Advice / Guidance in Portfolio and direction

[Antego]

I'm looking for some advice.

Here's a look at our 'portfolio':

Primary Residence

Market Value is about $550,000
Mortgaged amount is $315,000

Rental Property 1

Market Value is about $385,000
Mortgaged amount is $265,000

Rent is $2200 / month
Net is $-200 (a little more than the equity portion of the mortgage payment) - This includes savings toward agent fees for renting it out and vacancy (1 month / year)

Rental Property 2

Market Value is about $415,000
Mortgaged amount is $265,000

Rent is $2500 / month
Net is $-200 (a little more than the equity portion of the mortgage payment)

Property 3

I own a hotel room abroad which breaks even every year after everything is taken into account. We purchased this as a getaway to use for a couple of weeks every year. Our investment into this is $50,000 of our own money.

Property 4

Pre-construction scheduled for completion in 2014. Will be a rental only. $50,000 invested with another $50,000 required to keep at break even level for rent income. I'm skeptical that this property will appreciate much, and will probably be looking to sell, simply to break even once its completed. Poor decision - but live and learn...

Cashflow

Our net cashflow is +$3500/month on average. Of that, I am willing to use $2500 toward reducing mortgage debt.

What I'm looking for here is some advice.

One of my main objectives is to be mortgage free on our primary residence. But I don't want to do that at the cost of sacrificing too much opportunity for growth. My father's greatest advice to me was that life is all about risk management. Without risk, it is more difficult to grow, but risk may also represent disaster. I consider myself a person who is comfortable with taking risk, but would like to keep that within the 10-20% range.

My philosophical strategy is that I look to build solid foundation and then to use the benefits of those foundations to expand (hence the lower risk objectives). As such, I have developed three options:

-1- Sell Rental Property 1, pre-pay $50,000 of proceeds toward mortgage of primary and pre-pay the mortgage on our primary residence at a of $2500 / month. This would have us in a mortgage free position in about 2017. Retain Rental Property 2.

-2- Sell Rental Property 1, sell primary, payoff completely and move in to rental property 2. Be immediately mortgage free. This option would be fine for a couple of years, but we'd have to find a larger place in about 24 months to replace it. The advantage this provides is that the strong foundation of mortgage freedom further increases cashflow.

-3- Sell Rental Property 1, sell rental property 2, use proceeds to pay down primary, and pay down primary at a rate of $2500/month. Would be mortgage free on primary in March 2013. This seems to provide us with a balance between great lifestyle and mortgage freedom in the near future.

I'm sure that you see other options - feel free to share. What do you think is the best option for providing the stability of mortgage freedom while allowing us to maximize growth. We prefer to have mortgages on our rental properties, as we are not interested in the passive positive cashlfow at this time. I would definitely like to dispose of rental property 1 as its mid-lifecycle i.e. Its about 5 years old and will begin to plateau in appreciation within the next 5 years. The market is also slowing and I would like to contract our portfolio for more stability before it becomes more difficult to do so.

We are 30 years old, and I would like the stability so that my wife would have the option of pursuing a more creative career path for herself. By 2014, I expect that she will be bringing in half as much money - therefore reducing our household income by about 20%. Other than that, I don't have any real goals other than increasing our wealth and perhaps setting the stage for retirement at 45 or sooner. I am also interested in diversifying our portfolio, perhaps in stocks or other market.

I hope this makes sense. Please let me know your thoughts and / or advice. My parents advice is that we should sell off our assets, keep our mortgage and buy other hotel like properties. They have been fairly successful in real estate and have a keen sense for these things. I think they feel that we have a lot of risk with all of these properties.

[Antego]

Oh yes. We both currently have jobs with the public service. Given that my wife may make a career change. We have at least one pension. So normal retirement (if early isn't possible), is not a concern - unless you think it should be.

[Four Pillars]

You are far more comfortable with debt than I am. I would suggest that any strategy which reduces your debt load significantly is a good one.

[kcowan]

Well I don't have much real estate myself, but the glaring problem is that you are highly exposed to a volatile sector, and if RE takes a significant downturn you could be wiped out. Of course you already know this. However at 30 you have plenty of runway.

You don't say where you live, but if you are in a bubble market, why not consider combining options 2 & 3 and live for a few years in a rental as long as you wife is OK with this. Keep your options open. Start to diversify your investments during that period and then shop for bargains in RE?

[andrewf]

Sounds like you are a candidate for cash damming. The idea is you take your gross rental income each month and apply it to your mortgage. Then, use a HELOC (secured against either the primary residence or one of the investment properties) to pay mortgage, property tax, maintenance fees, insurance etc. on each investment property. These costs are all investment expenses and loans to pay for these expenses are tax deductible, regardless of what these loans are secured against.

This strategy would allow you to convert at least $4700 of your principle residence mortgage (non-deductible) each month into $4700 of tax-deductible investment loan. Not including your regular principle payments, you would be able to retire your non-deductible mortgage 67 months.

I'd suggest rolling your HELOC balance periodically into a mortgage to take advantage of lower rates, and this will maintain tax-deductibility. You can do this with a 1 yr mortgage terms.

If you can roll your existing mortgage into an investment loan, you can save 5.5k per year in taxes assuming 5% mortgage interest rate and 35% tax bracket.

[Cal]

Andrewf provides good advice.

Personally I am comfortable with your debt load, assuming you have a small cash reserve in the event that a property is vacant for a month or two.

However I see your real risk as having all of your investments in one asset class.

