To Domino or Not to Domino? That is the question

A very interesting debate has sprung up in a BiggerPockets Forum about my article on how to build a six figure income using real estate investing. In that discussion, the participants make different pro and con arguments over the use of the Domino Method to accelerate the payoff of debt in your portfolio. I think it would be beneficial for our readers here as well as the participants of that discussion if I addressed each argument in greater detail.

Not sure if I like this method… takes 149 months over 12 years to start seeing your income. If you’re looking for a retirement plan, well that’s a different story.

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When we first sit down with an investor to discuss what strategy they should pursue, I first ask you about your investment goals. Inevitably, you tell me that you’re looking to build an income stream or create positive cashflow . Then comes the crucial timing question: When do you need this income/cashflow? If you are looking for income nowI’ll be the first to say that the Domino Method won’t do much for you. The strategies and methods I write about are suited for long term investors that are looking to build large income streams in the future (read: retirement) and in so doing are willing to give up small income streams in the present. If you are looking for  income now and don’t have a scary amount of capital at your disposal to start, I would argue that real estate as an asset class is not a good vehicle to accomplish that goal. To create current income, you would do much better if you deployed limited capital into starting and operating a business.

Now, I’d like to address the point that this simply takes too long. I come into contact with plenty of people that have been investing for 12 years or longer without a particular plan. Just buying a property here and another one there as the opportunities came around. I’m yet to meet someone in that group whose performance during the last 12 odd years can even come close to the results they would get if they applied our Blueprint strategy over the next 12. The fact of the matter is time will pass for us all one way or another. But what we can control is how we spend that time and the results we reap are dependent on the soundness of our plan.

I don’t think that 100k (six figure income created by strategy) is net. The true net of that is probably more like 50k after vacancy, repairs, taxes and insurance.

The cashflow figures we are using to pay off the mortgages as well as the cashflow figures used to calculate the income at retirement are net of all operating costs (property taxes, insurance, homeowners association dues, maintenance and repairs), vacancy provisions and leasing fees but before taxes. The reason why I used before tax figures (especially in the case of income at retirement) is because the tax rate, tax deductions, tax shelter can vary wildly from investor to investor. Since we’re trying to present a case study that applies to the majority of investors, I thought that was the most prudent course.

Many investors have little capital to start. So they are looking for maximum yield and forced appreciation. Their jobs in many cases do not allow for much savings. Example if you make 75k a year a lot of that is used for living expenses. Even if you save 1,000 a month that is 12,000 in a year.

So it takes much longer to get going this way with slow build up.

This versus someone who has a business they own or a job with very high income can regenerate capital much faster to take advantage of market cycles where someone with limited capital might buy one property and be tapped out for awhile.

I would like to offer a different perspective this issue. I would agree that many people have little capital to start and struggle to accumulate large amounts of capital because their incomes won’t allow for such accumulation. But I think that by definition if you are going to be an investor you have to have capital to invest. That may sound a bit harsh but it’s a concept that’s well founded and proven. I believe that the sacrifices you make in saving that initial seed money (and it is very hard in the beginning, especially if the income isn’t very high) “temper” you and make you a stronger investor. On the opposite side of that spectrum,  you have people that try to create their capital through inherently risky strategies (read: flipping through hard money loans) and unfortunately, the wide majority of them don’t make it. Yes, it’s going to be a slow grind saving the money for that first property. It will be easier to save it for the second. And easier still for the third. But you don’t let that difficulty keep you from getting started or even worse, going in a much riskier path of least resistance.

I’m not a big fan of the article for a few reasons. The first being that you need ~$180K in cash to be able to pull this off. He’s suggesting buying 9 ~100K properties which will require 20% down each.

He’s then suggesting taking 0 cashflow on that for 12+ years. Over that time, you’ll be paying taxes on ~$40K of income that goes directly to the bank to pay down your debt while only capturing about 30-35K of depreciation.

If you’ve got $180K laying around there are surely worse ways to put it to work…but this definitely isn’t the best way

As I mentioned above, if you want to do it right, you will need capital. I make no apologies for that. But sometimes a sense of chronology can get lost in a simplified, linear case study. For instance, in reading the strategy, you’d get the impression that you would need to have the money in the bank this very moment. In reality, most investors I work with build up to that level of acquisition. They acquire 2-3 properties per year and recycle the positive cashflow from properties they own in addition to savings from job income to create the capital for the next 2-3 acquisitions.

The next point made is that the Domino strategy I suggested asks you to forego the cashflow for 12 years, pay taxes on the interim income to pay down debt since depreciation doesn’t cover all the income. All these points are correct, but I’m not sure they make much of a case against the strategy. First of all, when you invest your capital in a property to create a present stream of positive cashflow, you’ve made your money make some money. When you invest the “dividends” to grow your capital base, you’re essentially applying compound interest principles. If you spend the “dividends” in the present, you miss out on the magic they can do over time. So, if you don’t need the income from your properties to subsidize any other income you may have, but you opt to spend the cashflow created by your properties, you are essentially killing the goose that lays the golden eggs. You don’t play by the bank rules when you aggressively pay off your debt. You play by their rules when you pay off your properties in the schedule your bank set in the first place. Do you think they set a 30 year payoff schedule because it was in your interest or theirs?

