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15

Arbitrage – How to Use Your Mortgage as a Wealth Creation Tool

I am going to contradict what I have said in the past about my views on mortgage debt to articulate why mortgages can be leveraged as wealth creation tools through simple arbitrage.

What is arbitrage? In the simplest terms it is the shuffling of resources from a less favorable outcome to a more favorable income.  For example, buying candy for .50 cents and selling it for $1, or borrowing money at a 4% interest rate and then lending it for 6%. Sounds like what the banks do?

For a long time I believed and preached not carrying any mortgage debt on a personal residential property – in other words your home that you live in. This is still true, but that message is mainly for those who lack discipline or the financial literacy to be able to leverage alternative arbitrage opportunities.

While paying off your mortgage has its benefits, not paying it off also has a significant amount of benefits which I will discuss in this post. The reason why I am specifying the home you live in is because I have been and still am favorable toward good debt incurred to purchase investment property that you can financially benefit from over the long haul.  Investing in real estate is one of my favorite ways to generate passive income and build long term wealth.

Mortgages totally make sense if you have alternative investment opportunities.  What stops many from considering the alternatives is the risk element involved, or potential loss of capital.  While to each their own, this approach in my opinion ends up costing the homeowner not only the opportunity to make exponentially more money on their equity, but also money out of pocket when income taxes and inflation are factored into the equation.

So while many people would rather have their homes paid off and be debt free, the wealthy on the other hand consider themselves debt free based on liquidity on their balance sheets and cash flow to pay off large loans such as a mortgage anytime they wish.  They understand that mortgages are one of the best wealth creation mechanisms and one that can get them to their goal of liquidity the quickest.

Think about it, why would you tie up your cash and eliminate potential tax benefits, often yielding zero net return on equity, when you can invest your money elsewhere?

Fee Simple Mortgages

Another benefit of many mortgages is that one can simply walk away from a mortgage at anytime. Sure you will take a hit on your credit, but who cares when you have loads of liquidity? Need a house next time? No problem, just pay cash. The cash you save on a home purchase today can be invested in instruments yielding higher return on equity.

Can the authorities come after you for the mortgage debt default? Not in most cases. Most mortgage loans are fee simple loans. The lender can ding your credit, but cannot come after you personally and liquidate your assets.  The credit can be repaired in seven years if I am not mistaken. I am not suggesting you draw up your life plan based on these facts, but they are good to know.

Corporations Love to Leverage Arbitrage

Even corporations understand this is the right way to do it. Many large companies have the cash to pay off debt but they do not. They understand the power of leverage. In fact, most companies are highly leveraged! Why? They raise public debt in the form of bonds at 8% and turn around to make 15% on that money. They have it figured out.

Why can’t individuals do the same?  They can.  Those who have invested in their financial literacy can by using  mortgages as wealth creation tools.  A mortgage is not necessarily a bad thing.  It can be used as arbitrage to leverage what you don’t have and yet benefit from compounding returns on equity and tax savings.

Arbitrage Case Study

I like to visualize specific scenarios when I am learning so let’s consider the following:

Let’s say you bought an investment property worth $250,000 with a 20% down payment of $50,000.  By putting down 20%, you have full control over 100% of the asset valued at $250,000.  Highly leveraged? Yes I think.  You cannot do this in the stock market as you can trade of a 50% margin at best.

You can depreciate investment property over 27 years, in this case resulting in a $9,259 deduction per year.  If you are in the 25% tax bracket, the depreciation deduction alone would save you $2,315 in taxes, or roughly 4.6% return on $50,000 of equity.

Assuming a modest 3% appreciation of the property, you will have made an additional $7,500 or roughly 15%, which now puts you at about 19.6% return on $50,000 equity.  Say you paid off $1,500 in principal payments and generated another $2,400 ($200/month) from positive cash flow from rent, you now have an extra $3,900, roughly 7.8%, which brings the total return on equity to a nice 27.4%.

These numbers could be “bloomier” but I have maintained a relative conservative approach for demonstration purposes.

Paying Off Your Mortgage vs. Building Wealth

Let’s walk through another scenario in a slightly different example.  Let’s assume you get a $200,000 interest only mortgage at 7% on a $250,000 property. Assuming you are in the 25% tax bracket, your effective borrowing rate is 5.25%.  Your annual interest expense therefore is $10,500 or $315,000 total cost of borrowing over a 30 year span.

