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Ask Marco — Equity Acceleration, Book Recommendations, FHA Loans, Turnkey or DIY, Pay-off Loan or Not?
I got back from San Jose, California. I was there on a business trip and it was very productive. I always like to see what real estate is like when I go to different markets around the country. I found not to my surprise, but the median price of a home in San Jose, California as of late, mid-October was $1.01 million. Think about that, a price is over $1 million for a home and this was based on over 1,800 home sales. This is not a one-off. This is the mid-point. When you do the math, it breaks down based on square footage to a price per square foot of just under $700.
We’ve been selling properties for many, many years throughout the country in markets that make sense for $80, $90, sometimes $100 a square foot. Even our new construction in various markets like Cape Coral, Florida, in Tampa and Jacksonville, Florida, a lot of these properties are right around that $100 per square foot mark. In fact, it’s hard to find properties being built for over $130 a square foot in the markets that we’re in. It gets worse. If the million-dollar price tag wasn’t bad enough for a median sales price, the median rent per month in San Jose is around $3,500. If you do the math, if you divide that into the million dollars and you try to calculate your rent-to-price or rent-to-value ratio, what we call an RV ratio, that’s just a measly 0.35%.
Remember, we’re trying to get at or above 0.8% with an ideal target of 1%. When you’re down under 0.8% and you’re as far down as 0.35%, it is very small. You are not utilizing your investment capital in the best and wisest way possible. Not only that, it’s a very expensive market, high priced, high land values, therefore potentially high downside risk. This is why a lot of the coastal markets, particularly in California and on parts of the East Coast are just simply too expensive to invest in. Other than that, I’ve noticed a lot of volatility in the stock market. It’s hard to believe that October is the same month that we saw record highs in the Dow, yet at the same time we saw the top 30 stocks in the index decline just short of 10%. When you have a 10% drop in the stock market, that’s generally referred to as a correction.
When you look at the Dow and you look at the broader market, the S&P 500, if you were an investor at the beginning of the year, as of October 31st, you would be in negative territory. That means not only did you not make any gains, but you also haven’t had an increase in value. You haven’t had any cashflow either. Your capital is worth less now than it was at the beginning of the year and you had no cashflow. Your capital is worth less than it was when you first started because of inflation. You’re not even keeping up with inflation. How could you even call that an investment? I certainly don’t call putting capital in the stock market in terms of achieving capital gains as an investment.
I’ll get off my soapbox there in terms of the stock market and overpriced a real estate markets and get to what I want to cover here. That’s another episode of Ask Marco. I haven’t done one of those in a while. Those questions seem to keep piling up in my inbox and I do file them in a folder and I get to them and I do reply to everybody in a timely manner, as best as I can but I do travel quite a bit. I picked out some questions here and I think these are applicable most to everybody. I try to mix it up. Let me go through some of these and hopefully they’ll be helpful for you and you can relate to some of them.
Equity Acceleration
The first question is by a gentleman named Arman. Arman says, “I’m a huge fan of the podcast. Thank you for it. I have learned a ton from you. I have a question about the equity acceleration topic.” For those that you don’t know, it was episode 51. This was a couple of years back. He said, “I listened to the episode and it does seem too good to be true.” I’ve heard this many times. There are a lot of people that say it’s too good to be true. Arman says, “I was wondering if I could have your opinion on the topic. Is it a genuine way to accelerate payments on properties to own them free and clear in a few years or are there hidden caveats that are stored away in this method that make it not worth pursuing? I would love to hear your thoughts on the pros and cons with this because I don’t know much about it. Thank you for your time, Marco. Arman.”
I’ve gotten a number of questions based on that episode. It’s one of the hardest concepts to wrap your head around, even though it’s not that complicated. It’s also difficult to follow without discipline and organization. You have to be a disciplined person with your finances and with your income and paying your bills. It comes down to the process of taking your income, paying down your mortgage in large chunks using some line of credit. Then you’re basically paying your bills, paying yourself through that line of credit. It’s just one of those things that make a lot of sense when you see it visually. Even I find it hard. I know how it works and I’ve done it for a while, but I’ll be completely honest. It does take a lot of discipline to follow along and do it. It’s a little bit of a pain in the butt. The fact is it does work.
If you’ve been looking at other countries like Australia, this concept has been used for many years. It goes by different names. It’s not publicized here in the US. The fact is most people don’t have the discipline to stick to it. There are people I’ve spoken to that were following the system and accelerated their mortgage paydown in nearly half the time. It does work. You need to have the discipline and the follow through on the process. You need to have either a chunk of cash to start with or you’re borrowing from yourself or you are borrowing from a revolving line of credit. There are no tricks or hidden items. It’s just math. If you reduce the principal upfront, that’s the key. If you’re reducing the principal upfront, you end up paying more towards the principal and less towards the interest as you make each payment.