Finally, I would be happy to listen to any alternatives to invest $180k in capital and most importantly to compare results.

paying down and not using interest for your tax deductions is dumb in my opinion. But many people on here would disagree. So u own a fully paid off pile of bricks in a shape of a house… what’s so great about it? If u want to take money out.. u have to pay 4k to refi. Just dumb

Ah yes! Let’s spend a dollar to get back thirty cents. This deduction argument is so weak  and without merit when used paying off your own home but it really reaches silly levels when we’re talking about investment properties. When you own a leveraged investment property, the interest you pay on the mortgage is deducted against your gross income to calculate your taxable income. But the reason it’s deducted is because you spent it and didn’t receive it as cashflow. When a property is paid off, you don’t have the deduction of mortgage interest from your income but you don’t have the expense either.

If you own “a paid off pile of bricks in the shape of a house” you own an income producing asset that in alliance with other income producing assets can set you financially free. That’s what’s so great about it!

LOL, this “system” was bounced around in the 80s!

In financing this is a distribution of debt reduction and use of funds issue.

You’re paying off debt with expensive current dollars while reducing the after tax interest expense of cheaper money. In other words your real economic cost is greater with accelerating the payoff. The benefit is receiving future dollars with less value due to inflation. Keep in mind that raising rents does not effect the funds necessary to retire debt, increased rents are above amounts for debt service.

No one mentioned buying 9 properties with 25% down buys 2 properties free an clear and a third with 25% down. Property 1 could buy property 4 and property 2 can payoff property 3 or buy property 5. I’d say this could be quicker to the same end off hand.

In some cases this does have benefits depending on your age and retirement goals, wiping out any debt. Suffer now and enjoy later. 🙂

Actually this system has been around ever since mortgages and debt first appeared. The cashflow dollars you use to pay off the debt on your investment portfolio are (by and large) tax sheltered due to depreciation so I’m not sure how they’re “expensive dollars”. Again, you get to deduct the interest expense from your rental income because you’ve given those interest dollars to the bank. Interest expense is not some “paper expense” along the lines of depreciation expense. Yes, you will pay more taxes on positive cashflow from free and clear real estate but that’s because you’re receiving more cashflow than you would if the property was still leveraged. No matter how you split it, saving the expense is always better than deducting the expense for tax purposes. The future dollars you receive are subject to inflation (like everything else) but real estate is an asset class that is inflation resistant. The reason is that inflation makes 100k/year 10  years from now have less purchasing power than 100k/year today but it also raises property values and property rents. Generally speaking, you can’t built the same property 10 years from now for the same cost you can today because all the components that make up a property (bricks, roof materials, concrete etc) are subject to inflation as well. In the illustration of the Domino strategy, I eliminate value appreciation completely to keep numbers conservative and keep things simple. But if we were to account for likely appreciation, the discussion is over.

If you have $180k in capital and the properties we’re using for the sake of the discussion are $140k each, you could buy one property free and clear and have enough capital to purchase another with 20% down. The combined income of these two properties would be about 16,500 a year. Which means, you would need to wait 2.5-3 years till you could purchase the third. So, taking that alternative route would take you much longer than 12 years to just accumulate 9 properties – forget about having them all paid off in 12 years!

I’d like to end my take on the merits of the Domino strategy with this point: The factor that’s almost always missing from the arguments against this method is risk. I’ve said it before and I’ll say it again: Risk and return are best friends – they go everywhere together. A portfolio with 25 leveraged properties is inherently and substantially riskier that one with 9 paid off properties. So when discussing best use of funds and opportunity costs, it’s fine to consider the return but disregard its best friend at your peril.

Comments

  1. Erion: I have been reading your blog for over a year. All of your articles have been good and informative. This is by far the best article (“To Domino or Not”) you have posted. The subject matter to many is hard to comprehend in that they firmly believe that the mortgage deduction should above all else be held as a tax (“interest deduction”) advantage. To a limited extent it is. But not as a long term real estate investing strategy.

    The comments made by skeptics of the process show the financial illiteracy that is so prevalent. When starting out in real estate investing a mortgage deduction might be one of the benefits due to limited resources. However, as cash-flow continues to improve, whenever possible, it should be used for debt elimination. As your net income increases so does your tax liability. I would propose that that is always a good sign. My focus is on controlling my expenses. Last I read, mortgage interest is an “expense”.

    The example I use when discussing the benefits of debt free real-estate investing as it relates to mortgages has always mirrored yours. Why would you pay $1.00 in interest for the mere sake of saving .30 cents on your income tax? I would much rather not pay the $1.00 in interest and pay .30 cents in income tax. Seems like a no brainier.

    Happy RE investing!

    • Hi Wally

      It makes me really happy that you liked the post and I really appreciate the kind words.

      For those that act as if the only goal for their real estate portfolio is to minimize taxes I offer a very simple solution. Don’t make any money and the taxes will be zero. 🙂

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