Real Estate

Should You Pay Off Your Rental Property, Reinvest or Buy?

If you’re like most investors, you’ve probably asked yourself, “Should I pay off my rental property early?” With today’s high mortgage rates, troublesome inflation, low inventory, and risky economy, many investors don’t know whether it’s the right move to pay off their mortgage, reinvest in their properties, or go out and buy more. Paying down your debt gives you a guaranteed return, but with home prices still climbing, you could miss out on the sizable appreciation of getting another rental.

On today’s show, we’re going to debate which is the best move to make. Should you pay off debt, buy more investment properties, reinvest in your portfolio, or put more money down when you buy? Each investor has a different method for their next move, but thankfully, our expert panel gives their thought processes for figuring out which decision is best for your portfolio. Henry even shares his “three buckets” framework that EVERY investor should think through BEFORE investing or paying off a property.

We’ll also discuss the crucial calculations you can use to help you decide and avoid analysis paralysis if you’re stuck between choices. Plus, how a high-risk house flipper like James protects himself from downsides even during tough markets like today. Don’t pause on making moves that could help you reach financial freedom; stick around, and we’ll show you exactly how to know which moves to make in 2024’s housing market!

Dave:

With the trio of challenges facing the real estate industry, which are interest rates, inventory, and inflation. What should investors do right now? Should they try and buy new deals? Should they add value to what they have? Should investors stop investing and just pay off their current properties? Today? We’re digging into that and debating what investors should do. Hello and welcome to On the Market. I’m your host, Dave Meyer. With me today are my friends, Henry Washington. James Dainard, guys, good to see you.

James:

Morning. What’s up

Dave:

Buddy? Well, as you know with today’s interest rates, inflation, all these things, these challenges, I don’t know if you guys hear this question a lot, but I have a lot of people asking me, I have X amount of dollars, 20 grand, 50 grand, a hundred grand. They don’t know what to do with it. Do you put it into a new property? Do you reinvest? Do you pay down debt? So that’s what we’re going to talk about today. This big question is now a good time to invest or are there better ways to be allocating your resources in this economy? So I’m excited to talk to you both about that. But before we jump into today’s debate, I want to just give investors sort of a quick market update. If you don’t follow mortgage rates on a minute to minute basis, like I unfortunately do, you may not know that interest rates on mortgages have actually come down a bit over the last couple of weeks.

We are recording this on May 20th, so they shot up in April up to about 7.5%. They’re down now to about 7% at the time of this recording. So that is encouraging, improving affordability a little bit. We’re also seeing that active inventory is starting to tick up just a little bit over the course of the last few months, which is also encouraging for a healthier housing market. And as of the last reading, which is April, 2024, firmer Redfin median home price in the US is $433,000, which is up 6.2% year over year. Pretty strong situation. So James, given what’s going on with these market conditions, do you think right now is a good time to be pursuing a new investment or should people be thinking about putting their resources elsewhere?

James:

I think it depends on what kind of investor you are and what kind of your appetite for risk is. For me, I’m a riskier investor. I chase high return investments and when we have everything at high cost, interest rates, inflation, cost of product, cost of labor, the only way that you can keep up in investing is by buying high return deals and offsetting those costs. And so in today’s market, we treat this no differently than we’ve treated the last 18 years. How do we find high yielding investments that create high annualized cash on cash returns or equity growth positions? And then as long as we’re making at least three to four x of what we can borrow that money at the risk is worth the reward. And if you can get those large gains, you can reposition those and really keep up with the costs that we are all battling right now.