Can you do better by investing the $200,000 in cash elsewhere assuming you had it instead of paying off the mortgage?  Let’s have a look.

$200,000 invested at 8% compounded over 30 years yields a total interest income of $1,812,531. Assuming the same 25% tax bracket, you will have $1,359,398 in your pocket.  I know I know I am assuming an 8% compounded rate which you may have an opinion on despite what all the historical charts say.

I understand that the bitter reality can state otherwise.  That said, there are alternative opportunities for those who have invested in their financial education, such as investing in equity indexed annuities that can realistically yield 8% fixed interest on $200,000 of parked cash or investing overseas at higher risk free interest rates with the understanding there is forex and geopolitical risk.

I purposely did not factor in appreciation of property because this would equally apply to both scenarios. So what is the rush in paying off your mortgage? Would you rather pay it off early or have a few extra million in your bank account down the road?

Let’s look at this in a slightly different way.  If Person A is interested in a interest only mortgage and person B doesn’t believe in mortgages, assuming they have the same net worth today, who will come out ahead financially if both were to purchase a $250,000 property?

Person A

  • Current net worth: $250,000
  • Buys a home for $250,000
  • Pays $50,000 down
  • Takes a interest only mortgage for $200,000 at 7%
  • Invests the remaining $200,000 of net worth
  • Assets = $250,000 home
  • Liabilities = $200,000 mortgage loan
  • Investments = $200,000 at 8% interest per year

Person B

  • Current net worth: $250,000
  • Buys a home for $250,000
  • Pays $250,000
  • Assets = $250,000 home – no debt

Let’s make the following assumptions:

  • Appreciation:  4% annual appreciation on property for both homeowners
  • Tax bracket:  25% for both homeowners

Let’s have a look at where each Person stands at the end of 30 years.

Person B

  • Beginning net worth: $250,000
  • 4% annual appreciation over 30 years: $560,849
  • Current net worth: $810,849

Person A

  • Beginning net worth: $250,000
  • 4% annual appreciation over 30 years: $560,849
  • 8% ROI on investment, net of 25% tax:  $1,359,398
  • Total mortgage interest paid after 25% tax deduction / benefit:  ($315,000)
  • Mortgage payoff: ($200,000)
  • Current net worth: $1,655,247

Person A is better off by $844,398, or almost a $1 million dollars over a 30 year horizon.

Arbitrage can be so powerful that sometimes you can borrow at a higher interest rate than what you earn and still make money in the long term. Why? Because of the power of compounding. Let’s have a look how.

Say you borrowed $100,000 at 8% interest rate. Assuming you are in the 25% tax bracket, your effective borrowing cost is only 6%.  Your annual interest is therefore $6,000 or $180,000 over 30 years.

Say you are able to earn 6% return on the $100,000, this amounts to a total return of $474,349 over 30 years.  Assuming the same 25% tax bracket, you will keep $355,762 in your pocket after paying uncle Sam. Take out the interest payments of $180,000 and you will have benefited by $175,762 from this simple investment arbitrage.

WOW ? ? ?

Yes I know. The problem is that many just do not view mortgages a wealth creation tool, therefore many financial planners simply don’t include mortgages in their client’s financial strategy. I personally think it is one of the best tax advantaged strategy to create wealth.

I understand this information can take some time to digest and accept, especially if you have never been exposed to this type of an analysis.  We are just not accustomed to view mortgages under this light. Are we missing out?

Can You Still Make Money in Real Estate?

You can arbitrage your way into tons of opportunities in real estate yesterday, today and tomorrow.  It is my opinion that one can make money in real estate in any type of economy or era.  Majority of our Nation’s wealthiest have created more wealth from real estate than any other type of endeavor.

We currently have over 300 million Americans, and this number is projected to surpass 400 million by 2050, which is “just around the corner”.  The demand for real estate is likely to only increase and just like our historical past, real estate will AGAIN be the underlying basis for a heavy bulk of the wealth creation that will take place in the coming years.

I personally love real estate because of the leverage factor, the tax advantages through depreciation and what have you, potential capital gains through property value appreciation and short term cash flow resulting from rents collected.

