Ep 24: Norm and Norma Buy Free and Clear Rental Properties

Pro Tip: Listen to the podcast below and while you're listening follow along with the charts below. Then, when you're done, copy the  Scenario to your own Real Estate Financial Planner™ account to change any of the assumptions.

Welcome to the Real Estate Financial Planner™ Podcast. I am your host, James Orr. This is Episode 24.

Today we're going to continue with Norm and Norma’s story.

Norm and Norma have been sharing some of their ideas for achieving financial independence with some of their friends.

One work friend in particular is a little surprised that they’re considering using mortgage debt to acquire rental properties. After some additional conversation, they realize that their friend is a fan of popular radio show host Dave Ramsey’s teachings.

Of all their friends, this is the one friend who really seems to have their finances under control. They’re saving money aggressively. They work with this friend and know approximately how much they earn and this friend appears to be living below their means… just like Norm and Norma.

So, Norm and Norma decide: let’s look at what Dave Ramsey is teaching and see if it makes sense for us.

They read one of Dave’s books and listen to a significant sampling of episodes from his radio show.

After learning about what Dave teaches, they wonder to themselves: what if we don’t use debt at all. What if we don’t get mortgages on our rental properties and instead, we save up for them and then buy them with cash? In the meantime, we will invest the money in the stock market.

How long will that take for them to be financially independent and how does it compare to some of the other pure rental strategies they’ve considered previously?

Let’s take a look together.

Financial Independence

Ep 24 - Month First Achieved MTMIR
Ep 24 – Month First Achieved MTMIR

Back in Episode 8, they looked at putting down 20% each time they bought a rental property. When they did that it took them a little more than 31 years to be financially independent.

If they save up 100% of the cost to acquire the property and do not get a mortgage at all, it takes them… one year more to be financially independent.

Huh… just one more year to completely eliminate whatever extra risk there was in financing the rental properties. That’s certainly interesting.

If they put 25% down as we discussed in Episode 9, it is about 3 years and 8 months faster than paying all cash for their rental properties.

And if they put 15% down as we discussed in Episode 10, it is actually a year and 3 months faster to save up and buy properties with all cash then it is to put 15% down to buy the rental properties.

Well, that’s super interesting.

But what about the Nomad™ investing strategy we discussed in Episode 14? That was one of the more aggressive and faster strategies. They were borrowing 95% of the purchase price and putting just 5% down as they bought properties. That took a little more than 26 years to be financially independent. So, it was almost 6 years faster than saving up and paying all cash for their rental properties.

Standard of Living

Ep 24 - Number of Properties Owned
Ep 24 – Number of Properties Owned

Now, remember we’re measuring them being financially independent when their investments are providing enough to replace their $5,000 per month living expenses… adjusted up for inflation over time.

Saving up to pay cash for rentals means they’re buying properties much slower.

They don’t buy their first rental until almost 20 years in. But that one property, because it is free and clear of any mortgage has really, really good cash flow. They only have non-debt expenses like property taxes, insurance, vacancy, maintenance on it.

Ep 24 - Percent of MTMIR Achieved - Month 232
Ep 24 – Percent of MTMIR Achieved – Month 232

So, that single property and the little they have in reserves for it represents about 40% of their goal of having $5,000 per month in passive income in the month that they buy that property, month 232.

The only other strategy that has a larger percentage of their Minimum Target Monthly Income in Retirement™ (MTMIR) is the Nomad™ strategy with almost 47% of their goal.

For that month, month 232, when paying cash for rentals they have 1 rental. When putting 15%, 20% or 25% down, they have 3 rentals. And, if they’re Nomading™ they’d have 4 rentals and a property they’re living in… for a total of 5 properties.

It doesn’t take another 20 years to buy the next property when paying all cash for rentals… they’re able to buy rental #2 about 8 years later. Partially, because the rental they do own free and clear is contributing a significant amount to their savings each month.

In the month where they bought their second free and clear rental, they have 7 or 8 rentals depending on which other strategy they are using.

Ep 24 - Percent of MTMIR Achieved - Month 330
Ep 24 – Percent of MTMIR Achieved – Month 330

But those 2 free and clear rentals are providing almost 80% of their goal of $5,000 per month that they need to be financially independent… adjusted up for inflation.

Of course, by then the Nomad™ strategy is already providing more than 100% of what they need to be financially independent.

But in less than 5 years—before they even buy their third rental property for cash—they’re financially independent with buying free and clear rentals.

Ep 24 - Percent of MTMIR Achieved
Ep 24 – Percent of MTMIR Achieved

But this slower… and arguably steadier… acquisition pace does result in them having less overall cash flow which means that they enjoy a slightly lower standard of living.

Ep 24 - Percent of MTMIR Achieved - Month 480
Ep 24 – Percent of MTMIR Achieved – Month 480

For example, if we look at year 40… they can “afford” to be living on about 30% more than the $5,000 they wanted to live on if they’re buying free and clear properties or about $6,500 per month in today’s dollars.

However, even the next worst performer is over 100% more than they need… that means that with the 15% down payment option, they’re able to live on more than $10,000 per month in today’s dollars. The Nomad™ strategy could support approximately $13,750 per month in today’s dollars.

So, there’s a possibility of a higher standard of living when using debt when everything goes their way.

Risk

And, that’s a major point here.

