Gonna be concentrating hard tonight as my workout won the battle today. Sometimes I think the worst decision I ever made was acknowledging any birthday past my 40th. Can I hear an Amen?!
Let’s look at a real life income property tonight. It’s a small, but super well located commercial property. It’ll sell for about $335,000 with an NOI of $29,000. The loan will be 80% Loan To Value (LTV), amortized over 25 years with a fixed rate of 5.5%. The cash flow projects to be roughly $9,250 a year.
The investor is in it for capital growth. The cash flow is a bonus, as I’ve told him he needs a little of what I’ve come to call ‘Cash Flow Diversification’. He has more than adequate cash reserves (Sominex Account). The burning question: What’s the best way to handle the cash flow — especially in times like these? What that means, is if the cash flow isn’t the reason for the investment, he wishes to use it to enhance the overall return of the investment.
First we can dispose of the laughable option of any sorta bank instrument. Don’t wanna be a killjoy here, but last time I taught cash flow analysis, I told the class a negative after tax return on cash flows was pretty far down on the to-do list. Given what banks are offering, minus the State/Fed taxes, not to mention inflation, they’re simply not an option I’d put on our A-List.
I’m thinkin’ he’s gonna be better off, at least at first glance, by applying this cash flow systematically to the loan balance. Let’s break it down a bit, while keepin’ it simple. (Remember my workout?)
Down payment and closing costs will be around $75,000 give or take at time of purchase. Just so ya know.
The investor will obtain a $268,000 loan at acquisition. If he banks the cash flow, saving it for when it’s time to sell/exchange the property, his loan balance at the end of say, a five year holding period will be a tad over $239,000. He’ll have accumulated, let’s be forgiving here, a bit over $46,000 — after all interest received, minus all taxes paid. Close enough for horseshoes, OK?
After costs of sale/exchange his net proceeds, assuming an annual appreciation rate of 3.5% for five years, would be approximately $127,000. Add to that the accumulated cash flow of $46,000 and he’ll be moving up with a total of 173,000 or so.
On the other hand, if he takes my advice and uses his cash flow to make annual principal pay downs, his loan balance after the same five years will be just a pinch less than $189,000. This would result in net proceeds from his sale/exchange of $177,000ish. Well, blow me down Olive, what a surprise. Apparently the smooth pated one has spoken too soon. What will I tell him to do? (I’ve found it’s usually a good thing to build up the drama at this point.)
First of all, the difference of a lousy $4,000 over five years doesn’t float my boat much. How ’bout you? Nope, there’s gotta be another way. Ya gotta admit though, at first blush I bet ya thought for sure paying down the loan balance at 5.5% vs microscopic after tax bank savings was gonna be a whole lot better than kissin’ yer sister, right? Me too — which is why we do the dang analysis in the first place.
So now what?
We step back ‘n make a samich, maybe grab a Dr. Pepper, and ponder awhile. Not really, but I was hungry. Here’s what we’ll probably do.
We know there’ll probably be $46,000 or so in accumulated cash flow after five years. (And NO, I’m not counting on exactly five years holding. My crystal ball still sucks as much as yours does.) We also learned in the first step of Purposeful Planning, (Where are you now?) that this investor saves about $15,000 annually, after taxes, from all income sources. That’s $75,000 in five years. Add $46,000 and he’ll have an additional $121,000 in cash to add to his sale/exchange proceeds. But why would we do that?
Here’s the very cool Hollywood ending.
He’ll be able to buy at least $500,000 of additional property with that cash. And the best part? It won’t be saddled by five years of ‘Adjusted Basis’ baggage. What that means in plain English is this — his depreciable basis on the newly acquired property(s) with his savings plus his cash flows will be significantly higher than if he’d put all that money into paying his loan down. That is a crucial key to his long term Plan ‘cuz he already has far too much depreciation. How’s that, you ask?
Can you really have too much depreciation? Well, yes and no. Clear as mud?
Since the Internal Revenue Code allows you only $25,000/yr of depreciation to be used against your ordinary (job) income, the rest gathers dust on the shelf — year after year, after year. There’s a silver lining to that cloud though. At some point down the road, we’ll make the judgment call to take part or all of it off the shelf, dust it off, and — wait for it, here it comes — use it to offset capital gains. And yes, that means he’ll be able to pull tax free cash from a sale of some highly profitable property(s) ‘cuz way back in 2009 he made the decision to keep his impressive cash flow in the bank earning crappola after tax returns.
Here’s what I’d like you to take away from this.
Sometimes things aren’t what they seem, (Duh) and it’s so often because most investors don’t know what they don’t know, and therefore can’t even ask the questions they don’t know to ask. It often turns out to be a lose/lose situation. And the kicker, the bittersweet irony, is they rarely ever learn how much better off they coulda been. In other words, doin’ things on Purpose is a much mo betta way to roll.
How’re you doing these days? Ready to get serious about your retirement? Give me a holler and we’ll figure it out. Before ya know it you’ll have your own plan, and be on your way — Purposefully. Have a good one.