An amortization schedule on a mortgage frontloads the interest and backloads the principal. If you can turn that upside-down and on its head and pay off a big chunk of the principal upfront, you’re actually paying more principal on future payments. You are paying off more principal and less interest. When you can build it up and stack it that way, it accelerates the principal paydown. There are several educators and promoters out there that offer similar programs. I’ve seen many of them come and go. I was first exposed to this back in 2005 and they’re all based on the same principles. Feel free to call them. Go back and listen to episode 51 and reacquaint yourself with this. My guest was Jordan Goodman who was explaining how this works. Just revisit that. I hope that helps a little bit.
Book Recommendations
Question two is from Mark, “I’m newly interested in real estate investing. The idea of passive income amazes me and the idea of working paycheck to paycheck does not. Would you be able to recommend any books on real estate investing? Thanks for your time.” This doesn’t change much from year-to-year. There are certain books that I find I find to be very foundational. Here are my top four or five. It’s not necessarily a real estate-based book, but definitely a fundamental cornerstone book from a psychological and mindset perspective is Napoleon Hill’s Think and Grow Rich. I’m sure many of you have heard this said many times. The nice thing about Think and Grow Rich, and I’ve done a podcast episode on this, Napoleon Hill was a journalist and he went out and researched more than 500 self-made millionaires including the great Andrew Carnegie, Henry Ford, Charles Schwab. He studied these people and interviewed them and try to learn what they had in common, that lowest common denominator. Then he released a book in 1937 and it became a bestseller.
This is a timeless book and it’s one of those timeless personal finance classics that will help you understand that getting rich is more about the mental game above anything else. In fact, he barely mentions the words, money, wealth or even finances in the book. What he does do is he explains the psychological barriers that hold many people back from building what can be fortunes. He teaches you how to start thinking your way to success. That sounds woo-woo or ethereal, but the reality is your mind controls everything you do. It sets in motion everything you do or don’t do. When you can wrap your mind around the power of your mind, you will set in motion all the right actions and knowledge that you need to make things happen. Think and Grow Rich is a cornerstone book and you can get it on audio as well.
The next book I would say is not only the Rich Dad Poor Dad book by Robert Kiyosaki, but the whole series of Rich Dad books. They’re all excellent. They cover all the topics from real estate investing to taxes and school. What you learn and don’t learn from the school system and things to do with the economy and the Federal Reserve. It goes off in many different directions. That whole Rich Dad series covers a lot of breadth. It’s a must-read and if nothing else, the Rich Dad Poor Dad book, the very first one in the series followed by Cashflow Quadrant would probably be the two I’d pick out a first. If you read nothing else, that’s fine but those are foundational books.
The Ken McElroy books would be the third and fourth book I’d read. The next book is the Gary Keller book. It’s called The Millionaire Real Estate Investor. That book was great, but it went all over the place for me. It’s like every chapter was different from the previous one that they didn’t flow from one to the other, but it all came together. It’s a good book. A little bit on the math side is Frank Gallinelli‘s book, What Every Real Estate Investor Needs to Know About Cashflow. This is a very simple read, but there’s a lot of math in it and formulas. It gets you to understand the importance of the numbers and what those numbers are. I did a podcast interview with him years ago. Maybe you can learn a lot from that particular episode, but the book is definitely a good book to pick up. Then last but not least is a book called Big Shifts Ahead by John Burns. It’s a relatively newer book. These are great books to have in your library and certainly read. It will give you a great foundation.
FHA Loans
The next question. “First off, thank you so much for this podcast. I’m learning so much very quickly and appreciate the quality and clarity of your podcasts. I am looking into purchasing my first investment property. I live rent-free with my family in someplace in California here and I’m saving up for my down payment. I currently earn, but it’s not a lot which increases $2,000 each year. I have $10,000 saved up and my credit score is over 800. I am in the process of applying for my loan preapproval. I was initially planning to purchase a rental unit in the Midwest, however I realized I qualify for an FHA loan and potentially down payment assistance if I purchase a primary residence. I would ideally live in Northern California. I have three questions. One, should I take advantage of the FHA loan and try to purchase in California? The only affordable places I’ve found are foreclosed auction homes. I would like to find something with extra rooms, a multiunit so I could receive rent.”
That would probably be the only way to make it work. The thing with an FHA loan is they’re not designed for investment property. In fact, you can even use them for investment property. They are designed for your principal residence. If you could find a multiunit and use an FHA loan, which is easier to qualify for, it has a very low-down payment requirement. I believe it goes as low as 3% or 4%, then you can get into a property and rent out the other units to help cover the cost of the property. If the numbers work out in your favor, you could potentially be living there, rent-free or mortgage-free because the tenants that live in the same property with you are covering your cost.
