When it comes to real estate investing (REI), most investors who first get started like to compare it to other alternative options available in the marketplace. A Real Estate Investment Trust (REIT) is a very common platform that allows anyone interested in real estate to get exposure to the sector. REITs have become so popular, in fact, that many investors mistakenly assume that they are not only a suitable alternative to REI, but actually a superior form of investment (REITs are 100% passive whereas REI is NOT).
But like most things in life, if you want to know the truth, you must dig deeper… The nuisances and subtleties separating the two types of investments are NOT always so obvious at first glance, which is why I always preach the importance of education on this blog…
In this article, I will examine the pillar known as Principal Paydown. When it comes to REI, there are in fact 4 key pillars that are so immensely valuable (lucrative) that they keep investors coming back for more and more…
However, I would argue that perhaps the most potent and unappreciated pillar of them all is Principal Paydown.
Conventional wisdom teaches us that if you want to retire comfortably, you must invest in your future. The mainstream media and financial experts have all been telling us that you cannot rely on Social Security (it might not be around for much longer!), so you have to take control of your own destiny. This means, you need to load up heavily on 401k and IRA investments during your formidable years so that they can compound into something much larger by the time you’re ready to call it quits and exit the workforce.
But as most investors are well aware, something like a 401k or IRA is designed to only make you wealthy LATER in life…
What if you want your cake NOW and a lot more cake later?
Through the proper use of leverage, an investor will be able to utilize REI to not only accumulate wealth NOW in the present day, but also help plant the seeds for significantly greater wealth many years down the line…
Leverage involves the use of loans, but like a fine blade, it can simultaneously be both a great ally and your greatest foe… The saying goes — “Leverage cuts sharply in both directions… Use it carefully.”
Personally, I am a HUGE fan of leverage (but only in a downmarket!). In fact, I currently have over $1MM in “good debt”.
But I’m not so worried because I know that by utilizing leverage early in life, I will be able to benefit greatly from all 4 pillars of REI.
However, the ace in my backpocket, all along, has been Principal Paydown.
The Powers of Compounding
Principal Paydown is nothing more than compound interest at work for you. When an investor purchases a rental property through the use of leverage, they typically take out a 15 year or 30 year fixed-rate loan. If an investor purchases a piece of rental property carefully, it will be cash flow positive even after accounting for PITI (Principal, Interest, Taxes, Insurance) and any other bills (utilities, landscaping, HOA, etc.). Not only should you have free cash flow after all the above items, but you should STILL generate free cash after budgeting a fixed percentage for maintenance, vacancy, and CAPEX reserves (typically I like to budget 20% or so for my out-of-state rentals).
If you can “buy right”, you’ll be able to benefit from Principal Paydown for free; your tenants will be the one paying off your mortgage.
After 15 years, or 30 years, an amazing thing will happen — You will own a property FREE AND CLEAR!
Just think about that for a second…
Most homeowners slave away for 15 or 30 years to pay of their own SINGLE mortgage… But a real estate investor will be able to do EXACTLY the same thing, without having to endure any of the hard labor themselves…
That’s precisely why I love REI so much… Your tenants work hard for you 24/7, and you constantly build up wealth each and every month without having to lift a finger.
Unlike a 401k or IRA which will only pay you later, REI will pay you TODAY (cash flow), and you’ll amass a substantial nest egg (FREE AND CLEAR rental property) by the time you reach traditional retirement age.
It’s no wonder why so many savvy real estate investors were willing to withdraw from their 401k or IRA plans, take the tax hit, and buy up rental property, instead, after the 2008 financial crisis.
Really, who needs a 401k or IRA when you can buy strong cash flowing rental property?
At the end of the 15 or 30 years, rental property will most likely even put you miles ahead of the traditional retirement products…
In the right market environment, I can think of no better form of investment than leveraged real estate.
Like always on this blog, lets illustrate the above concepts with a real life example using my own numbers.
Here is a breakdown of Principal Paydown for each one of my properties:
Rental Property #1:
Rental Property #2:
Rental Property #3:
Rental Property #5:
Total Principal Paydown (2015): $13,935.66
Monthly Principal Paydown (2015): $1,161.31/month
So far this year, I have paid down close to $14,000 in principal… Averaging that out over 12 months gives me a monthly breakdown of over $1,100/month.