The modeling we do here is basic. It assumes property values always go up slow and steady at 3% per year. Rents go up slow and steady and 3% per year. Interest rates remained nice and low for the entire modeling period. Inflation was tame and steady. The stock market had nice slow and steady growth of 8%.

But, that’s not reality. In our advanced modeling, we look at what happens if our modeling better reflected the real world where property values go up and down, rents go up and down, mortgage interest rates vary, inflation varies and the stock market goes up and down too.

Saving up and buying free and clear properties changes the risk characteristics from the other strategies.

Since they’re saving up to buy the property and investing that money in the stock market in the meantime, they have more at risk if the stock market does not go their way. But, after they buy a rental, they have a good amount of their risk in a free and clear rental property.

Free and clear rental properties are much more resilient to rent declines. The rent can go down a lot before they’d have any negative cash flow. A 10% drop in rent might drop their cash flow by a little less than the same 10%. That’s very different than a leveraged rental property where a 10% decline in rents may result in a significant decline in cash flow… way more than just 10%.

Why? Let’s look at an over-simplified example together.

Imagine you had a rental property with $1,000 per month in rent with $200 per month in positive cash flow after all expenses including taxes, insurance, vacancy, maintenance, and property management. If rents go down by 10% from $1,000 per month to $900 per month… your cash flow is going from $200 per month to probably around $100 per month… that’s a 50% drop in cash flow on a 10% decline in rent.

If you had the same property but it was free and clear, you might have $700 per month in cash flow on a $1,000 per month rent property. If rents on that went down by 10% from $1,000 per month to $900 per month that means you have $100 per month less in cash flow. So, instead of about $700 per month, you still have about $600 per month in cash flow.

That’s what we’re talking about with rent resiliency. Free and clear properties have cash flow that is more resilient to drops in rent.

Free and clear rental properties are also much more resilient to property price declines. The property value can go to almost zero before they’d be upside down on the property and they’d need to spend money to get out of it.

But if you have a high mortgage on a property and prices decline, you be upside down where you owe more than the property is worth. Imagine, buying a Nomad™ property with 5% down and then having property values go down by 10% over the next year. You owe more than the property is worth in that case.

Of course that leverage can work in the opposite direction too… if properties go up in value or rents go up they would benefit from that.

A question for them is: is the extra few years it takes to achieve financial independence worth the extra risk of using leverage. And, it is a question they really need to reflect on.

Next Episode

But, after checking out Dave Ramsey there is another question they have… what if they buy an owner-occupant home with 20% down then save up and buy all the rentals for cash. Is that a faster path to financial independence than them renting and buying free and clear rentals like we discussed in this episode?

That’s what we will look at in the next episode.

Also, be sure to check out the Advanced Real Estate Financial Planner™ Podcast to see how having variable property appreciation rates and rent appreciation rates, variable mortgage interest rates, variable inflation rate and variable stock market rates of return impacts Norm and Norma as they buy free and clear rental properties.

I hope you have enjoyed this episode about Norm and Norma paying cash for their rental properties. This has been James Orr with the Real Estate Financial Planner™ Podcast. Bye bye for now.

More Detail? More Charts?

Get unprecedented insight into  Norm and  Norma's  Scenario with dozens of detailed, interactive charts.

Compare buying free and clear rental properties to other real estate investing strategies:

And here's all the  Scenarios on one chart… a little hard to read, but if you really want to compare all at once, click here to see that.

Inside the Numbers

Watch the Inside the Numbers video to see exactly how we set up their  Scenario and how to modify it to better fit your personal situation.

Buy Free and Clear Rentals

Login to copy this Scenario. New? Register For Free

Copy  Scenario into my Real Estate Financial Planner™ Software

Ep 24 Norm and Norma - Buy Free and Clear Rentals with 2  Accounts, 1 Property, and 6 Rules.
Or, read the detailed, computer-generated, narrated  Blueprint.

Nomad™

Login to copy this Scenario. New? Register For Free

Copy  Scenario into my Real Estate Financial Planner™ Software

Ep 14 Norm and Norma - Buy 10 Nomad™ Properties with 5% Down with 2  Accounts, 1 Property, and 6 Rules.
Or, read the detailed, computer-generated, narrated  Blueprint.

Buy 15% Down-Payment Rentals

Login to copy this Scenario. New? Register For Free

Copy  Scenario into my Real Estate Financial Planner™ Software

Ep 10 Norm and Norma - Buy 15% Down-Payment Rentals with 2  Accounts, 1 Property, and 6 Rules.
Or, read the detailed, computer-generated, narrated  Blueprint.

Buy 20% Down-Payment Rentals

Login to copy this Scenario. New? Register For Free

Copy  Scenario into my Real Estate Financial Planner™ Software

Ep 09 Norm and Norma - Buy 25% Down-Payment Rentals with 2  Accounts, 1 Property, and 6 Rules.
Or, read the detailed, computer-generated, narrated  Blueprint.

Buy 25% Down-Payment Rentals

Login to copy this Scenario. New? Register For Free

Copy  Scenario into my Real Estate Financial Planner™ Software

Ep 08 Norm and Norma - Buy 20% Down-Payment Rentals with 2  Accounts, 1 Property, and 6 Rules.
Or, read the detailed, computer-generated, narrated  Blueprint.

Podcast Episodes

The following are the podcast episodes for variations of Norm and Norma's story.

More posts: Norm Episode

Leave a Comment