Is Leveraging Really That Risky?

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I’d say one of the most famous debates that comes up on this website is the one about paying all cash for a property versus leveraging a property.

And by famous I mean, it gets ugly.

The heart of the debate seems to center around the difference in risk in buying a property using all cash or buying a property using leveraging. Those who leverage their properties boast that the benefit of doing so allows the investor to buy more properties with the same amount of money. Those who pay cash come back against that argument saying how risky leveraging is and that the risk isn’t worth it, even if it does get you more properties. From what I can tell, this point in the debate seems to always be the point of impasse between the sides. Being able to buy more properties by using leverage is an indisputable fact. Leveraging inducing more risk seems indisputable. So then, everyone stops debating at that point and goes about their merry ways.

I think this is the wrong place for the impasse. Being able to buy more properties using leverage, yes, that is correct. But leveraging being riskier?

Is it?

For any newbies out there, “leveraging” refers to using ‘someone else’s money’ to buy something. That can include loans from a bank, loans from an individual, financing on a credit card, borrowing money, etc.

For the purpose of what we are talking about here, I’m going to stick with referring mostly to mortgages. A mortgage isn’t the only way to finance a property but it’s the primary one and a lot easier and more common than other methods. For the purpose of this article, I’m thinking mostly about mortgages because I want to look at long-term loans rather than short-term (just trying to keep it simple).

What is Risky about Leveraging?

Obviously there are factors involved with leveraging that are cause for concern. There may be others, but for the most part, the following issues are the things that should be looked at in terms of risk associated with getting a loan for a property:

  • Cost. A huge concern with leveraging anything is that inevitably you will be charged interest which will make your actual cost significantly higher than the original purchase price. That extra cost can end up being quite substantial depending on the terms of the loan.
  • Losing what you put into it. Let’s say you buy a house for you and your family. You get a 30-year mortgage on the property. You do great with the house until year 20 when you unexpectedly lose your job. You can’t find a job quickly and you don’t have much in savings (and even if you do, having no income can suck all of that up painfully quick), so suddenly you can’t pay the mortgage. The bank who you have the mortgage with takes your house from you. So for 20 years, you paid a huge amount of principle on the house, you paid a ton in interest, and who knows how much in miscellaneous expenses for the house, and now you have no house. You don’t get any of that 20-years’ worth of money back and you have no house either. Oh, and your credit is in shambles.
  • Losing other assets in addition to that one. If you have a mortgage on a house that you lose, unless you have a non-recourse loan you are at risk for the bank taking away other assets that you own, in addition to the house with the mortgage, in order to pay for the loss. Luckily most mortgages now are non-recourse, meaning the only thing they are allowed to take is that particular piece of property and nothing else of yours, so that helps but recourse loans do still exist.
  • Type of loan. Speaking of loan terms, let’s say you don’t lose your job but instead the payment on your mortgage goes up dramatically. This can happen with an adjustable-rate mortgage. If you have a fixed-rate mortgage you are locked in at the same interest rate for the entire length of the loan. If you have an adjustable-rate mortgage, after a set number of years the interest rate on your loan will change. It will change to match the current going market interest rate (with some restrictions), which could be much higher than what you originally signed up for. If you were to buy a house for yourself today, you might be able to get a loan with a 2.5% interest rate (primary homebuyers, not investors). What if with the real estate market booming like it is right now, the interest rates in five years jump to 8%? Don’t laugh, it can happen. Remember in the 1980s when interest rates hit 18-19%? Regardless, the difference in monthly payments may be enough to force you to not be able to pay and you could lose the house.

Well that all officially sounds pretty miserable, I must admit. If those were the only sides of the story, I too would only buy with cash. However, investment properties can work slightly differently than a primary home and when an investment property is bought correctly, a lot of those risks can disappear completely. I would even argue that they disappear enough to justify saying that buying a property with leverage is less risky than buying with cash.