Each month and year, these figures will only further INCREASE, thanks to compounding, helping me build more and more wealth.
Further, here is how much TOTAL Principal Paydown I have paid for all of my own rental properties:
Total Principal Paydown: $18,213.29*
*Please note, the total paydown should be much larger, but I performed two separate cash out refis earlier this year, which wiped the old slate clean… I did NOT include any figures from the old mortgages (Rental Property #1, #2, and #4), which were first taken out in 2012 and 2013, respectively.
As you can see from the above spreadsheets, the Principal Paydown only compounds and INCREASES each and every month. When it comes to building wealth, Dividend Growth Investors (DGI) love to preach the powers of compounding that are gained with a growing income stream each and every year…
With real estate, Total Returns are magnified because not only can you achieve similar growing cash flows each and every year (like with DGI), but you also get compounding through the form of Principal Paydown, and to perhaps an even greater degree, Leveraged Appreciation.
And most everyone knows, hard assets like real estate are among the best known inflation hedges out there… Yes, property values fluctuate up and down, but over a long enough period of time (15 to 30 years), by the time your investment property is owned FREE AND CLEAR, the appraised value should DWARF the original loan balance you took out, which has now been fully converted over to you in the form of Net Worth.
Oh yes, and the best part? Once you own a property FREE and CLEAR, your cash flow will spike through the roof (take those monthly cash flow numbers and strip away the Principal and Interest payments to your lender for good)!
With REI, you can build wealth through many different avenues:
- Monthly Cash Flow with significant Tax Benefits/Depreciation (snowball approach)
- Leveraged Appreciation (life in the fast lane approach)
- Principal Paydown (“who needs a 401k or IRA?” approach)
Although less important than Principal Paydown, as mentioned throughout this article, real estate investors get many tax breaks as a benefit for being a landlord (the government rewards you for performing a “public service”).
Items that are “ordinary and necessary” may be deducted.
The following is a list of deductible expenses from TurboTax:
- Cleaning and maintenance
- Homeowner association dues and condo fees
- Insurance premiums
- Interest expense
- Local property taxes
- Management fees
- Pest control
- Professional fees
- Rental of equipment
- Rents you paid to others
- Trash removal fees
- Travel expenses
- Yard maintenance
The interest payments that your tenant is making for you each and every month are indeed tax deductible.
Here is a breakdown of my own interest payments for my rental properties:
Total Interest Paydown (2015): $34,587.31
Monthly Interest Paydown (2015): $2,882.28/month
Total Interest Paydown: $47,247.76
This is how the rich keep getting richer…
REI is a TREMENDOUS investment vehicle that allows the everyday commoner (such as myself) the opportunity to enjoy some aspects of the “good life”.
When it comes to traditional retirement, most of my peers think I am CRAZY for not fixating more of my efforts towards ramping up my 401k and IRA contributions… Further, they think that I am INSANE for not owning and living in my own personal residence…
But it’s because of tools like Principal Paydown that give me the peace of mind and confidence to keep on executing my gameplan…
Long-term, many of my critics will only ever end up owning a SINGLE property (that they slaved day and night for)… My own plan is to pay off at least 5 rental properties, without having to put in any of the work myself…
Lastly, in this article, I did NOT include any Principal Paydown figures for my 3 side hustle deals, which pay off a substantially greater amount of principal than my own properties (see below):
Rental Property SH #3:
I own a 50% stake in Rental Property SH #3.
Including the Principal Paydown for this property (just my own portion) would net me an additional $3,200 this year, or $267/month.
And so on for Rental Property SH #1 and SH #2…
Principal Paydown is the gift that keeps on giving…
It’s no wonder why so many investors LOVE owning rental properties… Going full circle now — REITS are fabulous investments, yes, but as I’ve stated before in the past (and again in this article), comparing rental properties to REITs is like comparing apples to oranges…
Don’t forget about Principal Paydown!
15 to 30 years from now, you’ll be most grateful that you had this potent worker bee slaving away for you, non-stop, rain or shine, day or night! 🙂