Dave:

I appreciate you saying that you’re a risky or investor because people do need to make that decision for themselves about where they fall in the risk spectrum and assessing their own risk tolerance and risk capacity. James, do you think you are able to take on more risk because you have an established portfolio and you have something to fall back on? Or have you kind of always been this

James:

Way? I’ve always been a high risk investor, but it put me in the position today, right? As you take on risks and you adapt your business and you create growth, if you save that growth and you save that money, you can actually make a high risk investment business actually less risky. And what I mean by that is over the years, every time we racked high returns, we would save a lot of it. It’d either get allocated to holdings that was going to pay down that real estate or we were going to take that cash and reinvest it in hard money notes, high interest interest paying investments that pay us a very high monthly income right now by saving the capital, I’ve been able to reposition it to where my monthly interest from my hard money business and my private lending business pays for a hundred percent of my lifestyle and allows me to save because I have this cashflow coming in, I can take on higher risk because if the investment gets stalled out for whatever reason, I can weather the storms by the income streams I’ve set up. So as you kind of grow as an investor, you want to set these multiple income streams up and then that’s how you can continue to grow because it’s actually less riskier when you have more income coming in.

Dave:

Yeah, that makes sense. There are a few things I want to dig in on that you just mentioned, but I first want to hear Henry’s take on a high level. Do you think it’s risky to be investing right now? Henry,

Henry:

Dave? I think it’s risky to invest in any time. Every market has different aspects of whatever’s going on in that real estate cycle that bring in a certain level of risk. And we’ve talked about this before, it’s that sometimes when people think about real estate investing, they don’t associate it essentially with as much risk as they associate other investing strategies because there are levers that we can pull to mitigate your risk, but it’s still risky. Right now the risk is cashflow. How do you buy something where you can actually make a good return on your investment? From a rental standpoint, you got to get pretty creative in those situations. And so it’s risky to buy something and then end up being upside down. But in other markets, if the market was in a place where interest rates were lower right before when the rates were low, we were talking about there was risk of people overpaying for properties because everybody was in the market and everybody was buying and there was just a different kind of risk.

So yes, I think it’s a risky time to invest, but I don’t think it’s any more or less risky than any other time. It’s about how are you evaluating your deals and what are your goals? Because when you talk about what should you do with your money, there’s really two ways to look at it. One way is you’re looking at what’s the return that I’m looking for on the money that I’m looking to put to work, and then which one of those avenues is going to produce the highest return for me? And the other aspect of it is to look at it from the standpoint of your goals. I break my investing strategy down into three buckets. There’s a growth bucket, so that’s where I’m accumulating, acquiring and growing my portfolio. And then there’s a bucket of stabilization where you’re trying to get those properties because when you’re buying value add, you’ve got to stabilize it.

Now, unless you’re buying turnkey, you’re buying already stabilized. But when you’re buying value add, there’s this period of stabilization. So just because I buy something doesn’t mean that thing’s producing me the return that I want to produce me from day one, I’ve got to get it to a point where it’s actually stabilized to produce that return. And then the third bucket is protection. So how do you protect the assets that you’ve now acquired? And that protection from my perspective is getting those things paid off so that no one can come and take them from me so that they’re actually producing that generational wealth, air quotes that people want. You’re not getting generational wealth if you don’t technically own the asset and the bank does.

Dave:

So that’s a great framework. I really like those three buckets. How do you decide what money and capital to put into which bucket is it even or how do you do it?

Henry:

Yeah, that’s where having your goals come in. Goals are different. If your goal is to create a certain amount of cashflow per month, well then that should let you know whether you need to be in the growth bucket or you need to be in the stabilized bucket or you need to be playing a little bit in both. You need to be looking at the analysis of the deals that you’ve done and say, okay, how many deals do I need to buy that’s going to hit me that goal? And then once you buy that amount of deals, then I need to stabilize these deals so that they’re actually producing me that return and getting me those numbers. And so there’s some growth there. And so you have to be consistently looking at your portfolio and seeing what are the returns that I’m getting on these assets?

Do I need to sell any of the assets that I purchased because they’re not hitting my goals? And then do I need to go acquire new ones or do I need to stop growing right now and look at stabilization so that I can actually get the return to meet my goal? And once that happens, then you can look at a perspective of, okay, now how do I protect it? If you bought, let’s say you had to buy 10 houses in order to hit your cashflow goals and then you stabilized those 10 houses in order to hit your cashflow goals, well now that you’re bought and stabilized, you may be able to sell five of those to pay off the other five, and that five paid off is going to produce more cashflow probably than all 10 leveraged. And so now you’ve got less property but making more income and you’re also protected and stabilized.