The problem with where you live is it’s very difficult to find a distressed or foreclosed property because the competition has been fierce and to find a cheap deal to fix and hold or even fix and flip is very hard to do. That doesn’t mean they aren’t out there, but it will require some work to find distressed properties or even distressed homeowners to find those types of deals. That and compounding the fact that FHA loans are designed to be home owner loans, this is not going to work out for you or at least not easily. Your next question here is, “Should I forgo the FHA loan and purchase a more affordable rental unit in the Midwest?” The short answer to that is yes, if you’ve got the credit, which you do in the down payment, then purchase a cashflowing investment property in a market that makes sense.
The Midwest has a lot of great markets where you can definitely do this. The third question is, “How easy or plausible is it to purchase an affordable foreclosed auction home in California?” It is very difficult. The good thing is you have a good start to your savings. Once you’re closer to the $20,000 point, you’ll have enough to purchase your first single-family or even potentially duplex, but a single-family home in the Midwest or the Southeast. We have plenty of them that come and go. If you’re living at home, that’s the cheapest thing you could possibly do. If you’re lucky enough to be able to do that, then take whatever investment capital you can and whatever you can save and put it towards building that portfolio of rental properties. Just get started. I hope that helps.
Pay Off Loan Or Not?
The fourth question here is from Thomas. He says, “I’m new to your podcast, but I have been binge listening since I have discovered it. My spouse has rehabbed houses in the Los Angeles area for the past five years, but in 2014 we got stuck with the duplex that was supposed to be sold.” We began to lease it out in 2015 for combined gross income of $4,250. We are fortunate to be able to pay off the mortgage and saving the monthly payment of approximately $1,950. My question is, does it make sense to pay the $390,000 mortgage off to gain the $1,950?” That’s probably their mortgage payments. I’m assuming that they’re netting $1,400, they’d gain an extra $2,000 or so by paying off the mortgage. He says, “Though this question is specific, we have a more philosophical question. At what point does it make sense to buy properties in all cash?”
Without knowing more about your financial situation, it is my opinion that I would not pay that loan off. Here’s why. First, I am assuming that you have a very low interest rate on that mortgage, so you have very cheap credit. Number two, your tenant is paying it off, not you. Let your tenants continue to pay it off. You can certainly accelerate that mortgage if you want to get to the point where you’re free and clear on it and that’s simple to do. You can just add extra payments during the year, during the month. You could go biweekly on your mortgage payment. You’ve got the cashflow to do it. You’ve got to think about it this way. If you have the $390,000 to pay off that mortgage now to gain an extra $1,950 a month, you would be better off taking that $400,000 that you would pay the mortgage off and acquire at anywhere from four to eight more properties in other markets where you have good cashflows and good rates of return. You can easily increase your monthly income, your monthly cashflows from those other properties that you add to your portfolio that would be higher than that $1,950 a month.
It would be smarter to build a larger portfolio and increase your cashflows beyond what you could do by paying off this mortgage. That has other benefits. Aside from the additional depreciation write-off that you get from those other properties, over time as those properties appreciate, you’re going to generate more wealth. Create more equity or net worth is really what it’s coming down to. That additional equity that is part of your net worth will be spread across the additional four, six, eight or more properties that you purchased using that $400,000 that you would have paid the mortgage off. You can still achieve that increased cashflow or income goal by not paying off the mortgage and purchasing additional rental properties in markets that make sense. You’ll far achieve your overall goal of just being debt-free on the one property and having an extra $2,000 a month. I hope that makes sense. You have a larger portfolio. You’re gaining equity over time across multiple properties. You have the same gain in terms of cashflow but probably higher and more diversification. I don’t see any compelling reason to pay off the mortgage unless you’re in “retirement age” or near retirement age and you just want to actually have a free and clear rental portfolio. That just makes you feel good.
To your second question, the philosophical question, “At what point does it make sense to buy properties in all cash?” The answer is the same. I think it’s case-specific, but it’s pretty uncommon that it makes more sense to purchase a property all cash because you eliminate one of the great benefits of investment real estate and that is the leverage. If you’re buying all cash, you take your $400,000 that you have now. If you bought four properties at $100,000 each, great. Now, you have four properties free and clear at for a total value of $400,000. Your cashflow is your cashflow. It’s basically income minus expenses, no debt service. Your net operating income is your cashflow. What if you took that $400,000 and you acquired eight or ten properties using that money as down payments? Using those as 20% or 25% down payments on other properties? Overall, cashflow will be higher in that situation.