Mitigations for the Risks

  • Cost. As long as your mortgage payment (which includes the interest payment) is well-covered by the monthly rent collected for the property, you aren’t paying this extra cost out of your own pocket. Yes, you are less that money you pay out in interest but if you actually run the cash-on-cash return of a property that you finance versus that of buying with all cash, the returns are usually significantly higher so you still make more money than if you bought with all cash and avoided the interest payment.
  • Losing what you put into it. Same scenario as before: after 20 years of owning a property, something drastic happens and you can’t make the mortgage payment anymore and you lose the house to the bank. If you are an investor and bought smart and the property made you money for the entire time you owned it, even if the bank runs in and takes it out from under you, the only thing that will take a negative hit is your credit score. All you put into the house originally was the down payment and some closing costs, and after that, the tenants essentially paid all of your expenses in the form of giving you rent every month. Okay, so actual worst case scenario you lose what you paid for the down payment and your credit score. That’s assuming the money you made on the house didn’t pay you back the money you put down because it likely did. So then it really is just back to your credit score. This mitigation is of huge consideration when buying an investment property versus a home for yourself. This mitigation flat doesn’t exist if the house is yours because you aren’t collecting income on it along the way and it remains a major risk. (Just in case you are wondering if you should finance a house for yourself anytime soon…)
  • Losing other assets in addition to that one. Never get a loan that isn’t non-recourse. For a mortgage, this shouldn’t be a problem but always make sure that is written in there. Then the only thing you could lose is that property and none of your other assets.
  • Type of loan. Never get an adjustable-rate mortgage, always get a fixed-rate. With the fixed-rate interest included, your payment should be well-covered by the rent collected on the property. So then you have some wiggle room in case of changing rents, but you don’t have to worry about drastic changes to your mortgage expense.

So assuming you know how to properly buy a rental property, the only official risk in leveraging a rental property versus paying all cash for it is a potential bash to your credit score should something go totally wrong, no? What else?

Let’s break this down…

An Example of Paying Cash or Leveraging

You set your sights on a rental property that you are interested in buying. The purchase price is $105,000 and it brings in $1,150/month in rent. The total monthly expenses (including estimates for vacancy and repairs) are $376, so you will then bring home $774/month in profit. For an all cash buy on this property, you will be looking at a cash-on-cash return of 8.84%.

Now let’s say you finance the same property instead of paying all cash. If you get a fixed-rate 30-year mortgage at 5% interest, you’re monthly mortgage payment will be $450.93. Add that to your monthly expenses and you will bring home $323.07 each month. It sounds like a lot less than the $774 from the all cash buy, but remember, instead of putting $105,000 of your own money into this, you only put $25,000 or so in. So your cash-on-cash return actually ends up being much higher. In this case, 14.77% to be exact. That’s just under double the returns you would earn for paying all cash.

Okay, so you know the numbers now. What happens if for some ungodly reason this property goes completely bunk? You know it hasn’t gone bunk because of an adjustable-rate mortgage because you bought a fixed-rate. So clearly the apocalypse must have occurred in your neighborhood to make the property go bunk. So now you can’t get tenants ever again and you didn’t have an apocalypse clause in your insurance policy so you can’t get that money either. The house is done.

For both scenarios, let’s look at what is lost:

  1. If you paid all cash for the property, you are out $105,000 cash (less what profits you made along the way).
  2. If you had a mortgage on the property, you are out $25,000 cash (less what profits you made along the way) and your credit score/ability because you had to foreclose.

Which are you more comfortable with? For me personally, I’d rather lose my credit score all day long than an extra $80,000 out of my pocket. But maybe you’re obsessed with your credit score and would rather lose $80,000 in order to keep it high. To each their own.

Back to the Debate

So what’s the verdict?

The way I see it, if I use leveraging I can buy a property for 1/5th of the cost of paying all cash, my returns are higher, my tax benefits are substantially higher, and I’m more covered for vacancy and repair issues because having more houses can cover those expenses as they come. Then, if all goes south, I only lose 1/5th of what I would have had I paid all cash. Doesn’t that essentially mean my risk is only 1/5th of what it would be if I used all of my own money? The only major difference is the risk to my credit score. Not sure how to weigh that into this, but to me the risk of losing my credit score is literally the only big risk I see. I’m not risking near as much of my own money as I would if I paid all cash. Which is more important, money or credit score? And that’s assuming something even goes that drastically wrong with the rental property in the first place to cause the whole thing to go under.

What if the value of your property drops significantly and now you owe more on the mortgage than what the house is worse? Easy. The value of your property doesn’t matter unless you are trying to sell it. Being underwater on a house affects you zero if you aren’t trying to sell. So that’s no argument.

What if you are forced to sell though and it’s underwater from what you owe? If you don’t have the money to make up the difference, you just foreclose and you only lose your credit score. If you had paid all cash, you’re going to lose the full difference between the sale price and what you bought it for. That could be tens of thousands.

So? What’s the scoop. What’s the big risk with leveraging that I’m missing? Oh, and happy New Year!

