Purposeful Planning Part III — Managing Your Loans — The Long View

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.

Shelby GR-1

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.

Mercedes concept car

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?

Jet engine concept

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.

This entry was posted in 1031 Exchanges, Capital Growth, Cash Flow, Financing on by .

About BawldGuy

I'm second generation real estate, first licensed in fall of 1969. Having been mentored by several iconic brokers, I'm also CCIM trained, having completed all 200 hours back in 1980. Have successfully executed well over 200 tax deferred exchanges, many of which have been multi-state in nature. Strong points are analysis and the creation and real world application of Purposeful Plans employing several strategies synergistically. The idea is to arrive at retirement with the most after tax income possible, backed by the largest net worth.

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11 thoughts on “Purposeful Planning Part III — Managing Your Loans — The Long View

  1. Robert Coté

    Stupid question. And yes there are stupid questions. Is it possible to purchase some form of occupancy insurance? As you note there is little diversification and only a few months of unexpected vacancy can eat into a whole lot of that accumulated cash flow.

  2. BawldGuy Post author

    Hey Robert — Agreed, there are stupid questions, but this ain’t one of ‘em. It’s among the most asked questions in my experience. The most asked question? Is there any more coffee? :)

    The short answer is no, I’ve not seen any such insurance, at least none of which I’m aware. Even if there was, can you imagine how much the premiums would be after what we’ve been going through the last few years?

    The real insurance policy is the Sominex Account (cash reserves), which is why it’s always been given such weight at the Brown & Brown client table. No cash reserves? We’re sorry, but we can’t in good conscience take you on as a client. And no, we can’t be convinced otherwise.

    What most folks consider ‘insurance’ is an office, industrial, manufacturing plant, or retail property with so-called ‘AAA’ rated tenant(s). How are those folks doin’ now? Imagine you’re a partner in a mulit-million dollar property with a few of the Wall Street investment bankers and brokerages as tenants? They’d been rated bulletproof, credit wise. How’s that workin’ out for ‘em now?

    You and I have always agreed on why the phrase ‘risk capital’ exists. That risk is reduced in many ways, certainly not least of which is maintaining generously abundant cash reserves. I know you do this for yourself.

    Am I making sense?

  3. David Shafer

    Jeff, you know I couldn’t let this one go by! The risk is managed with the sominex account. So why not put that cash flow to work for you? Two choices, fund an EIUL to keep it from the tax man or buy some Berkshire Hathaway or other solid stock while they are sale, make more money and pay the tax man the 15%. Stocks are liquid as hell, and are on sale now. If you know how to purchase real estate properly, it will be easy to learn how to purchase stock properly. Just saying, if your risk is managed…..then why not decide to put that cash flow (risk capital) to work for you too?

  4. BawldGuy Post author

    David — Was wondering if I’d smoked you out or not. :)

    If the client’s comfort zone allows for that approach, I’d have zero objections. EIUL’s though would subtract the accumulated cash flows from the real estate investment column. As you’re well aware, I fully embrace and recommend them. Funding an EIUL with the cash flow would be good for certain clients but not all of them.

    It is a viable alternative though — no argument from me. It would depend upon the client’s Plan, and how long they had ’till retirement.

  5. Robert Coté

    Thanks for the detailed answer. I kinda knew the answer but needed to talk it out. The little voices in my head aren’t considered a second opinion. I win the Shelby GR-1 right? [crickets, chirping]

    It should be noted that Berkshire Hathaway is down 40% since September in large part because of exposure to real estate backed financial products. Not particularly diversified IMO. That said, a little more downside and I may find the scratch to buy a share much like I expect some screaming CRE soon enough.

  6. David Shafer

    Robert, not sure what you are referring too on Berkshire??? Are you talking about the S & P Derivative bets and the accounting write downs because of it? Or the companies Berkshire owns that are construction/re based? Or the two banks he has been increasing his share ownership in?

    The drop in BRK was almost all on news of the derivatives that are not excercisable until 2018-2020. Warren has promised a full explanation (even though everyone who has read the financials or yearly reports already knew) when the annual letter comes out in a couple of weeks.

    Might want to take a look at his public buying spree and investing spree over the last 12 months. He has made many, many moves all the which in my opinion are going to pay our huge over the next 5 years.

    Make your move before the annual report comes out. With its operating profits still strong it isn’t likely to go down much from here IMHO.

  7. BawldGuy Post author

    As I’ve said here often, when the investors sporting three commas in their net worth decide it’s time to buy? I’ve learned not to debate the point. Just sayin’.

  8. Robert Coté

    [GR-1 v. MB] Ahhh the difference between the possible and perfection. Never would have thought you’d be distracted by the shiny object.

    [BRK-A] We will know this week with the annual report. As much as it pains me, I am on board with the tinfoil wearers at seeking alpha. He blew almost $3 billion on Goldman’s and the (re)insurance businesses are in deep trouble with little hope of bank type bailouts. Part of the “value” of BRK has been the myth of old fashioned investing. The truth is that some $37b of his market cap are exposed to long term derivatives of the general market. I see two land mines; general market conditions and the premium he gets for appearing to be immune from market forces. “Immune from market forces.” Ring any bells?

  9. David Shafer

    Well, Buffett could probably cover that $37B with his cash on hand. And that is if the S & P 500 Index goes to zero, not likely.
    As to the reinsurance business, you must know more than Buffett :-), because he invested in Swiss Re recently. My understanding is that much of the competition in that business failed because they were undercutting price, therefore pricing is coming back. If that is true, then profits will follow because Berkshire was refusing to sign business at a reduced price which he thought didn’t account for the risk. I don’t see any premium at current prices, maybe you do?
    Should be a interesting report, eh?
    Goldman is the only investment, I question. But only time will tell on that one. If Goldman;s goes out then the whole investment bank world is gone!


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