[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.
Conclusion
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?
Featured Real Estate Partners
Something interesting to add. When you put 25% down on a property, and pay it off over 20 years, even if your cash flow is neutral and you don’t account for any appreciation or tax benefit, your annual return on your money is just about 7%. Look at it this way, if you put $25,000 in an investment at ABOUT 6.7%, you would have a hundred thousand at the end of 20 years.
Our basic strategy was to purchase as many units as possible initially, then improve them and begin selling off our last favourites and each time we did we would pay off a loan on a building that we were keeping so the end result has been that we’ve gone from 53 units at a 75% LTV to 29 units with a 20% LTV and roughly the same cash flow! Fewer units, less management, the same money.
The time for debt for me was early in my career.
I needed debt to buy a house, a practice, a building, a surgery center, commercial real estate, etc.
I took out the smallest amount at the lowest rate and paid it off as quickly as I could.
I have been debt-free for over 15 years and never looked back.
The access and accelerated returns were great. But without debt, I keep all the cash flow, and risk is lower.
I would only add that it’s the use of non-recourse debt that enables the investor to truly diversify away their risk. All too often individuals leverage up their personal balance sheets by guaranteeing debt which is one of the quickest ways to find your way to the poor house. When markets turn lower, you may both lose your investment plus have to find a way to pay off the bank loan. Your only option is putting more money into the project or selling it. If you have to sell it for less than the bank loan, you owe the bank that money and your credit may be destroyed in the process too. The LLC is an important vehicle to reduce liability around accidents but a community bank lending to an individual buying a small property will also want a personal guarantee. Generally, non recourse loans are available on larger projects which makes this one of the biggest challenges with a do it yourself strategy. You have the potential to make more money but you also expose yourself to unlimited risk. This isn’t a big deal early in your career when you are building your net worth but when you amass a net worth, you have a lot to lose. Leverage is a great tool but it can cut both ways. Just make sure you put yourself in a position to only lose your investment. Non recourse financing is one of the holy grails of real estate investing. Try to secure this type of financing over a guaranteed loan even if it is more expensive. You will sleep better at night in times like this.
Totally agree.
Totally agree. I purchased properties, including hotel, mostly b/ 2004 – 2008. I was able to hold on to single family homes. But had to da a short sale on hotel. Able to work out a deal with bank, but due to personal guarantee, and high income, SBA did not let me off the hook for few hundred thousands, They gave me a 15 yr deal, with 3% interest. I am still making monthly payments, ad will do so foe few more years. Yet, all the big boys with non recourse loans, walked away from billions of dollars of liabilities without any consequences.
Just know that SBA even threatened to garnish my wages, and did not care about ruining my good name. They were ruthless with me b/ I had a high paying job. They let my non physician partner walk away with pennies on the dollar b/ he was an entrepreneur and had no regular salary. SBA even tried to assign his share of liability to me, but I guess they took pity on the. This happened to me at age 42, so I had time to improve my financial situation.
Good review post. Leveraging is awesome at the beginning of growth real estate and naturally transfers to cash flow over the career.
Deductions even greater if you spend 750hourd and able to leverage and depreciate the properties, then move then to generational with stepup. ….. Very good for high income docs with robust wealth portfolios.
The nonrecourse loan is the holy grail but depends on historically good credit on the company itself and few have this until well into a business career. But a valid point to reduce risk that much further.
Just Sayin
So many on platforms such as Bigger Pockets touted # of units and investing long distance are now finding themselves with many tenants who cannot pay rent. Quality + Quantity in a market you know. I focused on a mkt where I did my residency and rented to (mostly) residents. Boy am I fortunate – no missed rent to date and no turnover – they stay for 4 yrs at a clip.
My newest development has a wait list 10+ people deep!
Love the leverage but timing matters for me – stacking cash for larger purchases in ~12-18 months. Would focus on mid range rents as we will see continued unemployment stressors. Towns with only 1 anchor industry or even college towns – boy I just couldn’t touch those.
Happy investing
JustSayin
(WCI – staying positive in 2020 – doing better?)
Glad you’re doing so well in the storm.