Tenants Paying My Mortgage

by Mr. Cheap

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Some time ago Mike and his wife exchanged comments about having tenants pay off your mortgage.  My mother takes the same position as Mrs. Pillars does:  tenants paying off your mortgage is a good thing.  With respect to both frighteningly intelligent women, I’m suspicious this is a poor way to think about the investment.

Say you buy a rental property in Pleasantville.  This is a delightful small town, where few people move to but few people leave (’cause it’s so pleasant).  Because of this property prices are very stable, increasing at the rate of inflation.  Say you buy a property for $100K with a 100% interest-only mortgage and you manage to rent it out for exactly the same rental fee as your mortgage payment (so every month you take the rent check, hand it to the bank and you’re even with them).  Is this a good investment?

I don’t think so.  First off, you aren’t making much (in cash flow or appreciation, beyond the increases due to inflation).  While your mortgage is being covered, you’ll still have to pay the maintenance, vacancies (maybe), utilities and taxes yourself. You’ll also have to put in time dealing with tenant complaints or problems. If appreciation equals inflation, this may (or may not) exceed your costs, making this a pretty volatile investment.

Say as an alternative, I invest in ultra-safe GICs and get the 3% rate being offered by PC Financial. This will probably work out to be a little bit above inflation. Is this better or worse than investing in Pleasantville? With an unknown future (and all my made up numbers), it’s impossible to say, but I find it pretty tough to view the real estate investment as the clear winner. There’s FAR more volatility, and the returns don’t seem to compensating for this.

Some might say “Don’t invest in Pleasantville, invest in the hot markets!”. The subprime fallout in Florida, Arizona and throughout California paints a bleak portrait of one possible outcome of that choice.

Richard Thaler coined the term “Mental Accounting” in 1980.  A Washington Post article illustrated this difference with the example “Would you rather lose a $10 ticket, and have to buy another one to replace it, or lose a $10 bill on your way to the event?” Surprisingly, in spite of these being virtually identical situations (from a purely monetary perspective), most people would prefer to lose the $10 bill. Similarly, there’s something irresistibly enticing about matching up a tenant’s rent check with the mortgage payment that I don’t think is entirely rational.

My point ISN’T to debunk real estate investing. I just think that it would be very easy to have tenants paying the mortgage and it being a TERRIBLE investment. Having tenants covering the mortgage may be a small part of the reasoning about whether a deal make sense or not, but that CERTAINLY shouldn’t be the end of the consideration (if that’s all the investor is getting out of it, I think she’d do much better in an couch potato style portfolio or a even a high interest savings account or GIC).

What are your feelings about having tenants pay the mortgage?

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{ 21 comments… read them below or add one }

1 Mrs Pillars

Well, I thought it was a good idea because it worked for my mother. But I think she calculated the taxes in with her mortgage for the year and divided that by 12 to get the amount to charge for monthly rent.

2 Andrew

Under the scenario created agree with your logic. At least from personal experience though I’ve factored in those additional costs and compare the rent to the holding cost vs. the mortgage cost. Mortgage, taxes, insurance, upkeep all are included. If those balance your example doesn’t hold weight as you are gaining an asset at zero cost (assuming you have a 100% mortgage).

The tradeoff between the down payment and other investment vehicles is a different bag of worms.

3 Leslie

Owning a rental property is owning a business. You have to do more than break even or what you have amounts to a non-profit–without the tax benefits. Appreciation on the property at re-sale time should be considered gravy; the revenue should result in enough to also allow for contingencies such as vacancy, maintenance (non-capital improvements), advertising, legal costs, and your own property management services–as well as the mortgage, taxes, insurance, and utilities. An investor can actually lose money on a rental property when you take a close look at the P&L on the business. Those are my thoughts.

4 2 Cents @ Balance Junkie

Is there such a thing as an intelligent woman that doesn’t frighten you guys? I’m just kidding, but I couldn’t resist. ;) I know there are lots of guys out there who really do appreciate a smart lady and it sounds like you’re one of them.

I think your logic makes sense. There are risks in owning any asset and I would be uncomfortable with a 100% mortgage on anything. But that’s just me. If you are as knowledgeable as these 2 ladies seem to be and you are fully aware of the risks, go for it!

5 SlackInvestor

I do agree with your points about tenants and the issues of real estate as an investment. However, I disagree with your logic of comparing this investment model with that of a GIC. The reason is because to invest in the GIC you need 100% of the money up front (or you borrow to invest). In your rental property example, you use a 100% mortgage, so in that case you’re using someone else’s money. By using other people’s money you are still taking the investment risk, but any appreciation in either the increased equity or capital appreciation is a huge bonus, so you’re no longer just breaking even. Compare this with investing in a GIC using someone else’s money, and you’d be hard pressed to make any money since nobody is lending at interest rates as low as GICs are paying.

Great post as it makes you think. Keep up the good work!

6 Rob

If you lose a $10 ticket, you lose $10 plus the transaction cost (time, mental effort) of buying another ticket. Whereas if you drop a $10 bill, you just lose $10. So preferring to lose the bill is actually the rational choice.

7 Mr. Cheap

Rob: Sorry, I should have linked to the Washington Post article (link now in main article). It explains the paradox better than I did (along with a psychological study that shows it’s about more than the transaction costs).