Dave:

We do have to take a quick break, but when we come back we’ll talk about whether or not investors should pay off their debts or continue to invest and acquire new properties. This when we get back. Welcome back to the show. Let’s jump back in. It’s a big debate in real estate like whether or not you should pay off your debt. It sounds like you’re comfortable with that. And James, you mentioned earlier that sometimes when you had a big win for a flip or something, you would use some of the profit to pay off some of your properties or pay down some of your debt. How do you decide when to do

James:

That? It always comes down to what is your cost of borrowing versus what is your return that you can make? If I’m borrowing at 6% on a rental property, and let’s say I owe $200,000 on that loan, but I can make 12% through lending it out via hard money at 200,000 for me, I’m not going to pay off that note at 6% because I can get income at 12, right? I can actually take the extra 6% I’m making on the cost and pay down my balance if I want to be a little bit safer. You can start paying it down that way, but it really just comes down what is your cost of capital and what is the return that you can make? And if the return is much higher than what you can borrow at, then I would leave it alone. And if it’s a lot slimmer, then if I’m borrowing at six and I can make eight, that might not be worth the risk and the effort at that point.

If I want to lend out hard money, I got to underwrite meat borrowers go through that process, it’s a business I have to run and that 2% spread might not be worth it. And the thing about debt is debt for real estate investors is your gunpowder for growth. You have to have access to it, you have to understand it, and you have to utilize it for you to make higher returns, but you cannot abuse it. You have to know when to use it and when not to use it and whether it’s worth the effort or not. And for me, as I’m trying to look at whether I can make a return or not, the money coming from, is it a business venture or is it personal? A lot of times I don’t like to borrow just because I can get a big HELOC on my personal house and I might be able to pull it out at 8% and get 12. That’s putting myself in a riskier position because I’m now taking on debt in my personal life. And so those are the things you want to ask yourself. And over the years, especially after 2008 crash, I use business debt and then personal side, I take the returns from my business and I pay down my personal debt. I have very low personal debt and that’s paid for by the interest spread I can get from when I’m borrowing at six and lending out at 12.

Dave:

This is such an important topic. I’m so glad you brought that up, James is one, it is kind of simple in some regard where you’re just like, okay, if I can invest at 8% and my mortgage is at 5%, just don’t pay off your debt because you’ll be earning more on your capital by investing it than you would be by paying off your debt. But to your point, it needs to be worth the additional risk. Buying down debt is a great conservative option for people. If you want to lower your risk and as Henry said, increase your cashflow, that’s a great option for someone who’s trying to grow as quickly as possible. You may want to just reinvest that money and you need to make sure that the spread between what your debt is and what your new investment would be is large enough so that you can justify that.

So that’s a great point, James. I agree basically with what you’re saying, but I do think there’s a time and place for paying off your debt, and Henry alluded to one of ’em, which is if you want more cashflow, other ones, Henry, I think about people who are later in their investing career generally. I think most people start their investing journey with a lot of leverage and debt, and hopefully you’re being responsible with it like James said, but you can go for bigger equity gains with more debt and less cashflow. And then as you get older, you typically want to reduce your risk and increase your cashflow. Do you think that is a good path for people or there other scenarios where people should pay off their debt? Henry?

Henry:

No, I think that’s really smart. When you’ve got runway ahead of you from a time perspective, I think it makes sense to be focused on growth early on, but have a plan to be deleveraged by the time you want to not be so active and are ready to enjoy more of what your portfolio can offer you. But if you’re already in older air quotes investor, then you have to think about what are the strategies that are going to get me to the financial goal that I’m looking for the quickest? And that’s going to depend on what resources you have at your disposal. I was speaking to an investor at a conference recently who said that it was an older gentleman, I mean he was in his sixties and he was thinking about buying a multifamily because he wanted to have something that was going to produce a high return for him so that he could build up some income to pass off to his children later in life.