How do I personally create wealth in real estate? Arbitrage, arbitrage, arbitrage.  You can read my approach to value investing in real estate here.

Concluding Thoughts

When the $hit hits the fan you are actually safer if you have a large mortgage balance relative to someone who has paid a lot into their property.  Why? Banks foreclose on those who have the most equity in their properties first because that is where they can recoup the most amount of their money.

How sad but true.  Those who are fully leveraged (i.e. zero down mortgages) essentially shift all the risk from their personal balance sheets to the banks.  With that said why would one put equity in their home?  Think about it, if you lose your job and don’t have the cash flow coming in any more, no bank will lend to you no matter what kind of equity you have in your home. So what good is all that equity after all? Why are you rushing to pay so fast?

Most people view paying off mortgages as the more conservative approach, but ironically it’s just the other way around. Having the cash, or liquidity to cover emergencies is what sounds more conservative to me.  I’d rather have that cash liquid.

If you are interested in running some numbers, and particularly if you are interested in real estate investing either now or later, I highly recommend two effective tools that will help you crunch the numbers such as ROI return on investment, cap rates, pro forma financials, sensitivity analysis (if/then and “what if” analysis).

These are software packages that are very reasonable in cost and ones which I highly recommend.  They are well worth their nominal cost.

http://www.realdata.com/

http://www.ianalyzerei.com/

Readers: Do you agree or disagree with me? Why? What are some of the pros and cons involved in this kind of arbitrage? Is the risk worth the return in your opinion?

34

How to Increase Rental Income Effortlessly and Instantly

DON’T MISS MY $1,500 CASH GIVEAWAY AS WELL AS AN APPLE IPAD 2

Rental income is one of my favorite forms of passive income because it allows me to benefit from the ongoing cash flow, long term equity build up resulting from a decreasing mortgage over time, potential long term appreciation and significant tax deductions.

Real estate is where I invest a lot of the profits generated by my niche websites and other passive income endeavors.  What is rental income? Simply put, it is the money generated by rents received from tenants who are living in my rental properties.

If you are in a similar situation wherein you enjoy investing in real estate and benefiting from rental income, here is one strategy you can implement to quickly increase rental income without much effort on your end.

How to Increase Rental Income

Providing that the areas where you buy investment properties have the appetite for this approach, consider renting out your place for a shorter term (example: 6 months) instead of a year. Fully furnish the property and demand a higher monthly rent.

Some of the areas where I own rental property are perfectly conducive to this model, but other areas are not. You will have to determine if you can make this work where your rental properties are located.

This approach may lead to more vacancy, but will still put you in a better position in terms of total income from rent. How so? Let’s have a quick look.

If you own a unit that you typically would rent out for $1,200 unfurnished for a 12 month term, consider fully furnishing the unit and renting it out for $1,600 for a 6 month term instead to increase rental income.

Let’s guesstimate that your unit, if rented for $1,600 and only for 6 months, only stays occupied 70% of the year, therefore an average 30% vacancy or just under 4 months vacant during the year. Now let’s assume that at a lower $1,200 rate but unfurnished and a 12 month term, you experience a 90% occupancy, therefore a 10% vacancy or just over 1 month each year.

Let’s do the math. $1,600 per month at 70% of the year equates to $13,440 whereas $1,200 per month at 90% occupancy equates to $12,960 per year. Revealing isn’t it? The difference can be more favorable if you can reduce vacancy from 30% to 25%, 20%, 15% or even less.

The Flip Side of the Coin

I have one property that I have been renting out on these terms for years now and knock on wood, the property has yet to go vacant for even a full week!  This single simple strategy alone will increase your return on investment (ROI) from rental income.

Many shy away from this approach because they prefer the security of a steady cash flow, knowing that their properties will be rented out for a full year. They’d rather lock in a lower rent at 12 months than taking a higher rental income only for 6 months and worrying about replacing the tenant. Well, it just comes down to risk reward I suppose.

Personally this strategy has worked really well for me on several properties that I know. You can streamline the tenant search and replacement process significantly over time as you gain more experience investing in rental properties. I like to start advertising well ahead in advance so that I can screen tenants, get the leases signed and transition them quickly when time comes.

Added Tax Advantages

This strategy comes with some other ancillary advantages as well. First of all, it is my opinion that furniture and appliances are cheaper today than ever before – whatever happened to inflation? At least you get a lot more value for your dollar today than you did in the past.