[Potato]

First off, your portfolio is 100% real estate, leveraged 1.4M:845k 60%, unless there's something you forgot to tell us.

I see no stocks or bonds mentioned...

So far, you seem to be very comfortable with debt. Why the sudden urge to become mortgage-free?

What do you mean by "Net is $-200 (a little more than the equity portion of the mortgage payment)" Do you mean your rentals are cashflow negative?

What is the interest rate on these mortgages? If you're cashflow negative and just barely making a profit (via paying back principal) in the current interest rate environment, then things could go very poorly if rates go up in the future... it may be wise to sell all of them and look at other places to put your money. What's the rate of return on your rentals? Is it even as good as what you could get on a GIC, let alone stocks/bonds?

[Antego]

Hi All,

Thanks for your replies.

Yes, I am very comfortable with debt. My goal is to be mortgage free on my primary residence because:

-a- Stability in the even to of the unknown.
-b- This interest is not tax deductible.

My properties are cashflow neutral in conventional terms - rent pays for all expenses except all of the mortgage principle. I have been fine with this because our family income is relatively high and very stable. I don't feel much added benefit to increasing that at this time.

Why the change in attitude? Its not really a change in attitude as much as a development in attitude. I previously had not real strategy other than what turns out to be to spread out my investment into the market via leverage, and having others pay for those investment. I am evolving a vision, though it is all still quite foggy. And as I stated earlier, I am not risk averse, and am therefore comfortable continuing to navigate through the fog - rather than stop and ask. Mortgage freedom would represent to me the release of more cashflow for investing, and shielding my family from downturns in the market (we don't have any kids yet).

We have enough in accounts for each property to carry them through 6 months of vacancy.

The rentals were purchased at $300,000 pre-construction in 2005 (rental 1) and $335,000 2007 (rental 2) and our primary at $445,000 in 2009. We live in the Ottawa area. I feel that prices here are near their peak, and though I do not expect a burst, the cooling off has begun, and I expect a period of stagnancy.

I think that the sell high advice is fairly good, considering my outlook of the RE market over the next few years. Perhaps the appropriately priced pre-constructions will come along. I will now look into other investment avenues as well.

[andrewf]

My goal is to be mortgage free on my primary residence because:

-a- Stability in the even to of the unknown.
-b- This interest is not tax deductible.

You can address 'b' through cash damming, replacing your non-deductible mortgage with a deductible investment loan. On the other hand, 'a' is probably best accomplished by lightening up on your real estate exposure. I can't stress enough, though, that if you do keep those investment properties without cash damming, you're giving up substantial tax savings. Cash damming doesn't necessarily change your total level of debt, it just makes what debt you have deductible.

[Antego]

You can address 'b' through cash damming, replacing your non-deductible mortgage with a deductible investment loan. On the other hand, 'a' is probably best accomplished by lightening up on your real estate exposure. I can't stress enough, though, that if you do keep those investment properties without cash damming, you're giving up substantial tax savings. Cash damming doesn't necessarily change your total level of debt, it just makes what debt you have deductible.

I did a little reading - and the whole cash damning principle is still very unclear to me.

What are the precise steps?
What are the risks?
Is there a reason my accountant would not have already pointed this out to me?

[andrewf]

Steps:

1- Set up a HELOC or other source of credit. All investment related expenses are paid for using this line of credit, including mortgage principle and interest, insurance, maintenance, property taxes, etc. on your two investment properties. Interest to be paid on this line can also be paid by withdrawing the amount and redepositing (aka 'capitalizing the interest').
2- Use all of the rent income you receive from your properties (as you say, $4700 per month) to make additional mortgage payments on your principle residence. This will rapidly reduce your principle residence mortgage--depending on your mortgage terms, it may even be worthwhile to renegotiate to make this possible. You would be able to eliminate your principle residence mortgage in ~5 years.
3- Your investment loan will likely have grown to about the size of your principle residence mortgage, but it is now tax-deductible. You can now continue to pay this down as you would have your mortgage, but it is tax deductible, so the incentive to do so is less (after tax rate of interest is nearly halved).

Risks:

-HELOC may be called, causing liquidity problems. You can address this by taking a mortgage to pay it off. This mortgage is still an investment loan, and would remain tax deductible. You could probably also get a lower rate than on your HELOC.

I think that's the main risk. You're not taking any additional real estate, tenant, or interest rate risk. Your total debt would be the same as your status quo in five years, unless your HELOC rate is substantially higher than your mortgage rates. Indeed, if you use your tax savings to repay debt, it should be lower.

The most important thing is that you never use the HELOC for anything besides investment related expenses. If you need a credit line for personal use, get a separate line. This keeps the paper trail unambiguous.


Edit: I missed your last question. My guess would either be laziness or a reluctance to propose a tax strategy that might sound risky, though I wouldn't say it is. 'Don't rock the boat.' Go ahead and ask him/her, though.

[Antego]

Thanks andrewf - I understand where I can saveon taxes, but I'm obviously missing something, because I'm watching those savings get gobbled up by taxes that I would now have to pay on rent income - as I have no deductions left to eliminate this income on the books.

To keep it very simple, let's assume 10% tax rate.

[Antego]

Or is it that the deductions still apply to the income, but now, on top of that, the interest paid to pay those expenses is also deductible?

[andrewf]

It doesn't affect deductibility of any of your current expenses. It just adds new deductible expenses. It seems like you've got it in your second post.

Million Dollar Journey has a post on this topic (http://www.milliondollarjourney.com/the-cash-flow-dam-explained-cash-damming.htm).