Ep 5: Andrea Pays Off Properties Early with Cash Flow

Pro Tip: Listen to the podcast below and while you’re listening follow along with the charts below. Then, when you’re done, copy the Scenario to your own Real Estate Financial Planner™ account to change any of the assumptions.

In Episode 5, Andrea asks herself a common question: should I pay off my properties early with extra cash flow?

Plus these related questions:

Will paying off properties early lead to achieving financial independence earlier?
Will it increase or decrease my net worth?
Will that increase or decrease my risk?
Will it give me a higher or lower standard of living in retirement?

Welcome to the Real Estate Financial Planner™ Podcast. I am your host, James Orr. This is Episode 5.

Today we’re going to continue with Andrea’s story from the previous 4 episodes.

In her original baseline Scenario from Episode 1, Andrea utilizes the Nomad™ real estate investing strategy and buys a property every year… as an owner-occupant… putting 5% down each time. With each property, she moves into the property and lives there for a year to fulfil the requirements from the lender to get an owner-occupant loan with just 5% down and with a better, owner-occupant interest rate.

While she is acquiring properties, her account balance is dropping as she pulls out a 5% down payment and closing costs with each new purchase each year.

But something interesting happens after her sixth property… five rental properties and the one she is living in.

After she buys her sixth property in month 61, she realizes that between the net cash flow… after all expenses… that she is getting from the 5 rental properties and the returns she is earning in the stock market… she realizes that even with the down payments and closing costs removed to purchase properties 7, 8 and 9… her account balance will continue to grow.

In other words, her lowest account balance will be when she buys that sixth property.

When she buys her last property… property number 9… 8 rentals and 1 to live in… it will be about 8 years after she started. She’ll be 48 years old.

At that point in time, in month 97, her bank account balance will be about $83,000… which we assume is primarily invested in stocks earning about 8% per year.

Ep 5 - Total Account Balance - Month 97 — Ep 5 – Total Account Balance – Month 97

Now, for someone that has 9 properties… 8 rental properties and the one she is living in… having $83,000 represents having about 5.1 months of reserves.

Ep 5 - Months of Reserves - Month 97 — Ep 5 – Months of Reserves – Month 97

The Real Estate Financial Planner™ software calculates reserves by taking the total of all the account balances and dividing it by the sum of all the operating expenses for all properties plus all the mortgage payments plus all her personal living expenses.

Months of Reserves = Total Account Balances/((Operating Expenses + Mortgage Payments) + Personal Expenses)

Let’s break that down.

First, it takes the total of all account balances… so in Andrea’s case… it is all the money she has invested in her all-in-one account that she has invested in the stock market.

Next, it divides the total of all account balances by the sum of three things: all the operating expenses on her properties plus all the mortgage payments plus her personal expenses.

For operating expenses, that includes:

Property taxes
Property insurance
HOA
Landlord paid utilities
Maintenance for the properties
Any other property expenses
And any property management… although in this case… we assume Andrea is managing the properties herself unlike what we assumed in Episode 4

So, when calculating her need for reserves we assume that she needs to have all the operating expenses plus all the mortgage payments on her properties and all her personal expenses.

If we divide her total account balance by all the operating expenses on her properties plus all the mortgage payments plus her personal expenses we get the number of months of reserves that she has.

In this case, by the time Andrea buys her 9th property… she has just over 5 months of reserves saved up.

This is as good a time as any to have a brief discussion on reserves.

If Andrea only had 1 rental property, it would be prudent for her to have 6 full months of reserves for all the operating expenses of the rental and her mortgage payments for both her rental and her personal residence and… ideally 6 months of reserves for her personal expenses as well. In an ideal world, she’d have this money set aside in a very low risk account… like a savings account… that is not subject to the market fluctuations.

If she had 2 rentals, she probably still needs 6 months for each property.

