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

16952551595_7fad5fb025_k

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!

Print Friendly, PDF & Email
Sharing is Caring:

24
Leave a Reply

avatar
11 Comment authors
JetsunSimonAlexander @ CashFlowDiariesmikeNo Nonsense Landlord Recent comment authors
  Subscribe  
newest oldest most voted
Notify of
JC
Guest

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.

Nick
Guest
Nick

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?

Midwestern Landlord
Guest
Midwestern Landlord

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!

Mike
Guest
Mike

Another great write-up FF!

Nick
Guest
Nick

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?

Mary
Guest
Mary

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.

mike
Guest
mike

keep these posts coming. Doing great!

No Nonsense Landlord
Guest

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!

Alexander @ CashFlowDiaries
Guest

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.

Simon
Guest
Simon

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

Jetsun
Guest
Jetsun

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

Close Menu