8 Matt

It’s too early to tell whether my investment in real-estate is paying off, but I remember crunching a bunch of numbers prior to purchase with fictional, yet realistic numbers and it certainly looked like a good investment in the longer run. Also, I’m getting some intangible benefits from the purchase and management of the place: I’ve become much handier, I’ve spent more time with my father (who helped me renovate) and I’m learning to become more assertive as well. If I counted my time and energy, it might seem a poor investment, but it works for me!

Ooh, it’s also an excuse to own a bunch of cool-looking and useful power tools, which, as an apartment dweller, I lacked previously to owning. ;)

9 The Rat

I’m not a big fan of having tenants pay the mortgage. The best experiences I’ve had with real estate involved me selling my principal residence on two occasions and I think it offers one of the best tax havens for the average Canadian to take advantage of.

Also, in my portfolio, I hold a sizable enough % of my weighting in REITs. There are a lot of good REITs out there that offer anywhere from 4 to 10% yield and you can sleep at night without the worry of getting a call that a pipe busted and there’s water gushing into the basement or that the tenant needs new lightbulbs.

Nice post!

10 Adam

Ultimately cash flow is the point…

I do think you missed the idea that each rent payment that a tenant pays you every month (which is ultimately equals the mortgage payment + opex in your example) decreases your mortgage principle by a %. So assuming the property increases with inflation, you get the inflation increase + the monthly increase in equity. *Theoretically at $0 cost to you*

One also needs to consider the increase in rents over time weighted against a decreasing fixed mortgage cost. (assuming steady interest rates)

11 Mr. Cheap

Adam: I do think you missed that it’s an interest-only mortgage (as well as there being other expenses: I provided examples of some of these).

Cash flow is certainly a large part of the equation, but most real estate investors use a naive approximation of cash flow to convince themselves they’re doing better than they actually are.

12 Adam

Doh! I totally missed that!

Yes, in that case, you’re right.

13 Eevie

we have someone paying off the mortgage on our rental…the actual rent covers the total mortgage (principal and interest) plus taxes plus strata fees. I am using a spreadsheet to calculate the cost of the rental so that when the time comes to sell, i will know in the long run if the we have made money or not. So far, (after 4 years) i need my rental to appreciate by $15,000 to cover the cost we have put in…for maintenance & repairs & other sundries. There are also tax deductions to take into account but I have not included that in my spreadsheet. We are not slum lords and perhaps put a bit too much into upkeep (ie., painting, floors, new furnace, roof), but overall, we have had excellent tenants and the rental has appreciated by $50,ooo-$60,000. Only when we finally sell will we know if it was worth it!

14 Jess V.

With the example you gave, my answer is Yes, that’s a bad investment.

But if the renters are paying for all the expense such as mortgage, maintenance, insurance and etc… And have a positive cash flow, then it is a good investment. Even without RE appreciation, increased in equities, hedge against inflation and tax advantages.

Another alternative is REITs. I own both REITs and Rental.

15 youngandthrifty

Hmm well, if anyone in Canada is considering getting a rental property, they better do it soon, because after mid April you’ll need a 20% down payment.

I like the idea of tenants contributing to your mortgage, it generates cash flow (provided that they aren’t picky and you don’t have to spend oodles of cash to maintain the property), and the property will appreciate in value over the long term, when you sell the property at a later date.

16 Pacific

I have been a landlord for about 18 years, and there was always “The 100% Rule” with renting: To make a good deal on investing in property and renting it, you should receive, per month, 1% of the cost of the property. So if an apartment costs $140,000, you should recieve $1,400/month in rent. This simple guide formula covers all the costs, like intererest, insurance, repairs, etc.
Landlording is a job, you get paid by increasing your net worth.
As an aside, be careful of the future payments, because there is only one direction for interest rates to go (duhh: up!), and you don’t want to have too big of mortgage paymens that you can’t cover.
There are places to invest that still have the 100% rule covered.
BTW, I sold my rental house 2 years ago, and have invested the money in stock market ETFs and GICs.

17 Todd

I have been buying residential real estate for 8 years. I own 5 houses, a duplex, and 15 town houses. If it cost you nothing to purchase the asset (1o0% financed) then you tied up an asset for nothing. This is VERY rare in investment real estate. But would be good. Yet the real key is cash flow as already stated. If at the end of the month after all is factored in you have more in your bank account than less- you have made a good purchase. People paying my mortgages and expenses has made my balance sheet impressive considering I am not a high wage earner. Think outside the box and do your homework. Anything is risky if you do not understand what you’re getting into.
Happy hunting,
Todd
ending the rat race

18 ltsmash

its for a retirement nest egg idiot

19 Jeff

Assuming you’re horrible at business and got a property that only breaks even, if your mortgage is a fixed 30-year, then inflation will drive up rent while your mortgage stays the same. Eventually you will make a profit despite yourself. This article also ignores a slew of tax deductions that landlords enjoy (mortgage interest, taxes, all operating costs, home office, property depreciation, etc.).

You would of course have to figure out all the numbers before you bought a property, but you should be able to beat your 3% ROI by several fold.

20 Jeff

Also, you never said how much you put down. Many people misread 100% interest as 100% financed, but if it’s a fully financed purchase, then you have invested nothing. If you’ve invested nothing, you can’t say it’s a terrible investment because there’s no investment on your part at all.

21 JG

I think it is low class and scummy to have tenants pay off a mortgage. I earned my own home. I did not get a loan and pass off the cost to a tenant. Buying property and renting it is a mindless investment.

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