How paying a mortgage can INCREASE your cashflow

I was recently asked by a client to explain why she should consider using debt to buy an apartment building. After all, having a mortgage would decrease the amount of money she had left at the end of the month. And, since she has a bunch of cash and she’s buying buildings to build a passive income stream, it seemed crazy to her to do anything to reduce the size of that stream.

Reasonable question. Here’s the (long answer):

Compare these scenarios for buying a building with the following characteristics:

Price: \$800k
Annual rent: \$80k
Annual expenses: \$20k
NOI (profit after expenses but not any mortgage payments): \$60k
• Pay \$800k in cash
• Pay expenses of \$20k
• Receive \$60k / year in profit
• \$60k/\$800k = 7.5% / year return

Scenario 2: Borrow 50% of the value at 4% interest

• Pay \$400k cash
• Borrow \$400k at 4% fixed for 30 years
• Receive \$60k in profit before mortgage (same as above)
• Pay mortgage of \$1,910 / month x 12 months = \$22,920 / year (you can get mortgage numbers here)
• After paying mortgage, you have \$60k – \$22,920 = \$37,080 in cash flow
• But you only put down \$400k, so \$37,080 / \$400k = 9.3% / year return

Remember that Scenario 2 only uses \$400k of cash. You have \$400k left over (compared to Scenario 1, where you paid \$800k in cash). So now consider Scenario 3:

• You buy two of these buildings, each with 50% down
• All of the numbers from Scenario 2 above are doubled
• Put down \$400k x 2 buildings = \$800k
• Receive \$60k x 2 = \$120k in profit before mortgages
• Pay \$22,920 x 2 = \$45,840 in total for both mortgages
• After paying mortgages, have cashflow of \$120k – \$45,840 = \$74,160 in cashflow after mortgages
• \$74,160 / \$800k = 9.3% / year return

In Scenario 1, your \$800k got you a cashflow of \$60k. In Scenario 3, where you buy two buildings each with a 50% mortgage, your \$800k got you cashflow of \$74,160.

There are two other benefits to moderate amounts of debt to consider:

• The numbers in Scenarios 2&3 above actually understate your return, because they don’t account for the fact that a portion of your mortgage payment goes to actually paying down the debt. If you factor that in as part of your return (which you technically should), the returns are even higher.
• Consider what happens in the event that the overall market goes up by 10%. In Scenario 1, you own one building worth \$800k which increases in value by \$80k to \$880k. In Scenario 3, you own two buildings worth a total of \$1.6MM which increase in value \$160k to \$1.76MM.

The flip side of all of this is that leverage increases risk, because if something goes wrong and you can’t pay your mortgage, the bank takes your properties.

This risk can be mitigated to a large extent by buying properties where the rents are already a bit under market, so the tenants won’t move out (the thinking being, if the tenants pay their rent, you’ll be able to pay the mortgage).

And, most importantly, the risk can be mitigated by using debt responsibly, which means keeping it to 50-70% of the value, thereby insuring that your month mortgage payment is much less than the amount of profit you’re bringing in each month (giving you a cushion in case something goes wrong).