Real Estate Investing: Principal Paydown (The Most Unappreciated Pillar)

by FI Fighter on December 10, 2015

in Real Estate Thoughts

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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…

Most everyone can appreciate Cash Flow and Appreciation… To a lesser degree, most people are also aware of the Tax Breaks (such as Depreciation) that you gain for becoming a landlord…

However, I would argue that perhaps the most potent and unappreciated pillar of them all is Principal Paydown.

Retirement Plan

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?

Enter REI.

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.

Real Numbers

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_1

Rental Property #2:

Rental_2

Rental Property #3:

Rental_3

Rental Property #5:

Rental_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:

  • Advertising
  • Cleaning and maintenance
  • Commissions
  • Depreciation
  • 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
  • Repairs
  • Supplies
  • Trash removal fees
  • Travel expenses
  • Utilities
  • 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:

Rental_SH3

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! 🙂

 

Fight On!

{ 24 comments… read them below or add one }

1 JC December 10, 2015 at 9:22 am

REI and REITs are similar but still very different. For the guy that doesn’t want to put in the work I think REITs are probably the best route to go and I think the overall risk is lower if it’s a conservatively managed REIT. While REI is riskier the rewards are much greater to compensate for the higher risk of fewer properties under control and work involved.

Just curious about your thoughts on the advantages/disadvantages of using extra cash flow to further pay down principal. In order to access the principal that’s been paid down you can either sell, do a cash out refi, or wait until the principal is fully paid down to reap the benefits through higher monthly cash flow. Cash out refi seems to be the best option as you get some of the principal/equity back quicker. Selling would just make you have to find other investment options which would lead to higher transaction expenses. And waiting 15-30 years to enjoy the benefit of higher monthly cash flow seems to be too long to wait. Curious what your thoughts/plans are for that.

I’d still like to get a few rental properties under my control over the next few years but the easy value/cash flow is gone. There’s still some decent ones available in my area but until I’m home on a regular basis REI will have to take a backseat to REITs.

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2 FI Fighter December 10, 2015 at 9:34 am

JC,

Yes, there are some similarities between REITs and REI, but I think risk is relative… With REITs, if you buy say Realty Income (O) you should in theory be getting one of the best in the business… Therefore, risks should be mitigated…

The same applies for rental property. A slumlord who bought a rental in say Palo Alto during the downturn has probably got the easiest job in the world right now… They simply rent out to Stanford students every year and collect a big fat rent check each month without fail…

Using that same example, if you buy right, you can increase cash flow every year… you don’t necessarily have to wait 15 or 30 years to access it… Market rent for my first rental was about $2,000/month when I first got started… It’s about $2,600/month today…

In regards to paying down principal, I’m personally not a big fan of it… My own preference has always been to execute cash out refis to pull out over 100% of my downpayment (no skin in the game). I then use those proceeds to fund other investments but still collect positive cash flow and principal paydown.

Yeah, rentals are tricky… You have to buy right and at the opportune times… In the Bay Area, today is NOT a good time to get started. Cash flows are negative, there are too many retail investors chasing, and I can’t imagine anymore insane appreciation happening anytime soon…

The most important investment lesson I’ve learned is to NOT chase the markets… Let the opportunities come to you.

All the best!

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3 JC December 10, 2015 at 9:47 am

I understand that if you buy the right property you can still increase cash flow in most years. But there’s a difference between raising rent $25-50 per month versus unlocking the principal which could free up $1000 per month.

I didn’t think you would pay extra on the principal and I figured cash out refis were probably the route you would take and it’s probably what I would do as well. Seems to be the most logical because you can get a quick one time payment after a couple of years and not have to wait 15-30 years to reap the benefits of the principal paydown.

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4 FI Fighter December 10, 2015 at 9:54 am

JC,

Yup! It’s extremely difficult to time these things, but with real estate (and every other investment) you really have to buy low and sell high…

With my first 2 rentals, I’ve pulled out about $200,000…

But I didn’t redeploy those funds back into real estate… They are in gold mining stocks and cash right now…

If there is a market crash, you can be certain that I’ll deploy that cash yet again and buy assets for pennies on the dollar (whether it’s real estate, stocks, or whatever)…

Every market cycle is so different, it becomes impossible to generalize these type of things…

That’s my own plan, anyway…

Buy low and sell high! 🙂

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5 mike December 11, 2015 at 7:50 am

It all depends on your cash needs and market location. If you are in an area where rents are very slow to rise (5-10 years) and only then incrementally, it makes total sense to pay down your debt so you can tap into the higher cash flow. Again thats why you invested was to have more cash each month.

