A friend of mine told me over the weekend that her coworker is planning on paying off 300 thousand in home mortgage loans over the span of five years. Yes you read that right, 300k over 5 years. I spit out my juice and took a double-take. How is that possible? That is 60k paid off every single year. That kind of dedication at being debt-averse takes commitment, guts, and a whole lot of capital.

And this doesn’t even take into account the multitude of other expenses her friend had to make in lieu of having a vanishing mortgage loan: mortgage loan interest (although it will be dropping like a rock as the principle disappears), property insurance, property tax, maintenance & repairs, and utilities. And those are only the costs related to the house. We’re not even going into all other things like transportation, food, etc… I never asked how much her friend was making, but it must be at a minimum over 100k/year.

Thinking about the ambitious course her friend is taking, I started taking a closer look at my own situation. I should only have a 106,000 balance left at the beginning of 2010, which is well under the 300k amount her friend is trying to conquer. Under my current plan, I can pay off everything by 2017, close to eight years from now. If I possessed her friend’s aggressiveness then I would be throwing everything I had at the loan and chopping down the final payment date to the end of 2014, which is five years from now. In that scenario I would be paying off 21.2k of the loan principle every year instead of the current average 13.3k. I believe I could do this — actually I know I can — but the downside is I couldn’t save or contribute for anything else (eg. Roth IRA or save a 20% downpayment for another real estate property). The upside is both peace of mind and stable return of money (4.5% pretax).

Reviewing my options, I think I want to stick with my current plan of just paying the mortgage + another 500 prepayment. I want to keep my options open and have the ability to jump on opportunities as they rise (such as investing in more foreign currencies or buying vacant land properties). Although this will make my debt load greater, the leverage could end up magnifying my gains should real estate properties rebound back in value. And anyways, when you’re young is when you should be taking more chances and be less risk-averse.

Below is the amortization schedule that I am sticking to [variables used: 4.5% rate, 15 year fixed, 500 prepay/mo, 113,666 starting loan]:

Unfortunately, most of the new listings are still overpriced… I mean seriously, you’re trying to sell a condo for $300,000 when another one down the street from yours is listed at $210,000?? That person’s agent is obviously asleep on the job.

And of course I’m staying away from short sales that can take anywhere from three to six months to complete. And I’m also staying away from auctions that might have other hidden liens or structural issues I am not capable of dealing with. So that just leaves me with either bank owned or real estate owned properties.

So obviously I get excited when I find one that looks like a gem. But there’s still a lot of steps you need to do before you can figure out if it really is a diamond or a cubic zirconia. I’m gonna try to delineate the usual suspects I go through everytime I see a potential buy:

1. Hit up Google Maps to see where the property is really located. Check out the street view of the property. Make sure it looks like the selling agent’s picture. Many of these properties have been on the market for months at a time and sometimes the agent’s pictures don’t truly reflect the property’s actual condition.
2. Next, look at the Google Map’s overview of the property’s neighborhood. Is it right next to a freeway or train? If so then discount the property cause most likely it is noisy to live there. Is it close to bus stops, subways, freeway exits, parks, shopping, libraries, schools? If so then that ups the value.
3. Then hit up Zillow.com to look up the technical aspects of this property. Check the specifications of the property’s number of bedrooms/bathrooms and square footage. Make sure that matches the selling agent’s listing. Check what this property sold for in the past to give you a good feel of how much it might actually be worth. Also look at similar houses around your property and what they sold for. The neighborhood’s house values can affect your property’s value significantly.
4. Now look up the county property tax assessor’s public records to see how much this property was assessed for. This factors into how much property tax you will be paying if you bought this place. But more importantly, it can give you a more accurate view of how much this property really is worth. If the agent is listing the selling price at $400,000 but the county assesses its value around $350,000 then most likely the house is overpriced and the seller is trying to make a quick buck. Definitely a warning signal.
5. Go to Movoto.com to find out the more esoteric parts of the property. The website lists the school district and specific dining/shopping areas around the property. That information is very useful to both parents and the elderly that might want to rent your property in the future.
6. After this comes the important part… remember I am assuming this is an investment property not homeowner occupied… how much loan can you actually take on? Yes, you will need to determine how much you can put down and how much of a mortgage you will need to get. If you put down less than 20%, don’t forget to factor in PMI (private mortgage insurance) which can cost around $100/month. Now look at current interest rates from Bankrate.com and calculate a rough estimate of your monthly mortgage payment.
7. Also don’t forget to calculate your monthly property insurance, property taxes (get rates from the assessor’s website), HOA (if you are buying in a gated community/condo), and estimated repairs/maintenance costs.
8. Add up points 5 and 6 to get to your monthly investment property expenses.
9. Finally the good part and the reason why you are actually buying an investment property: look up websites such as craiglist, rents.com, rentometer.com, etc… to see what you can actually make in rental income per month from leasing the property out.
10. If your income from 8 can’t beat or breakeven your expenses in 7 then this might not be a good deal. If so then you need to really look hard and explain why you want to buy the property so badly.