And we just had a conversation about, well, where is he at now in terms of what he has to invest with? And he had paid off assets and he had access to that capital at a low interest rate. And from that perspective, I said, well, I don’t know that buying a multifamily is the best use of your capital because of the time it’s going to take for that thing to actually start producing the result you’re looking for buying a value add multifamily. That’s a lot of work for that thing to start producing the income you’re looking for. You’re talking five to 10 years is what people typically underwrite these deals for, but with access to the kind of capital he had access to, I was like lending money is probably the easiest way for you to get a return that you’re looking for a higher return than probably a multifamily can get you in order to help you build up the resources you’re looking for.

And so it’s really a matter of what resources do you have at your disposal and then looking at what are the options that are going to produce either that cashflow or that safety net that you’re looking for. It may not be that you need to go buy massive assets if you’ve already got access to capital, but if you don’t have access to capital, then you’ve got to think from that perspective. I would tell somebody if you don’t have access to capital but you’re trying to build it up, it may be that you need to flip some properties to try to build up that capital and build up that cash on cash return that you’re looking for that you’re not going to get or have time to get with a rental property.

Dave:

That makes sense. One of the popular things that’s coming around in real estate investing now is reinvesting into your existing portfolio. I think a lot of us get excited about acquisition, buying new stuff, it’s fun, but reinvesting into your existing portfolio can be great, like doing value add to properties that you’ve held onto for five or 10 years and maybe they need some, I don’t know what you call it, res stabilization, something like that. So I wanted to ask you about this sort of practically, James. How do you keep track of your portfolio to make sure that it’s optimized and evaluate it for potential opportunities for reinvestment?

James:

Yeah, we do this every year. We run return on equity and we’re looking at, okay, what do we currently have? How much equity do we have in that property? Because we treat equity like a bank account. It is sitting there and it’s making really zero. It’s making appreciation. That’s what it’s making. And if it’s a standard depreciation, it’s making three to 4% a year, then what is my return? What is my overall cash flow, annualized cash flow that I have on my equity balance? And then we look at, okay, what is that return? Can we trade it elsewhere or can we actually do more with it and we evaluate that property? Can we raise rents? Can we add value by adding an additional unit in the basement? Right now we have a rooming house next to University of Washington. It’s an eight bedroom rooming house.

It was up zone two years ago. And because of that upzoning, it allows us to build a DDU detached rooming house in the back of this property. And so we can get an additional four bedrooms unit in the back of this property. And then it comes down to is it the right decision to invest into your portfolio because it’s going to cost us 350 to 375,000 to build that unit in the back. We need to go, what is our cost of money and what is our debt service and then what is our average income? So the great thing about that is it is going to generate six to $6,500 a month in rent income. And because it’s 350,000, our debt service on that is roughly going to be on the spot about 3500, 30 $800 a month for that debt service. So that tells us that’s a great investment for us.

We can build that in the back, we can borrow it and then make a higher return. And so we’re always looking at what do we have, what is the equity, what can we trade it for? And then is it smart to add more money into that portfolio? It could be putting in new cabinets and countertops. It could be adder, washing dryers. You want to run all those metrics. What’s your current rents? What can you do to improve? But don’t forget to really run the math because just because you can get more rent doesn’t mean that it’s the smart move and you have to run your cash flow. I see a lot of people make that mistake. They’re like, I just did this, I could. I’m like, well, you could have just bought something else and made more cashflow. And so just because you can invest in it doesn’t mean you should.

Dave:

Well, I totally agree. And one of the things I recommend to people and wrote about in my book is this concept of what I call benchmarking, which is basically like even if you’re not going out and buying deals right now, you should constantly be aware of what type of return you could get in the current market. So to your point, James, if you were going to go out and buy a, let’s just say a rental property and your return on equity and that would be 10%, then if you know that even if you don’t intend to buy it, then when you go out and say, look at my current portfolio, if I reinvested and use this example and I built something, can I get 12% or could I do 14% or would it get 8% and then it wouldn’t be as good because there are actually mathematical ways that you can make these decisions about how to reallocate capital.