To take this to an extreme example for a moment… if she had 1,000 rentals, the chance of EVERY rental having something happen all at the same time is low, she probably could get by with less than 6 months per property. Although, there are events that… COVID being a recent example… that could have impacted ALL her properties and personal living situation all at once where having a full 6 months for each property is probably still a prudent decision.

That begs the question: when… if ever… is it OK to have less than 6 months of reserves per property?

I think most investors would agree that full reserves for the first property is a given. Many, I think, would agree with full reserves for the second property. I think an increasing number of investors would want to argue that you don’t need full reserves for EVERY property as the number of properties you have increases. But, then you have events like COVID that could have impacted a large portion… if not all of Andrea’s properties. In cases like that, having full reserves for EVERY property seems less risky.

And… you’ll notice… I’ve been saying full reserves… even though a stopped using the specific example of 6 months of reserves. I think many accountants, CPAs, real estate agents and brokers and financial advisors might suggest 6 months of reserves as being a reasonable amount for most people in most situations.

I’ll add in that it seems reasonable for most situations if you have that six months in a safe, easily-accessible, non-volatile account… like a savings account or a good portion in a savings account and the rest in maybe a CD-ladder or bond-ladder…. ideas we’ll discuss in future episodes.

However, if Andrea wants to keep her reserves… like the $83,000 that she has once she’s done buying properties in something with higher returns, higher market volatility and higher risk, is 6 months enough?

This is a topic we discuss in the class Everything You Learned About Deal Analysis is Wrong where I introduced the quadrants with reserves… the Return on Investment, Return on Equity and Return in Dollars quadrants with reserves.

If she decides to keep the $83,000 in the stock market where the value can dip, maybe she needs MORE than 6 months of reserves because she really wants to have a full 6 months of reserves available to her when things get ugly… and things might get ugly with the stock market and the real estate market at the same time.

So, for peace of mind, I might suggest that if you’re going to keep the majority of your reserves invested in something with higher risk, higher volatility and higher possible rates of return… something like the stock market… maybe you should have 12 months of reserves per property.

I know that for some listeners this seems extreme. I remember distinctly hearing 6 months of reserves from my accountant when I first started investing in real estate and that seemed like an excessively conservative number at the time. We will revisit this idea in future episodes… especially in the Advanced Real Estate Financial Planner™ Podcast episodes… where you can see the impact of market corrections and random market conditions and why having ample reserves will keep you in the game.

Back to Andrea… that means… in this case… with Andrea… she has about 5 months of reserves… which is less than the recommended 6 months of reserves if she had that money in something like a savings account. Instead though… she has it invested in the stock market… which we’d normally recommend she have 12 months of reserves.

But… and this is the main point of this Episode… she either does not know about the recommendation for 6-12 months of reserves per property… or chooses to ignore that recommendation… and instead opts to use excess cash flow to pay off properties earlier.

One might think… especially since we use “how much debt she has” as a measure of risk in some cases… that by paying off mortgages, she is reducing risk. We will see how that plays out.

Paying Off Loans Early

Here’s what Andrea does in this Episode… starting in month 120… year 10… she takes any excess cash she has over $50,000 adjusted up for inflation… and uses that money to make payments toward paying off the lowest balance mortgage.

A couple points about this.

First, until she completely pays off a mortgage… making extra payments does NOT improve cash flow. Once she pays off the mortgage the payment goes away and it does improve cash flow… significantly at that point. But, just because she paid off a little bit of her mortgage does not change her mortgage payment and therefore it does not improve cash flow.

And, because it does not impact cash flow… until she pays off the mortgage in full… that does not help her achieve financial independence. Once she pays off the mortgage it helps her qualify for having achieved financial independence, but until then… she just is converting relatively liquid net worth in the form of cash invested in the stock market to relatively illiquid net worth in the form of equity in a rental property.

A second, related point. The money she has invested in the stock market is earning our assumed stock market rate of return… 8% per year. When she takes that and opts to use it to pay down her mortgage she is taking the money that was earning 8% and now is earning the mortgage interest rate that she is no longer paying. In other words, she goes from earning 8% per year to earning 3.125% per year.

