How To Create Cash Flow On Your Rental Properties
| | Saturday, November 20, 2004 @ 12:50 PM EST
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Contributed by: Carlos Aguirre
Carlos Aguirre Properties
Read more archived articles about Squeezing More Profit
Normally, most people will use a 30 year fixed loan. That might be ok if you intend to hold on to the property for that long. Most properties will be sold within five (5) years or maybe exchanged through a 1031 exchange. Even if you hold it for 30 years, the first five to seven (5-7) years you made nothing. The bank on the other hand, made money since those first few years most of your payment went towards interest only and maybe reducing your principal balance by approximately $1000.00 a year. Not a good return for having the bank use your money is it?
Be advised that this article is not intended in any way to provide financial advice or to suggest that this product is right for you. An accurate assessment of your risk tolerance is always advised on
any investment. Please consult your mortgage or financial advisor.
All of you have experienced the need or flexibility for multiple exit strategies. After all, that is the first consideration you should make when evaluating an investment property. However, the strategy might manifest itself sometimes when you end up renting the property-Or maybe that was your exit strategy to begin with.
In addition to your exit strategy, you have to determine your acquisition strategy. Are you using OPM such as Sub2, Lease Option or are you using HML with the hope to flip the property short term. The reality is that unless you structured the deal right you might not have any positive cash flow. You might just break even-once you take into account PITI and MVM (Management, Vacancy Rate and Maintenance). Well, what happens when OPM is not available and you have to hold the property even if for mid-term (2-5 years)? You have to find your own financing!
Normally, most people will use a 30 year fixed loan. That might be ok if you intend to hold on to the property for that long. Most properties will be sold within five (5) years or maybe exchanged through a 1031 exchange. Even if you hold it for 30 years, the first five to seven (5-7) years you made nothing. The bank on the other hand, made money since those first few years most of your payment went towards interest only and maybe reducing your principal balance by approximately $1000.00 a year. Not a good return for having the bank use your money is it?
I.e. $100,000.00 30-yr. Fixed @ 8% rate.
PmtNo. Beginning Balance Total Payment Principal Interest Ending Balance Accumlative Interest
1 $ 100,000.00 $ 733.76 $ 67.10 $ 666.67 $ 99,932.90 $ 666.67
2 99,932.90 733.76 67.55 666.22 99,865.36 1,332.89
3 99,865.36 733.76 68.00 665.77 99,797.36 1,998.66
4 99,797.36 733.76 68.45 665.32 99,728.91 2,663.97
5 99,728.91 733.76 68.91 664.86 99,660.01 3,328.83
6 99,660.01 733.76 69.36 664.40 99,590.64 3,993.23
7 99,590.64 733.76 69.83 663.94 99,520.82 4,657.17
8 99,520.82 733.76 70.29 663.47 99,450.52 5,320.64
9 99,450.52 733.76 70.76 663.00 99,379.76 5,983.64
10 99,379.76 733.76 71.23 662.53 99,308.53 6,646.18
11 99,308.53 733.76 71.71 662.06 99,236.82 7,308.23
12 99,236.82 733.76 72.19 661.58 99,164.64 7,969.81
As you can see in the example above your average payment towards principle is only .09% with a reduction of principle of $835.36 for the first year. On the other hand, the bank received total revenue of $7,969.81 Consequently, you have to do justice to yourself and structure a fair deal for you, which will still allow the bank to make its money.
How can you accomplish this? It is simple...find the right financing for you. By that I mean, reassess you goals and if it is a short to mid-term holding or even if it is a longer than five (5) year term look for the right loan that will allow you to pay more towards principle. Thus, accelerating you mortgage, this in turn will create cash flow in addition to reducing your principle and creating additional equity when you sell the property.
A good product to do this with is a 2/1, 3/1, 5/1 or even 10/1 Option ARM depending on your holding period. It is important to make sure that if you have prepayment penalties it will not prevent you from getting out of the property should you need to do so. Option ARM loans might go by different names depending on the financial institution. Some call it Pick a Payment loan or Option Payment loan, etc.
The neat feature of this product is that you can choose your payment whether, interest only, 30 fixed-fully amortized or a minimum payment that will be lower than the interest only option. The interest rate you’ll pay on this product will be lower, in average about 2.5% lower, than the regular 30-year fixed rate.
Remember, there is risk with everything you do-that’s why it is important for you to do your homework and make an assessment if the financing product you choose works for you. The Pay Option ARM is a hybrid adjustable mortgage. It is normally fixed for the first 2,3 or 5 years and then it becomes variable. Meaning, the fluctuation of the future interest rate will depend on the performance of a normally attached index, such as LIBOR, COFI, MAT, CMT, etc.
To illustrate this approach, the interest rate and payments of an Option ARM vs. 30-Year fixed loan is as follows:
Fully Indexed Rate: 5.390%
Minimum Payment (1.00% Start Rate): $321.46
Deferred Interest $127.71
Minimum Payment (2.00% Start Rate): $369.82
(Only Applicable when LTV>80% and/or Non-Owner Occupied loans)
Deferred Interest $79.35
Interest Only Payment: $449.17
Fully Amortized Payment: $560.91
$100,000.00 30-yr. Fixed @ 8% rate
PmtNo. Beginning Balance Total Payment Principal Interest Ending Balance *****ulative Interest
1 $ 100,000.00 $ 733.76 $ 67.10 $ 666.67 $ 99,932.90 $ 666.67
As you noticed the difference in the Option ARM fully amortized payment and the regular 30yr. Fixed is…
$172.85 ($733.76- $560.91 = $172.85) The $172.85 x 12 = $2074.20
The difference between the interests paid on the 30-yr. fixed vs. the Pay Option interest only payment is…
$ 217.50 ($666.67 – $449.17 = $217.50) $217.50 x 12 = $2610.00
Can you imagine $2610.00 in cash flow-specially if it is additional cash? Can you see the benefit?
$2610.00 $2610.00 $2610.00
X 2 years X 3 years X 5 years
$5220.00 $7830.00 $13050.00
The additional cash can either be used as additional working capital or a way to build up equity. Remember, financing and interest rates are just variables, that to a degree, you can control to your benefit. This is the beauty of thinking outside the box and the uses of the creative intuition investors have.
“An Obstacle is something you see when you take your eyes off the goal”
Carlos Aguirre
RealVestment Associates, LLC
PAES Plus, Basic & Lease Option Made Easy
Note: Carlos is the author of the PAES Basic and PAES Plus Investment Software. You can calculate if your investment is worth investing in.
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