A while ago, I did a three-part ‘anatomy of a commercial real-estate deal’ …
Drew wanted to know:
You mentioned 63k income that you can spend, but I don’t see you including principle payments. Wouldn’t that cut into your cash flow?
You’ll need to go back and read the three-part article, but this question goes to the heart of whether to pay off your mortgage, and is somewhat the same argument whether you want to do this on an investment property or even your own home.
It boils down to return:
The building that I was looking at buying would have generated $255k in rents – $192k in expenses (including $130k bank interest) = $63k net ‘profit’ p.a.
Paying down principal doesn’t change that dramatically: it does lower my interest expense, which should increase my net profit, hence my return …
… in $$$ terms.
But, when you do the math, it can lower the % return that I am getting on my money.
Continuing with the comment from the previous reader, can you elaborate a bit more on why principal payments would not affect this deal? On the previous article you mentioned going for a 7yr financing or so, which will represent about 250-300k of additional capital you need to put each year. After the first year you would have invested 700 + principal (let’s say 250k) = 950k. The 63k you make then will become a 6.6% return on your own money… Then down to 5% the next year… And so on…
Aldo has forgotten to allow for the reduction in interest expense as my equity increases (and, the bank’s loan decreases), but he points to the % return on my overall investment decreasing …
… whereas, an investor should generally be looking to increase their % returns.
In simple terms: if I can buy a $100k property with 20% down (i.e. $20k), when I find (e.g. by saving) another $20k, am I financially better off:
1. Putting it into this property to pay it off quicker?
2. Putting it into my home mortgage to pay my home off quicker?
3. Putting it into another $100k property that I can buy with 20% down?
In order of decreasing return, it’s generally 3. then 2. then 1.
I know which I would rather do. How about you?