Just as James said, and just for everyone who doesn’t know, there’s a metric, it’s called return on equity, maybe my personal favorite, one of my personal favorites, it’s a measure of how efficiently your investments make cashflow not based on your initial purchase, which is what cash on cash return is, but based on the accumulated equity in that property. Because as you own a property, as we’re talking about investing into your own portfolio, if you own a property for five or 10 years, your equity is going to grow. And so the amount of equity you have is more and more. And so often what happens is the opportunity cost of keeping that equity in that home increases so you’re making cashflow less efficiently even though the investment is quite successful. And so that’s why, as James said, always measuring your return on equity is a great way for you to sort of compare potential investments, new investments to reallocating resources, taking out a cash out refinance so that you can reinvest it elsewhere. It’s a great metric, very easy to calculate that pretty much everyone should be using. Yeah,

Henry:

I don’t want it to get lost about how important or how overlooked this strategy is of reinvesting back into your current portfolio. It doesn’t get talked about enough, and there is absolutely opportunity there if you’ve already started building a portfolio. So one of the things that we are doing is we tested a midterm rental strategy with a property that we bought because we had the option to be able to do that and we would fall back as a long-term rental if it didn’t work. But what we’re finding is that it’s working and it’s working better than our short-term rentals. And so now that we have these data points to go off of, we are now evaluating other properties in our portfolio in similar locations and seeing, okay, instead of us going out and buying a new property, what if we take the capital we would use to do that to furnish something existing to turn it into a midterm rental, add some amenities, and then get the return on that investment even higher without having to acquire. And so you have to have your finger on the pulse of your portfolio and you’ve got to use data to help make some of these decisions.

Dave:

That’s great. And I mean it’s not any different from how other businesses operate. Most businesses aren’t just constantly acquiring new things or hiring new people. You’re constantly just looking at what you got? Is it working well? Where’s my money going to be put to the highest and best

James:

Use? I mean, sometimes it’s not to be just increasing the cashflow either. It’s about just increasing the equity and then selling. They do that quite a bit too going, let’s throw 50 grand this property and sell it because now all of a sudden every end user in town wants this property. So it’s selling for a premium and now I can trade it for value add or a different better investment even if I’m paying a higher rate.

Henry:

You also have to watch the market to know, for me, I watch the market to know which one of these buckets I have I need to be pouring into. So the market right now is telling me to buy and then I can grow and stabilize and then and when rates change and come down, even if they go up before they come down, when they come down, that’s my cue to start selling so that I can do the payoff strategy. But you don’t just want to do it blindly of the market. It could be a terrible time to sell when you’re trying to actually pay off some of your properties.

Dave:

We do have to take one more quick break to hear a word from our sponsors more from on the market after this, and while we’re away, make sure to go to your favorite podcast app, search on the market and give us a follow so you never miss an episode of the show.

Welcome back to On the Market. One of the other topics I wanted to ask you sort of related to this stuff is about putting down more equity. This is something that I’ve been considering doing on my properties is rather than taking out max leverage, which for out-of-state investors or a lot of investment loans is 25% down 75% loan, would you consider or recommend to anyone putting down 30%, 40%? Because that’s basically, it’s kind of like paying down your loan at the beginning of your investment. It reduces your overall risk and helps your cash flow, but obviously comes with the trade off of growing slower because you have more equity tied up in that property and you probably can’t use it to acquire new properties. Henry, is that anything you’ve ever done or something you would advise people to do?

Henry:

No, that would be something I would look at doing once I’ve worked on or completed kind of phase three of my plan, which would be the protection of the assets. So once you start getting some things paid off, then as you continue to grow, you can consider putting down more because you’re not in that growth period anymore and you’re not in that stabilization period anymore. Now you’re worried about, alright, how do I truly maximize the return on the dollars I’m putting in? And so from that strategy, Dave, I think where I might, I don’t necessarily say disagree with you, but what I might do with that is to say, okay, if I’ve got a hundred thousand dollars that I want to put down on this new property, I would probably look at my existing portfolio first and see, okay, can I pay off a property completely with this $100,000 because that’s probably going to net me a higher cash on cash return with that a hundred thousand dollars having a completely paid off asset versus two properties that are 50% paid off.