That said, not only will you hoard quality furniture at affordable prices, but you also get to depreciate your furniture over time and benefit from tax advantages. Some even go the more aggressive route and claim the IRS Section 179 deduction and deduct the FULL price of the furniture in year one instead of depreciating it over time, therefore further benefiting from tax advantages.

So not only are you benefiting from an increase in rental income, you are also benefiting from not paying as much in taxes, or potentially even getting money back from uncle Sam depending on your personal situation.

Concluding Thoughts

If you are not doing this or feel that this strategy will not work in your rental neighborhood, try to at least increase income from rent by adjusting the rent payments.  Tenants expect rent increases over time, especially in a period of inflation.

You may be able to justify a rent increase even without inflation playing a factor. Regular maintenance, wear and tear can all lead to rent increases over time. Regardless, make sure you are charging a fair amount and taking your fair share as well.

Readers: Good way or bad way to increase rental income?  I’d love to hear your thoughts. Do you have rental property? What have you done to increase rental income over time? Any additional tips on how to increase rent?

13

Generating Positive Cash Flow from Rental Properties

Today I’m inspired to talk about generating positive cash flow from rental property investing.

Couple years back a friend of mine bought a property in the Dallas Fort Worth (DFW) area in Texas.  This was his first home purchase, and it was a good one.  He bought a an older 1,800 square foot 3 bedroom 2 bath house for under $100 a square foot near the downtown area.

Wow I reacted, and I knew that I wanted to look into TX real estate at some point down the road.  If you have been following my blog you may know that I like to take my earnings from my various websites and invest them in real estate.

Generating positive cash flow from rental properties is one of my favorite hobbies. I have been investing since the early 2000s.  The new Dallas story just gave me yet another reason to get excited about it in a new way.

So I started traveling, researching properties within the DFW area to learn the various communities and study the local real estate market.  I started to establish contacts with local real estate agents, attorneys and tax accountants.

Fast forward a couple years, I am now ready to make my first investment property purchase in the Dallas, Texas area.

LO-CA-TI-ON

The real estate industry is a unique one in that it is very much localized.  Property and rent values in one area can be drastically different from another one just a mile away.

For example, anyone can purchase a property in Detroit for $5,000, or even less. This is a microcosm of what has happened to the state of Michigan as a whole.  A condominium that sold for $140,000 in one of the more affluent areas in the state is today selling for $60,000.

However, drive down to Ann Arbor, Michigan just 20 miles Southwest and property values have held their own. In fact, some areas of A2 have appreciated even through the down market in the last few years.

Ann Arbor is a country of its own, and therefore an economy of its own.  It is home to several well know company headquarters such as Borders, Dominos pizza, the Google Adwords program and previously home to Pfizer.  It’s a huge talent farm thanks to the University of Michigan, which one can argue single handedly runs the city.

But this post is not about Ann Arbor, so let me share with you what I’ve learned about rental property investment, generally as well as specifically as it pertains to the Dallas, Texas area.

Why Dallas Fort Worth?

There are several reasons that attracted me to the Dallas area for my next investment property purchase. Of all the reasons, stability and predictability were likely the most influential factors.

Real estate in the Dallas Fort Worth area has neither appreciated, nor depreciated in what seems like the last 19 decades.  I’d probably trust the security of my investment more in Dallas real estate than in the hands of the US Government. Just ask Mark Cuban and he will tell you the same.

I don’t speculate on property appreciation, nor do I care about the topic. As someone who practices value investing in real estate, there is no better place for me to protect my investment principal than in the Dallas area I thought.

Another reason is the high migration rate that Texas as a whole is experiencing.  There are over 300 bodies moving to the Dallas area alone daily. That trend is about to hit 24 months, or essentially over 200,000 new bodies.  No wonder restaurants and businesses have popped up everywhere.  Dallas has become a melting pot (at least it is more so obvious today) that it wasn’t on my last visit just less than 5 years ago.

Why are people moving? Well let’s see.  Ideal weather, no state income tax, beautiful, convenient and well maintained freeways, great real estate values, stability in home prices, central location or geographic accessibility, overall cost of living is much lower and most importantly jobs and opportunities.

