The Poor, Underrated “P” of PITI
Would you buy a rent house with zero cash flow? Negative cash flow? I might. Okay, I did. The best answer to this question is: “I need more information to decide”. So it’s kind of a trick question. But take a second before reading on and think about what info might convince you to invest your hard-earned money into a deal like this.
You know that PITI thing we talk about? It’s the Principal, Interest, Taxes, and Insurance that we pay towards owning a home; our own, or an investment. We know Taxes and Insurance aren’t going anywhere anytime soon and we pay them even after we pay off our houses – if we’re wise. Interest changes with the market and the type of loan etc. and is an important aspect of a loan. But Principal never gets much attention. I kinda feel bad for old “P”. Everyone talks about cash flow and appreciation these days but what about debt pay-down? Isn’t that exciting anyone? Just me? I’m used to this. Let me try to offer some food for thought regarding why “P” should excite you a bit more.
Let’s say you heard I wanted to sell my house but I wanted more than you wanted to pay to make sense as an investment. And let’s say you offer to pay me principal-only payments on the house for four years at my full price. Now I’m listening. If you pay me cash, I could have a capital gains problem. If I take payments, I might be able to lessen the impact of the tax problem. And wouldn’t you want to pay as much to P (principal) as possible while I (interest) is not a factor? I would! And this is how we structured a deal on one house recently. We paid close to the asking price but agreed on principal-only payments for the first four years. We agreed to pay higher payments than the seller requested because we wanted to make the best use of the zero interest* money. This house will cash flow close to zero for four years but will be halfway paid off in four years. Kinda cool, huh?
Another way “P” gets overlooked is in the age of a loan you might assume. If you’ve ever looked at an amortization table, you’ve probably noticed that the payments to principal are very small for the first several years and very large towards the end. This is normal. So if you ever have an opportunity to take over a loan for a seller as part of your negotiation, an important question would be “how old is the loan”? If the loan has a rate that doesn’t impress you but it’s 15 years in to a 30 year loan, would this get your attention? I’d argue that it should. This means that payments are going largely to principal every month. The same loan starting new today would be largely interest payments (regardless of rate). If you assume a loan be sure to familiarize yourself with the “due on sale” clause that most modern loans have in place but banks rarely utilize to call a note due. More on that in a future post.
What about that plain old vanilla rental with conventional financing? The one you have a 30 year loan on and that makes a couple hundred dollars per month. It too has a “P”. Its “P” is constantly growing as you work your way down that amortization schedule. We always hear about cash flow. And cash flow is very important. Especially as you are getting started. But you don’t hear as much about debt pay down. People will talk about how much cash flow per door but rarely mention how much pay-down per door. I think if your cash flow is anemic but your pay-down is strong it is still worth considering depending on your overall strategy. Now, I wouldn’t have taken a deal like this as my first rental because I needed the cash flow but now I am willing to have a “break-even” house for the tradeoff of rapid pay-down.
As you evaluate deals, don’t forget to look at the pay-down schedule. Even starting out with a new loan there is some payment to principal. Get excited about this! This is where someone else pays off your asset! The cash flow today is awesome but also look at how much goes to Principal each month. That’s your money too! It’s not liquid cash to feed you today but it’s building your wealth every single month while you sleep! I hope that some of this has helped you to see PITI from a different perspective. It really is an amazing aspect of real estate investing.
So when the slow road to wealth seems too slow, look at the P of any loans that someone else is paying off for you. Remember that those are deposits into your savings account called “Equity”. After equity grows you have all kinds of options. You can strip equity through cash-out refinances. You can sell and roll profits into bigger deals. Or you can sit back knowing that each and every month, the part of the payment going to equity grows a little. And equity is wealth.
I hope this helps you see one more of the amazing characteristics of buy and hold real estate. It generally doesn’t make people rich quickly but over time it is hard to beat. I am obviously a huge fan of this niche. We’re expanding into owner-financing and private lending as well so stay tuned to hear how those methods work out for us.
Have a great week and as always, more than ever, “keep the main thing the main thing!”
*Imputed Interest is a term we had to learn about regarding zero interest deals. I’ll write more on this in the future but there needs to be some point of accounting for some interest or the IRS may tax the seller on interest they “should have” charged buyer. This can be adjusted by discounting the price and adding a small amount of interest to come to the same outcome in pay down. There are other methods for accounting for interest as part of a balloon payment but this came as a surprise to us after negotiating our first zero interest deal. Just something to be aware of.