By taking any extra money over $50,000… adjusted for inflation… and using it to pay down the mortgage on the lowest balance mortgage she is able to pay off her properties much faster. Her first property gets paid off in month 131… that’s 7 months before she would have otherwise achieved financial independence in the baseline Scenario from Episode 1.

Ep 5 - Number of Properties Paid Off — Ep 5 – Number of Properties Paid Off

The reason I compare it to when she achieves financial independence from the baseline Scenario from Episode 1 is because by paying off the first property, she does achieve financial independence.

So, by opting to be a little more aggressive with less months of reserves, she is able to achieve financial independence about 7 months faster in this case. Of course, different people with different situations will see different results… in fact that’s the whole idea behind the podcast… showing how these types of ideas impact people in a variety of different situations.

Ep 5 - Percentage of MTMIR Goal — Ep 5 – Percentage of MTMIR Goal

For Andrea it means slightly improving her goal of financial independence and… for the most part… it means being able to live at a slightly higher standard of living.

That’s because paying off the properties is slightly better than having that extra money in the stock market with a 4% safe withdrawal rate.

Net Worth

It is not all upside… because she took money earning 8% in the stock market to pay off 3.125% mortgage debt, her overall net worth is lower.

Ep 5 - Net Worth - Month 480 — Ep 5 – Net Worth – Month 480

She would have had over $16 million in inflated net worth 40 years from now compared to about $13.6 million if she paid off the properties early.

Ep 5 - Net Worth - Month 480 - IA — Ep 5 – Net Worth – Month 480 – IA

That’s almost $5 million in today’s dollars when not paying off properties early compared to just under $4.2 million in today’s dollars if she did pay them off early. That’s about an $800,000 difference… not trivial.

Mortgage Balances

By aggressively paying down her mortgages, she has them all paid off by about month 291 compared to it taking until almost month 455 if she did not pay them off early.

Mortgage Payments

Each time she completely pays off a mortgage, that mortgage payment goes away… that means that the amount she paying on her mortgage payments is lower by that one mortgage amount.

Cash Flow

It doesn’t impact the rents she is getting on properties at all, but with each mortgage payment she pays off that improves cash flow.

Cumulative Cash Flow

Because cash flow increases each time she pays off a mortgage that means the cumulative total amount of cash flow she’s collected over the entire Scenario is much higher when she pays off properties early.

Ep 5 - Total Cumulative Cash Flow - Month 480 — Ep 5 – Total Cumulative Cash Flow – Month 480

For example, by year 40… she’s earned about $6.7 million in cumulative cash flow from all the properties… compared to just over $5.1 million if she did not pay off properties early. This is what partially makes up for the money she did not earn having it invested in the stock market. She traded some stock market return upside in exchange for improved cash flow (once she paid off the property).

Return on Equity

Ep 5 - Total Equity — Ep 5 – Total Equity

By paying off properties earlier, the equity in her properties goes up. She’s taking money she had invested in the stock market and converting it to property equity after all.

Ep 5 - Return on Equity from Appreciation — Ep 5 – Return on Equity from Appreciation

Ep 5 - Return on Equity from Depreciation — Ep 5 – Return on Equity from Depreciation

Because the equity in her properties has gone up and the returns from appreciation, depreciation… and to a lesser degree cash flow… until she completely pays off a property… do not change… that means that her return on equity from appreciation, depreciation actually are worse when she pays off properties earlier. Again, it is the same dollar return but the equity has increased so the return she is earning on that equity is actually a little worse.

The same with return on equity from cash flow until she pays off the property and cash flow really increases with no mortgage.

Eventually, her return on equity from cash flow… when she has paid off properties… does improve.

Debt To Net Worth

Let’s talk a little about risk.

Remember, one of the ways we measure risk is to look at the total debt to net worth.