Note: In my case, House #3 is currently generating a negative inflow per month mainly due to two reasons:

1. I’m renting to Bae at a very below-market price.
2. I’m on a 15 yr loan payback period instead of a 30 yr payback period.

The average operating-expense ratio of a residential rental property is 45% plus or minus 2%. That is, the operating expenses – taxes, management, utilities, insurance, etc… – will consume about 45% of the gross income. That percentage applies all over the U.S. for all types of residential property.

Note however that the mortgage isn’t counted as part of the operating expenses.

After reading that, I decided to do a little homework to calculate the operating expenses, P/E (price to earnings) ratio, and earnings yield for House #2 and House #3 – assuming they are rented out at market prices. I can’t do it for House #1 because we live in that house and have never rented it out before, so I don’t know what kind of rental income I would be able to generate from it.

House #2

• Gross Income = 2,100/month or 25,200/year
• Expenses = 500 Property Tax + 100 Insurance + 100 Repair/Maint = 700/month or 8,400/year
• Net Income = 1,400/month or 16,800/year
• P/E Ratio = 480,000 price / 16,800 net income = 28.6
• Earnings Yield = 16,800 net income / 480,ooo price = 3.5%

Based on the above calculations we can determine that House #2 has a current price that is worth 28.6 times the annual profits it generates. And the earnings yield is 3.5% per annum.

House #3

• Gross Income = 1,200/month or 14,400/year
• Expenses = 150 Property Tax + 276 HOA + 50 Repair/Maint = 476/month or 5,712/year
• Net Income = 724/month or 8,688/year
• P/E Ratio = 147,000 price / 8,688 net income = 16.9
• Earnings Yield = 8,688 net income / 147,000 price = 5.9%

From the calculations we find that House #3 has a current price that is worth 16.9 times the annual profit it generates. And the earnings yield is 5.9% per annum.

Based on our findings we can financially conclude that House #3 gives a better rate of return than House #2. This is probably why it is easier to generate profits on N-plexes than single family homes. The cost for one single family home is much greater whereas it’s rent is not that much higher than a similarly sized condo or townhouse. The difference in rent does not justify the large margin in property price disparity. As a result, in order to make money in real estate, it is better to focus on smaller or more compact housing such as apartments, N-plexes, condos, and townhouses rather than buying single family homes.

So yesterday she called me up and asked me about the Chino/Chino Hills area. The properties there have come down by quite a bit (I think more than 40%) and as a result it is much more affordable than the prime real estate areas that are closer to downtown Los Angeles like Alhambra, Arcadia, Temple City, and Monterey Park (houses there are still around $400,000).

At her insistence I pulled up my email listing provided by my agent and started clicking on properties that were within her price range (less than $200,000). I was surprised to find two houses (yes, houses! not condos) that were selling for less than $200,000. I rattled off their addresses and off she went to see if they were to her liking. I haven’t heard back from her yet so I don’t know if they met her qualifications. But one of the listing’s description definitely caught my eye, it said:

**WOW** SOLD FOR $400,000 in 2007** BANK in & OWN this deal!! Association features pool, spa and playground!! Darling family home in move in condition! Bright living room features fireplace, sliding glass door and ceiling fan. Kitchen has a cushy layout with plenty of pantry space. Master bedroom features full bath. Both bedrooms have sky lights. Home has lots of large windows making it airy and bright. Property close to shopping centers, parks, and near the 71 and 142 freeways.

Can you guess what stood out in that description? Yes! It stating that this property sold for $400,000 in 2007! Mind you, this 1985 house has 2 bedrooms and 1.5 bathrooms. The house has a total of 974 sqft and the lot is 2,000 sqft. In addition, even though it is a house, you need to pay $166 HOA every month. The real kicker is that this REO house is selling for $148,750 right now!

What the frack right? How did it go from selling for $400,000 to $148,750 in two years?? I couldn’t believe it so I went over to Zillow.com and pulled up this address. This is the sales history for the address:

So it was true! I knew that the housing economy in southern California was depressed but I didn’t know it got this bad. Think about it, how would you feel if you bought a house in 2007 for $400,000 and it dropped to less than half it’s value within two years? No wonder people are walking away from their houses, it’s impossible to recoup their costs. Of course, you could always say that these people should have known the house was overpriced and never should have bought it, but hindsight is always 20/20 (well, except for people that were warning we were in a bubble like Dr. Housing Bubble) and it’s too late to say shoulda.

But I guess it is a good deal for people that saved to buy a house now. Though, on an ominous note… I wonder how much lower prices will go in the next few years when the Alt-A and Option ARM loan crises hits.

