor for H4 is earning lots, spending much less and investing the difference……everything else is just optimization. If the markets do poorly in the coming years H4 will have a more comfortable ride. If the market chuggs away a little longer I’ll have nice ride. No one can predict! Maybe a mix is good idea for H4….sell the one house with the most equity and put it into index funds.
Hi Wanderer,
i agree that you are correct with your analysis and somehow you answered their question. If they were to invest in real estate they should have kept tbe mortgage and a good ROE. I believe this can be a good strategy in addition to the index funds. Have a base income from real estate so that you can invest more in stocks and less in bonds (index funds of course). If the market goes down you still have the income from tbe rents.
At least that is my current plan. This way, even after FIRE, I intend to allocate the majority of my savings to stocks index funds.
Food for thought…
That’s not a bad strategy either, though at their current cap rates they may as well just buy REITs and be done with it.
Is there a reason you didn’t add in an extra $10,000 a year for vacations for their retirement? I feel like their numbers for estimating their monthly spending might be too low as while they likely got raises over the years and acknowledging they’ve been paying off mortgages and interest – they should have way more savings should they not? It seems like money’s bleeding somewhere, and likely not just the occasional big repair bill. I agree that the only house they should be racing to pay off is their own, but I wouldn’t jump super fast to sell and change my entire investment strategy after a 5 hour binge session! Take the time to reassess your position/focus and for example consider selling one house only to start and see what impact that has on your stress levels lol!
They wouldn’t need vacations after they’re retired 🙂
There are a few FIRE bloggers out there who are happy with a non-house nomadic lifestyle. But what if you’re a homebody? Consider your own ideal life before adopting someone else’s. If you wish to have roots, owning a home might just be a fantastic idea.
Also, the country you are in affects your situation from a tax perspective. If you are in Canada, you’re going to want to push all of your debt onto your rental properties so that the interest is tax-deductible. I have no idea how it works in the US.
I am not well-versed in real estate investing, but given the “cost” to sell 3 rental units (legal fees, real estate, capital gains), I wouldn’t rush to do this. Could they get HELOCs on the equity from the 3 rentals to make a huge paydown on their own mortgage? That would free up their own living expenses on their primary property (ability to invest more in ETFs), and improve the ROE on the 3 rentals. If they want to diversify in stocks+real estate, they could then sell their primary property (no capital gains) and potentially live in one of the rentals (not sure if they are in a similar area, if it would work for their lifestyle). The funds from the sale of the prime property could be put into ETFs. This way they have an investment portfolio and rental properties. Would love it if Wanderer could “math the shit up” on a blended scenario like that.
I don’t know the specific details, but for sure I would sell House #3, the ROI is really low. Even for houses #1 & #2 the ROI is not great.
Ok, so if I understand this correctly, they r roughly 1100$ cash flow positive on their properties. My suggestion would be to stop aggressively paying down house 3. Get mortgage payments as low as possible so it gives u a better cash flow. That should give you an extra 200$ month cash flow, that brings you up to 1300$ month. Now you only need to make up 700$ per month to meet your $2000 month expenses.
700x12x25=210,000. Minus the 60,000 you already have = $150,000. You could retire in a couple years.
Plus eventually when you pay off the other two houses your income will go up. Real estate investing could be a key to retiring early, but there is a learning curve.
Nice information, thanks for sharing.
It’s always a good idea alongside affiliate marketing, blogging and becoming a side hustle millionaire to diversify your income potential through real estate. That gives anyone a financial blanket to fall back on just in case of anything.
Only read this today but thought I could provide 4H food for thought…
Seems like 4H could really benefit from a better understanding of how they are being taxed and will be taxed. This is probably the most complex part of their plan, but it can really increase their Roe.
1. It seems that they may not be maximizing their Rrsp. The savings they get by deferring their taxes can outweigh any savings they gain by reducing interest payments from paying down debt.
2. Understand if they can deduct the interest payments on their rentals or any heloc they take out vs no deductions for interest on their primary residence.
3. The capital gains tax from selling properties now will be significantly higher than if they sold when Fire and will be in a lower tax bracket.
These and other tax implications make this analysis quite complex but that is 4H’s reality and she will be much better off once she figures that out.
À trip to a tax planner is my recommendation.
First post on this blog and I know I am a bit late for this reader’s case but I just had to post given 4H’s situation.
It seems that 4H is seriously in need of getting better understanding of the tax implications of their capital allocation strategy. Tax issues are complex, but they are 4H’s reality and can make a huge impact on how quickly they get to their goal.
1. 4H and her partner are fairly high income earners and appear to be in a high tax province (maybe they live in an Atlantic province), but they seem to be negleting their RRSP. It is possible that advantages of deferring taxes by contributing to their RRSP are far greater than the savings they get from reducing interest payments on their RE investments by paying down mortgage using after tax money.
2. 4H needs to understand what expenses are deductable. Interest and maintenace expense on the rentals are probably tax deductable, interest on their primary residence is not. Taking out Helocs to pay down the mortage on their primary residence may also be tax deductable. Given their tax bracket, this can make quite a big different.
3. 4H needs to understand their capital gains tax implications if they sold their RE investments now (while earning a good income and are in a high tax bracket) versus selling when FIRE (when they will be in a lower tax bracket). If they are retiring soon (in the next 10 years), that capital gains tax alone could make it not worthwhile to switch to an index investing strategy.
When you throw taxes into the mix, it becomes much harder to Math it all up. But that’s what makes the Math even more fun! And 4H will be much better off if she learns how to do it. Unfortunately, you will not get that kind of tailored advice on a blog.
A trip to a tax specialist (or a serious dive into Canadian tax rules) would be my recommendation.
Great post and great comments. We’ve been contemplating this topic as well. We have 7 investment properties in Ontario with $3.1M in equity. 2 are paid off, with around $2700k/mo in cash flow. No mortgage on primary home, but HELOC of $400k was tapped to fund down payment for some of these properties. New ‘job’ funds are being directed to pay off a 3rd investment property to increase cash flow for FIRE. (from 2700 to 3600). I know, bad for ROE, but great for cash flow.
SOOO… to retire, we were going to use rental property cash flow + $600k RRSP funds until RRSPs run out. Then sell off properties one at a time and use the after tax, after sale money to fund any deficit living expenses. When the money runs out, sell another one. Repeat. Is this crazy?
Such a great post
Keep sharing it with us, Very interesting post….