Dave:

Yeah, that’s a good point. James, how do you think about it?

James:

I think I have no problem putting more money down as long as it’s getting my minimum return that I want. And I think that is the most important thing for investors. We all have different expectations and buy boxes depending on where you are in the growth of your career. When I was younger, I did not have a lot of money. I could not leave a lot of money down. I had to grow it and grow it and grow it, and it was detrimental if I left too much cash in the deal. For me, I have a clear understanding if I’m going to put money and leave it in a deal for a long period of time, what is my minimum cash on cash return or equity position that I’m going to make? And if I don’t know that I can’t make that decision or not.

And so if I’m looking at putting, let’s say 50% down on a property and it’s making me an 8% return and my minimum return is 10, that is a bad decision for me to put down that 50%. Now if I have cash sitting there and all I’m doing is making four point a half percent at my bank or less, maybe putting that money down and I’m getting that 8% return makes all the sense in the world. And so having that clarity because I think people get confused. They hear about all these different strategies, I’m doing this, I’m doing this, I’m doing this. But at the end of the day, we’re all at different spots in our career. Think of it as a math equation. What am I trying to accomplish and is it hitting that return or not? Every property for me is just a math equation. I don’t care what it looks like where it is, it’s a math equation and is it going to get it to my goals of where I want to be in one year, three years and five years? And so write down those goals and really make sure that it’s hitting your returns yes or no. Clarity is key if you want to grow. And clarity is key, especially if you don’t know where to put in your capital or when to use it or where to use it.

Dave:

That’s a good point. And just to explain sort of my thinking about doing this is I invest in a different way than both of you. Everyone does it differently, but I sort of take these two parallel paths where one I invest in passively in syndications, and for me those are sort of the riskier ones. I’m just taking some bets and taking some swings to make big equity gains, whereas my rental property portfolio, I’m just trying to make sure that in 15 or 20 years that they’re paid off or that they’re generating sufficient cashflow. And for me, I am happy to put down a little extra money to just make sure that I’m generating a little bit of extra cashflow every single month and that I’m reducing my risk and just can make sure that it can definitely hold onto these assets for a long time. And

James:

There’s a little hack that investors can do too to pay off your debt faster. If you’re looking again to that example where you’re putting 50% down and you’re making an 8% return and your goal is to get ’em paid off in the next five years, that’s an aggressive plan. Yours was 15. That’s a steady plan that you can really work on. But if it’s to get it down in five, you can always put down the 20%, 25% and then take that other 25% and put it in a high yield. Like again, hard money loans. If I’m making 12% and I’m borrowing from the bank of eight and I’m making an 8% return on that investment, I can take that extra 4% from my hard money payments and just pay down that loan. That’s true. And what it does at the end of five and 10 years is you still have that balance of capital sitting there too that you have access to as you’re paying off your rental properties, but it really depends on your interest spread, your yield, and then what’s your plan? 15 years? That’s a lot more work. I would just put more money down if you want to pay it off faster. Look for different faucets that you can turn on to pay down your debt.

Dave:

Yeah, that’s a great suggestion for people. I don’t have the energy to do it, to be honest, so I will for some things, but to your point, if I’m just doing this for 15 years, I’d rather just put the money down and just let this thing be on autopilot for a while. But I think that’s an excellent suggestion for people who are really trying to maximize their every dollar right now. Alright, well thank you both so much for joining us today. This was a lot of fun. Hopefully this conversation helped all of you listening make some decisions about your own portfolio. Henry and James, appreciate you being here. And thank you all for listening. We’ll see you for the next episode of On The Market.

Dave:

Very Soon. On The Market was created by me, Dave Meyer and Kailyn Bennett. The show is produced by Kaylin Bennett, with editing by Exodus Media. Copywriting is by Calico content and we want to extend a big thank you to everyone at BiggerPockets for making this show possible.

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