What is a rule of thumb for accruing debt on a rental property?

Question

My sister and I were fortunate enough to inherit 2 properties from my father, one a suite of apartments and cottages worth about ~$3M and also his home.

We currently have about $200K in mortgage debt in the apartments set to be paid off in about 6 years; the property has appreciated probably about 20% in the few years that we've owned it.

We're planning to refinance the mortgages but are trying to figure out how much, if any, additional debt we should take on. The banker working with us has suggested about $1.6M total debt over 15 years, and although it would be nice to write of the mortgage interest and put that money into the market, the properties are also appreciating and that seems like a large proportion of the total value of the property to convert into debt.

What is the general rule of thumb on this kind of thing?

Answer 1

To start, I hope you are aware that the properties' basis gets stepped up to market value on inheritance. The new basis is the start for the depreciation that must be applied each year after being placed in service as rental units. This is not optional. Upon selling the units, depreciation is recaptured whether it's taken each year or not.

There is no rule of thumb for such matters. Some owners would simply collect the rent, keep a reserve for expenses or empty units, and pocket the difference. Others would refinance to take cash out and leverage to buy more property.

The banker is not your friend, by the way. He is a salesman looking to get his cut. The market has had a good recent run, doubling from its lows. Right now, I'm not rushing to prepay my 3.5% mortgage sooner than it's due, nor am I looking to pull out $500K to throw into the market.

Your proposal may very well work if the market sees a return higher than the mortgage rate. On the flip side I'm compelled to ask - if the market drops 40% right after you buy in, will you lose sleep?

And a fellow poster (@littleadv) is whispering to me - ask a pro if the tax on a rental mortgage is still deductible when used for other purposes, e.g. a stock purchase unrelated to the properties.

Last, there are those who suggest that if you want to keep investing in real estate, leverage is fine as long as the numbers work. From the scenario you described, you plan to leverage into an already pretty high (in terms of PE10) and simply magnifying your risk.