[Editor's Note: Today's post from Passive Income, MD is the second post of a two-part series in his overview of using cash vs leverage for purchasing real estate properties.]
In part one of this series, we discussed all the reasons why cash is king when purchasing rental properties.
However, there are two sides to every coin, and there are certainly some legitimate reasons to use leverage and financing over cash. Some even say that this is the best way to purchase real estate.
Leverage is indeed one of the most powerful and well-known tools used to create significant returns when investing in real estate. But before we can get into the reasons why it might be a good option for you, let’s make sure we’re on the same page.
What is Leverage?
In essence, leverage is using a small amount of capital to purchase a larger property. You can get all the benefits of a higher-performing property without sacrificing all of your capital.
Utilizing leverage is optimal when property prices and rents are rising. If the property is increasing in value, you’ll see even better returns.
An example of using leverage is this: say you had $100,000. With that, you could purchase a $100,000 rental property.
Or, using a mortgage and leverage, you might be able to purchase a $400,000 property, using the $100,000 as the down payment and borrowing $300,000 from the bank.
With that understanding in mind, let’s look at a few reasons why leverage is a great option.
1. Greater Diversification
With financing, it’s possible to spread your cash around to purchase multiple properties instead of having it all tied up in one.
Take the example above, where you had $100,000. You could only buy one $100k property. But if you decided to finance, it’s possible that you could divide that $100,000 up into two $50,000 down payments—or even four $25,000 down payments. Then use those down payments to buy multiple properties.
Using this strategy to buy multiple properties can be a great way to diversify. When you’re not limited to one property, you can buy properties in different locations (geographic diversification).
For example, I used leverage to purchase properties in Indianapolis, Texas, and California, and for my next property, I’m eyeing Washington. If I was purchasing these properties in cash, I might only be able to choose one of those properties in a single state.
Real estate is considered a local investment meaning that each county or two might perform differently in a certain economic market. For example, job and population growth are huge drivers of supply and demand in an area and affect rental rates and purchase prices.
Again, every place is different so diversification when purchasing properties can be a powerful advantage.
2. Greater Return on Investment
Everyone understands that if the price of the property you purchase goes up, you’re able to sell it for a gain.
When you purchase a property using financing, you get the best of both worlds: even though you put down a smaller amount to purchase the property, you’ll still get the full benefit when the property goes up in value. Here’s a simple example (excluding fees and such).
If you buy a $100k property and it goes up 5% in value ($5,000), then you just made $5,000 and a 5% return on your original investment ($5,000/$100,000).
However, if you instead used $25,000 to purchase that $100,000 property and the property goes up 5% in value ($5,000), you again made $5,000, but now with a 20% return on the original investment (5,000/25,000).
Imagine if you were able to buy four properties using that $100,000, splitting up that capital into four $25,000 down payments. Multiply $5,000 profit x 4 properties, and you’ve made $20,000. Compare that to the $5,000 return on the property you’ve paid all cash for. That’s a 400% greater return.
3. Greater Tax Benefits
One of the most powerful benefits of investing in real estate is being able to take advantage of tax benefits. And again, as an investor, you’re able to take the full tax benefits of the property whether you leveraged it or not.
For example, let’s say that you’re able to take a $10,000 deduction for one property because of depreciation. If you used leverage to buy four properties, you could get 4x the amount of deductions, all using the same down payment amount.
Furthermore, you’re able to take some additional deductions for the mortgage interest as well. Of course, you’re paying interest by having a loan, but it makes leveraging more attractive if you know you can write a portion of it off and still get all the other tax benefits.
4. Risk and Liability
If you sink all your capital into one property, you risk losing it all if something were to happen to that property.
If you’re using leverage, the good thing is you’ve probably diversified. If something happens to one property, like a fire or natural disaster, and your insurance coverage isn’t great, you can rest easy knowing that all the equity you owned isn’t destroyed.
Plus there’s liability risk to consider. Let’s consider the situation you get sued for whatever reason. If your property is leveraged and held in separate LLCs, they can only take up to the amount of equity that you have in the property itself.
Imagine if you paid all $100,000 for a property all in cash. In a lawsuit situation, you could lose that full amount.
However, if you leveraged $25,000 to purchase a property and got sued, losing that $25,000 is the absolute worst-case scenario.
Hopefully, if you’ve read the first post in this series as well, you now have a good idea of why some people advocate for either cash or leverage. This debate will likely continue forever, but at the end of the day, which one is better for you depends on your risk tolerance, capital at hand, and ultimate goals.
Leverage allows you to build your portfolio at a more rapid rate. However, leverage can be a double-edged sword. It can multiply returns, but it can also multiply losses.
Ultimately, the question is not whether to use cash or leverage. A better question would be when is the best time to use cash or leverage. For example, I helped my parents buy several rental properties. For the multifamily properties, they used financing. But for a duplex, they used cash because they recently retired and getting a loan would be quite difficult.
I’m in what I consider acquisition mode meaning that I’m in the phase of life where I’m trying to acquire a good number of units as quickly and smartly as I can. I’m trying to build a portfolio that will balance cash flow and still builds equity at the same time.
So I’ve found the best way to do that is by using leverage but that doesn’t mean there won’t be a time where it might make sense to pay for a property in all cash or really work hard to pay down the mortgages on my existing properties instead of looking to acquire additional properties.
Really, the decision comes down to your personal situation and the timing.
Now that you’ve gone through the benefits of both, which do you think is right for you in your situation?
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