Texas has surpassed the state of New York as the number one state with the most Fortune 500 companies.  Not to mention all the start ups in the oil, gas, information technology, wind energy and alternative energy fields.  Banks, venture capitalists and private equity firms are moving to Dallas faster than one can say “money”.

Finally, I have friends and distant relatives in the area who can keep an eye out on the property while I am away.  No, I don’t want them to manage, that is what property managers are for. I simply want them to visit the place once a year or so to ensure it is still there and that no one has stole it. That’s the Indian in me talking.  Peace of mind counts for something too 🙂

With all that said, I said “why not?”

Taxes are Bigger in TX

Everything is indeed bigger in Texas.  That is not merely a saying. Yes, you don’t pay state income tax and overall cost of living is lower, but property taxes are ridiculously higher.

Because property taxes in Taxes are the size of Mars, I found out that the traditional equation I use to evaluate rental property investments was showing more unfavorable prospects than it usually does. This just means more preliminary work for me vetting properties.

Another thing that is bigger is utility bills.  This is ironic. As an oil, gas and energy state, one would think utility rates are lower in TX. It’s quite the opposite however. Texas has some of the highest utility rates in the country, go figure.  Gasoline however is cheaper.

Because the utility bills are higher, I also had to adjust the “vacancy reserve” component of my rental property investment equation. Typically I allocate 5% of monthly rent to this bucket, but I am contemplating wiggling it up a bit.

What I Am Learning?

I have been evaluating rental properties in Dallas for just about a week now. I have learned that foreclosures, bank owned properties and short sales can be found in all kinds of markets, good or bad.

There are always people dying, getting divorces, losing jobs and so on no matter what place on earth we are talking about.  Because of the strong economy and stable house prices, the selection in Texas may be far and few relative to Michigan, but Texas has its share of great buys as well just like anywhere else.

And because of the scarcity factor, coupled with the fact that people know real estate values hold their own down in Texas, I will have to make a lot more low-ball offers than I usually do when I purchase an investment property. I am not expecting this to be a quickie at all.

I have also realized that I have to settle for a positive cash flow amount much lower than what I am used to thanks to higher property taxes, which is a fixed expense that I have to bear until I remain the owner of the property.

What Do You Need to Succeed in Generating Positive Cash Flow from Real Estate Investing?

Understanding real estate investing and the local area where you are going to invest goes without saying. You definitely need some sort of property management software to make it easier to stay organized. But what you need in addition to that are good partners to work with.

I am referring to local real estate agents, attorneys, tax accountants and property managers who can help you navigate the terrain. Of all these, I consider the real estate agent to be the most important.  A good real estate agent is well connected with the rest of the professionals you will need, so take your time and do your diligence to land the right real estate agent for you.

You will need an agent who understands the rental property game and who is very much comfortable making ridiculous offers that work for YOU and no one else.  I like to work with agents who are absolutely shameless and persevering like I am.

There are not many of these, so if and when you find one, wine them, dine them and do all that you can to hang on to them for as long as you plan on investing in rental real estate.  I only have a handful of agents in my rolodex who I always return to for business.

Concluding Thoughts

I know that Texas stole the show in this post, but that is only because I am considering an investment there.  There are other similar areas all over the country, and I am sure there are several in your own backyard.

You don’t have to fly to Dallas if you want to generate positive cash flow investing in rental properties. The underlying discussion points are applicable anywhere. Just make sure the investment works for YOU when analyzing it. My winning rental real estate investment equation may help.

It is not uncommon to make hundreds of offers to land one that works for you and the seller.  In fact, because of the local economics I discussed above, I am anticipating making a lot more offers in Texas than I normally do before I get someone to bite on it.

I will come back and update you on my purchase as soon as it happens. Until then, I will continue to learn the market, evaluate rental properties and make offers.

Download this spreadsheet if you are interested in seeing an analysis of some of the properties that I am evaluating.  I have included some instructions to walk you through the steps I took to compile this, as well as how you can use it to evaluate and compare rental properties.

So with attractive real estate prices in most parts of the country making it conducive to generating positive cash flow, is rental real estate investing in your to do list? Why or why not?

Outside of investing in the stock market, which comes with relatively higher risks in my opinion, what do you do with your excess cash? Or your earnings from side gigs such as your website or blog?

More on my thoughts on positive cash flow from rental properties here.

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