Let’s do some calculations to satisfy my curiousity of whether this is a good deal:

• Assume price bought is $148,750
• Put 20% down so get $119,000 mortgage
• Investment property so qualify for a mortgage loan with a 6.25% interest rate over 30 years
• Monthly property expenses total $1,149.04
  • Mortgage = 733.04
  • Insurance = 50.00
  • Taxes = 150.00
  • Misc maintenance = 50.00
  • HOA = 166.00

Looking on Rentometer.com I was able to find the average monthly rental income in that area in a two bedroom is between 1,200 to 1,400. So all things considered, the rental property should be able to cover its own monthly expenses assuming a good tenancy rate. And even if you have a lower tenancy rate, the monthly expenses of $1,1,49.04 should not be able to wipe you out. All in all, at first glance this looks like a possible buy. But of course, you need to go scout that area to see if the house is in good working condition, what kind of neighborhood it is, and if there are any other market factors that might affect its price (such as what other similar houses are selling for in that area).

• House #3 – I will pay the fixed payments of 870/month and prepay by 500/month. The loan will be fully paid within 8 years and the title will be free and clear in the year 2017. That’s the year I hit 35 yrs old.
• House #2 – This house only has a mortgage loan of 39,000 left on it. No more prepayment will be done on this loan; prepayment was done drastically in the past by both me and my parents. Based on information from the lending bank this loan will be paid off on May 2012. That is in three more years, or when I hit 31 years old.
• House #1 – This house has a mortgage loan of 147,000 left on it. No prepayment has been done on this loan. Based on the information from the lending bank, by May 2012 the loan owed will be 111,000. If no prepayment is done on this loan then it will be repaid on May 2019.

Now assuming we take the income from House #2 to help prepay the mortgage on House #1 (this is after House #2 is fully paid in May 2012):

2,100 (rental income) – 500 (property tax) – 100 (insurance) – 100 (repair/maint) = 1,400 income per month or 16,800 a year.

The depreciation we get to use as expense for this property is about 5,000/year. Thus the taxable portion of the income is 1,400 *12 – 5,000 = 16,800 – 5,000 = 11,800. The tax (assuming a 30% tax bracket) on the income is 3,540. Thus, leftover income after paying tax is 16,800 – 3,540 = 13,260 a year or 1,105 income per month.

Using Bankrate.com I plugged in all the facts of House #1 as of May 2012 and added in the prepayment of 1,105 a month. This resulted in a revised loan payoff date of March 2016. That’s the year I hit 34 years old.

Thus, based on the above information we can pay off all three properties by the time I am 35 years old.

Terms of my bank loan:

• Borrowed 114,000 from bank
• No fee mortgage plus (bank covered my closing costs)
• Fixed 4.5% interest rate
• 15 year loan payback time (2009 to 2024)

Expenses related to condo:

• HOA cost of 276/month (covers trash, water, gas, insurance)
• Electricity cost per month
• Mortgage payment of 870/month
• Property assessed at 147,000 so property tax is ~150/month

Total expenses: about 1,300/month excluding electricity costs

I bought this property mainly to be a real estate investment. I plan on renting it out to generate cash flow and hold it for capital appreciation.

Researching rent costs for similar condo properties in my area I found that the average rental price is 1,250/month. As a result, if I rented this out at market price then I would only have a negative cashflow of (50) per month. And this negative cashflow is mainly due to limiting the loan payback time to 15 years. If instead I went for a 30 year loan period then the mortgage payment would average 670/month. But I would much rather pay an extra 200/month and have the payback period be cut down in half from 30 to 15 years. Less expenses looming over me for a long period is always a perk.

However, even though the market rental price is 1,250, most likely I will rent it for 1,200 because it is always easier to rent when you price it just a little below market price (what good is a high rent but no tenant right?). This would then set me back (100) per month, which is doable with my income.

Current situation: Right now Bae (my significant other) is renting my place for 700/month. This amount is much lower than the expected rental price of 1,200 and thus I am set back about (600) per month but with my current income I am able to make up the negative cashflow. It is possible that Bae will move out in a year or so because Bae’s parents are going to move to the United States and most likely that will result in moving out of the condo and into a nicer place. However, in the case that Bae doesn’t do that and continues to live in the condo with Bae’s parents, we have agreed to increase the rent to 900/month. This would then only set me back (400) a month. We’ll see what the future holds.

Prepayment: Even with the current negative cashflow I am prepaying the principal on the mortgage by a sum of 500 per month. Using Bankrate.com’s mortgage calculator I was able to determine that doing so will help me cut the 15 year payment period down to 8 years as well as cut the total interest paid from ~40,000 to ~20,000. Dang! The lure of cutting interest paid in half and being able to own a property clear and free within 8 year motivates me to prepay 500 every month.