In Fi’s case and others who bought low we are already realizing higher cash flows. Example: P&I = $500. Rent = $1000 when we bought. After 2012, 3 years later we can charge $1400 in rent. The cash flow went from $500/month to $900/month. We don’t need to pay down our principal because higher rents are already serving that purpose. In fact imagine how little $500 will be 20 years from now. That might be a nice steak dinner (jk). So I get the bonus of more cash over time and my P&I stays the same. This works in growth areas as Fi eluded to.

Fi will make some more postings on this topic regarding which style suits which person and the different strategies for each. I’d like to see him talk about snowballing effect.

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6 Nick December 10, 2015 at 9:38 am

Just curios, how many months of payments do you have in reserve for all five homes. For example if two or three went vacant and needed repairs would you be able to survive for six months or so? What does your home emergency fund look like?

Reply

7 FI Fighter December 10, 2015 at 9:42 am

Nick,

I set aside a portion each month for reserves, but I don’t compartmentalize them… I’ve got over $120k in the bank to weather any storms… I don’t know if there is a rule-of-thumb, but that’s a number I’m comfortable with…

6 months is a long time for vacancy… Outside of something catastrophic, I can’t imagine why it would take so long to rent out a home? In the Bay Area, if you put an ad on Craigslist today, you should have 10 inquiries by the end of the night (at market rate). If you go below market, you might have 30+…

Take care!

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8 Midwestern Landlord December 10, 2015 at 10:56 am

I came across this quote the other day and very much believe in it:

“If your objective is to build wealth for a secure and prosperous early retirement, then the message is clear: the mathematics of saving and passive investing through paper assets is too slow”.

How many people achieve early financial independence from 401K’s / saving? The key being early (achieved before age 40). I am not saying that it is impossible, but it is rare. When it is done the common factors include extreme frugality, extremely high savings rate, maxing out 401K’s typically by two people at a young age, above average take home pay, etc. And once you achieve it, you are typically in a position where you need to be relatively frugal for the rest of your life if you want to retire early.

It is hard to do it all by yourself. Very hard if you want to achieve financial independence early. Real estate (leverage) can get you there early if done properly. Low 30 year fixed interest rates are wonderful. Rent checks coming in the mail every month are wonderful. $3,000 / Mo in steady rental income is the same as saving $900,000 (based upon the 4% rule). I never could have saved $900,000 for early financial independence. But my net rental income far exceeds $3,000 / Mo. And that is just one pillar!

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9 FI Fighter December 10, 2015 at 11:26 am

Midwestern Landlord,

I could listen to you talk/lecture for days on end! I am in complete agreement with you there, and I think your comment is very beneficial to other readers since you are someone who has “been there, done that”.

You’ve achieved early FI through REI, so you most definitely know what you are talking about…

And I’ll be frank — my results would not have been possible without the use of other people’s money (OPM)…

It is EXTREMELY difficult to build wealth by yourself, or even with dual-income without the use of leverage…

Most real estate investors who get to $1MM+ only put in a fraction of that using their own capital.. Through paper assets, you literally have to fund every $0.01 yourself (assuming a Buy and Hold approach that experiences modest appreciation).

With stocks, you have to bet REALLY BIG on either hyper-growth stories, or during a commodities bust (what I’m doing now!) and hope for a drastic turnaround story…. That, or leverage up with options (which are far more risky because you have to nail the timing aspect of it).

REI and the 4 pillars are an early freedom fighter’s best friend! 🙂

Take care!

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10 Mike December 10, 2015 at 11:07 am

Another great write-up FF!

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11 FI Fighter December 10, 2015 at 11:29 am

Thanks for the kind words and support Mike!

All the best!

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12 Nick December 10, 2015 at 11:48 am

I am debating a new construction lot across the road from my other investment home. Purchase price is 152k, rent is 1400. It is pretty darn close to the 1% rule. I will put 20% down, have a low $700 a month loan. My only concern is to constaly find renters throughout the years. I live in MD, the investment homes are in S.C.