Well, when Andrea is paying off debt, this improves her total debt to net worth a little bit. She has a similar amount of net worth and less debt. This makes sense.

Total Debt to Account Balance

But, another way we measure risk is to look at the total amount of debt she has compared to her liquid net worth… her account balances.

Since she is using her account balances to aggressively pay off her mortgages we have conflicting forces. On the one hand, her debt load is going down, but on the other hand her account balances are going down too.

Ep 5 - Total Debt To Account Balance — Ep 5 – Total Debt To Account Balance

In the end, using her account balance money to pay off debt results in a significantly higher measure of risk when we look at risk through the lens of total debt to account balance.

That is until she pays off all the properties… at that point, her risk is lower by having paid off the debt. But, by that time, her debt is relatively low compared to what the baseline Scenario would have been at that point anyway.

Reserves

We previously talked about reserves.

I’ll add a few more things.

First, every time she pays off a mortgage, she reduces the amount she needs in reserves because she no longer has to keep that mortgage payment in reserves. She still needs to keep all her other operating expenses for that property… and all the other properties for that matter… but she no longer needs to keep the mortgage payment for a mortgage she has completely paid off in reserves.

So, her need for reserves does go down over time faster than it does if she naturally waited for mortgages to be paid off.

Ep 5 - Months of Reserves - Months 1-148 — Ep 5 – Months of Reserves – Months 1-148

But, lower account balances means she has fewer months of reserves… especially after she starts paying down on the mortgages but before she has completely paid off any of the mortgages.

The $50,000 inflation adjusted amount she is keeping in reserves works out to be a little more than 4 months of reserves.

Ep 5 - Months of Reserves — Ep 5 – Months of Reserves

But overall, using her account balance to pay down mortgages means she has significantly fewer months of reserves making it riskier to pay off mortgages than to just hoard the money in the stock market.

Now, there’s some nuance here because once she gets over a certain number of months of reserves, how much safer is it to have 12 more months of reserves… not much right?

Conclusion

In conclusion, having Andrea reduce the amount in reserves and using that money to pay down her lowest balance mortgage faster does help her achieve financial independence a little bit faster… about 7 months. It also leads to the potential for her to live at a slightly higher standard of living once she achieves financial independence.

It does increase her risk in some ways but reduces risk slightly when we look at total debt to net worth.

One thing we did not discuss in this episode but that we will visit in future episodes and especially in the Advanced Real Estate Financial Planner™ Podcast episodes is how she is changing the characteristics of her risk from a more volatile, less predictable stock market risk to a in quotes… “guaranteed” return of paying down a mortgage she has. She knows what return she’s getting when pays down that mortgage… it is the interest rate of the loan compared to the uncertain return… at least in real life… of the stock market.

Next Episode

In the next episode, we will meet a new set of characters: Norm and Norma and learn about their situation and their journey toward financial independence.

Also, be sure to check out the Advanced Real Estate Financial Planner™ Podcast to see how having variable property appreciation rates and rent appreciation rates, variable mortgage interest rates, variable inflation rate and variable stock market rates of return impacts Andrea as she pays down her mortgages with extra cash flow.

I hope you have enjoyed this episode about Andrea. This has been James Orr with the Real Estate Financial Planner™ Podcast. Bye bye for now.

More Detailed Comparisons With More Charts

Get unprecedented insight into how Andrea paying off properties early with extra cash flow compares to her baseline by comparing the Scenarios.

Inside The Numbers

Want to learn more about the assumptions and dive deep inside the numbers for the Scenarios in this episode?

Now you can!

Click on the button to copy either of the Scenarios to see a detailed explanation of all the assumptions, read through the Blueprint™, or copy the Scenario to your own account so you can change any of the assumptions we used and see how the changes you made impact the outcome.

Copy

Scenario into my Real Estate Financial Planner™ Software

Ep 1 Andrea - Baseline with 2 Accounts, 1 Property, and 3 Rules.
Or, read the detailed, computer-generated, narrated Blueprint™.