You’ll have the same equity that $400,000 spread across different properties in different areas or different markets. You have that geographic diversification, but you also have a larger portfolio of property. As your equity grows over time from the mortgages being amortized by your tenants paying them off, you’re also getting the additional benefit of growing the equity through appreciation year-over-year or over the course of time. This magnifies that wealth creation effect. You get the power of leverage and you have more equity grow. Those capital gains grow over time faster. I don’t think it makes sense to purchase anything all cash unless it’s a screaming deal that falls in your lap and time is against you and you have to just pick it up now or you’re going to lose it. Then what I would do is I would look at purchasing it all cash and then refinancing it to pull the cash back out. 75%, 80% whatever the loan-to-value is. That would be the strategy there with an all-cash purchase.
Turnkey Or DIY
David says, “I have a question regarding the cost of buying turnkey versus the true cost of purchasing, rehabbing, renting and refinancing investment properties. For example, would it be a 10% to 15% savings if doing the work oneself versus turnkey or breakeven given all the time and effort needed to find, vet and assembled the necessary teams? Taking into consideration the price breaks given from turnkey providers for materials and labor costs versus full retail and materials and labor for non-turnkey properties?” He goes on to say, “You can also include the holding costs during rehab and all of the other hidden costs associated to do it yourself. The main question is, it appears to be cheaper to do the work yourself versus buying turnkey properties, but is it really given all the hidden costs involved? This would be for an out of state investor.”
In the hopes of you saving 5%, 10% or even 15% on what you would be purchasing a turnkey rental property or even a retail property, by trying to do it yourself, you have to go through assembling a team and vetting the team. Then going through the acquisition and making sure that you purchase and purchased correctly. With enough of discount that when you go in and renovate the property and spend that money on the materials and more importantly, the time for contractors and especially your time, which is the number one thing here. Then renting it or handing it over to a management company and then refinancing it to pull out whatever you can or just financing it outright as if it was a regular purchase.
The thing is you have to put a price and a value on your time. If you want to do this, a do-it-yourself project and not purchase something that is at the least rent-ready but at best, completely turnkey. A fully turnkey property, meaning no deferred maintenance, it’s like new, what you’re really doing is if you do everything right and everything falls in place. You’ve got the right team and you don’t have any cost overruns or it doesn’t take longer than what you expected. You end up with that 10% or 15% equity cushion in that property because you’ve done it yourself, what you’ve done is you’ve paid yourself for the time and effort and risk that you’ve taken. That’s what that 10% or 15% or even 5% equity at the end of the day is. It’s the compensation for what you have so-called saved. You’re paying yourself in terms of equity.
This is fine for some people and I’ve done it myself. It doesn’t mean that you can’t or shouldn’t. It means that you need to understand what you’re doing and have the right team. Have the right knowledge, have the capital, understand the risk, have the right time horizon and know that it can take three to six months or more. Sometimes these don’t all go well. Unfortunately these shows on TV, Flip Or Flop, Flip This House, Property Brothers and all these other shows, they’re great and they’re entertaining but it’s reality TV. A lot of it is scripted and they don’t always show you the deals that go south and the deals where they lose money.
Ken Corsini in Atlanta, he’s a very good friend of mine and I’ve had this conversation with him. We’ve talked about the show and it’s not always what you see. There’s a lot of stuff that goes on behind the scenes that are the real reality, not what you see on reality TV. I don’t know if I’m helping you out here answering this, but it’s really a decision on how involved you want to be and what your risk tolerance and time availability is and capital. If you do it yourself, that’s great. That’s the active approach to going about it. I had past clients who are doing this. They were clients of ours and they started building a portfolio and then they decided, “I’m going to go into real estate full-time and I’m going to be the one driving the ship, finding the deals. I’m going to be assembling the team and managing the team, renovating them and then putting them in my portfolio and maybe we’ll flip some of them too.” That’s the active role. That becomes a business. It’s not passive in any way, shape or form.
The other end of the spectrum is just be a real estate investor, end of story. Build a portfolio as fast as you can, as large as you can and stay focused on finding the deals and buying the deals. Building the capital, saving that capital as fast as you can, buying more deals and building your portfolio. If that’s not what you want to do, then you can go down these other roads in the world of real estate and real estate investing and do it yourself. You can buy them, fix them, flip them, buy them, fix them or hold them. I don’t know if that helps, but a 30,000-foot answer to your question. I hope that helps.
I’ll continue to do some Ask Marco episodes. If you have questions, go to PassiveRealEstateInvesting.com. Click on the Ask Marco link at the top and submit your question. I try to answer all of them via email, but of course I’m going to hand-pick some of them for future episodes. I hope that’s been helpful. If you haven’t subscribed to the show, do so and we are a top ten podcast on iTunes. I don’t know if many of you have known that, but it’s a great place to be. Thank you for that. Help us spread the word, visit iTunes. Leave us a rating and review. Thank you in advance for that and I will catch you next week on our next episode. Thanks for joining me.
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