Thoughts?

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13 FI Fighter December 10, 2015 at 12:05 pm

Nick,

Without knowing more intimate details, analyzing any rental property from afar would be difficult for me (or anyone else) to do properly…

I would have to know a lot more about: neighborhood, employment, infrastructure (highways, schools, shops, etc.), crime, demographics, etc…

Also, your rationale for buying: cash flow, appreciation potential, both, etc.?

On the surface, though, the rent is close to the 1% rule, and using the 1% rule, it should be sufficient where the property is cash flow positive after all expenses…

But again, much more additional information would be needed to properly assess the property and whether or not it was a good deal.

All the best!

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14 Mary December 10, 2015 at 1:20 pm

Passive Activity Losses (PAL) in Taxes – Assuming you are above the income threshold and still have a “full time” job, how do you take into account passive activity loses in taxes? Or do you not have any passive loses?

My biggest gripe is joint income is too high, both are not real estate professional and can’t write off PAL in taxes. Such a bummer! Should not have gotten married legally.

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15 FI Fighter December 15, 2015 at 7:27 am

Mary,

I actively manage all of my units, even the ones out of state (such as tenant screening).

To err on the side of caution, I would consult with a tax professional to get their input on this matter.

Take care!

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16 mike December 10, 2015 at 5:33 pm

keep these posts coming. Doing great!

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17 FI Fighter December 15, 2015 at 7:28 am

Thanks Mike!

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18 No Nonsense Landlord December 10, 2015 at 7:12 pm

I could not have been planning on retiring as soon as I am, with the income I will have, if not for real estate. My equity is substantial, and my investment account will be able to give more stability in retirement.

Tenants, if you know how to get good ones, will send you to a nice retirement!

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19 FI Fighter December 15, 2015 at 7:28 am

Eric,

Real estate investing FTW! 🙂

Cheers!

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20 Alexander @ CashFlowDiaries December 11, 2015 at 8:15 am

This has got to me my favorite post I have ever read from your blog. I completely agree with everything you have said and of course as you already know am already in love with REI.

Tenants paying down my principal + monthly cash flow x 10 = financially free.

That will be me someday! Also FYI, im catching up on a bunch of your older posts before I contact you. Ill text you later.

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21 FI Fighter December 15, 2015 at 7:29 am

Alex,

Thanks! Glad you enjoyed the post.

Sure, give me a shout when you get the chance.

All the best!

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22 Simon December 11, 2015 at 11:07 pm

Have you considered the return on time invested? Although it’s not gonna work out mathematically because REIT takes close to 0 time from you. But in a broad strokes, i assume you have to spend a substantial amount of your time managing your real estates. As opposed to a REIT that is more or less care free for the individual investor and thus leaves a lot of time to do something else that will provide cash flow.

You shouldn’t compare (REI) with (REIT:s), but Rather (REI) with (REIT + what you do in your time). How is for instance, the cash flow from investing in REITs and working the same amount of hours needed to manage real estate in a normal job. I am not arguing how great REI is as an investing vehicle, but rather how much worse REIT:s are. I feel like they should be somewhat equal on a Return on time and capital invested.

Cheers

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23 FI Fighter December 15, 2015 at 7:33 am

Simon,

Real estate doesn’t have to take up too much time, but for the ROI it is well, well worth it.

If you follow some of the commenters above, Midwestern Landlord, No Nonsense Landlord, you’ll see that REI helped them reach early FI and create substantial wealth…

REI + consumed time = worthwhile proposition

The trick with REI is you have to buy right… Unlike REITs, physical real estate isn’t so liquid and debt service adds another layer of complexity. However, if done right, REI is perhaps one of the most lucrative asset classes that exists out there.

Cheers!

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24 Jetsun December 22, 2016 at 6:27 pm

Hello Fifighter,

Great post BTW!

I plan on investing into rental properties after I pay off my student loans first. I’m from Surrey, British Columbia which is an hour away from Vancouver. As you know, properties in and around Vancouver is expensive. I can only afford properties that are between $100-300k. What are your thoughts on condo rentals in and if they are a good cash flow investment? If not, what is your advice for me to get started?

Thank you

Thanks

Reply

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