Photo Credit: striatic via Compfight cc

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About Author

Ali Boone(G+) recently left her corporate job as an Aeronautical Engineer to work full-time in Real Estate Investing. She began as an investor only two years ago but managed to buy 5 properties in just 18 months using only creative financing methods. Her focuses have been on rental properties and overseas investing in Nicaragua.

93 Comments

  1. Jason Merchey on

    Very smartly written article. I’m not surprised!
    I like all of this. However, in the case of someone who has a fair amount of capital available, it makes a certain sense to buy with all cash because then you have a free and clear asset that hopefully will perform well, won’t encounter an apocalypse, and will have more cash flow in a given month. This usually doesn’t occur because the same person who has a lot of cash available is typically a savvy investor or a hard worker, or both. In that case, they get caught up on the cash on cash return thing, and think “I would be ashamed if my money was only bringing in 7% ROI instead of a cash on cash return of 15% with a loan involved, thus I will get the loan. As well, I want more cash available to do other smart investments, so thus, I will get a loan.” In some cases, an investor can’t take a loan out either.
    But, there is a slice of the pie chart of reasons for buying houses where one prioritizes the relative safety of ownership, appreciates that no bank is making twice or three times what the house is worth, and values the instant, better cash flow that an outright purchase commands. I get that it makes a certain greater sense to buy with a loan, but I am actually contemplating buying one house outright with some cash that I am going to free up in the next year, versus up to four houses using 25% down each (leverage). Whereas one cash house seems way too conservative or even compulsive, four houses on loan seems a bit tilted in the other direction. I was also thinking about all the money you pay on a 30 year loan. It is a LOT, even at 4.5% interest. So my most recent thought was to split the difference and perhaps get into two different houses (a little diversification) both of which had 50% down and on 15 year amortization schedules. It’s kind of a hybrid I think. Two things I like are the fact that the cash flow on each rises from about $200 a month to more like $500 a month, and there is no chance of going underwater. Other advantages are the fact that you have double the chance for a leveraged amount of appreciation to occur (two houses vs. one) and my ability to get the loan with 50% down and on a 15 year schedule increases my chances of getting approved (I am on the borderline of being a loan candidate). I think of this idea of sort of “cash purchases with a few hybridized advantages thrown in.” I think the bank makes about 25% of the payments in principal, the loans end in 15 years, and the risk is distributed among two assets instead of one.
    One problem with doing something that takes something of each of the opposed schools of thought is that both schools will find something they don’t like about one’s method. However, it is possible that this is a wiser, if rare, perspective. I imagine that you might find some things about this idea that don’t hold water as much as using leverage, and from you Ali I would respect that refutation because clearly you have a rational and balanced view of the debate between all-cash vs. 20% down/30 year loan folks. In fact, I haven’t shared this hybridized view with anyone yet, so I look forward to your feedback to see if my plan has a fatal flaw to it.

    • Hi Jason. Nope, I won’t refute anything. I personally would leverage it all but I said my reasons why in the article but more than that, and more than anything, I am 100% in favor of everyone doing what they are personally comfortable with. I am personally comfortable leveraging everything, but I know most aren’t. I think the hybrid method is great and it would fit a lot of people’s comfort levels.

      My only refute, and not really a refute but more of a counter/point…. I personally never think about how much someone (in your statement, the bank) makes off a deal. That’s not my business. I know people who focus so much on how much everyone else is making that they don’t make anything themselves. What someone else makes has nothing to do with me. I look at a deal solely for how much I make on it, no one else. Because they don’t matter.

      • Jason Merchey on

        That is fair enough. I’d rather have 50% of something than 100% of nothing. However, the human brain just works like this (worries about what the other is getting compared to one). In studies they can show that it causes unpleasant emotion and even a fairly predictable reaction if say, the researchers set up a scenario where a person you’re “competing” against or at least in relation to can get $20 if you just to x or y, for which you are given $2. Sure you could look at it as “$2 is better than what I came in here with” but you tend to worry about the justice involved with seeing someone else get something they don’t really deserve. As to whether a mortgagee (do I have that term right?) *deserves* 100%, 150%, 200% of the value of the home to be paid in order for you to get 100% of the home, well, it’s kind of a mental toss up for me. True, you would point out, that I wouldn’t be able to get that house without them. And true, that I might literally make 1000% if I do all that I’m supposed to do regarding maintenance and tenant placement and I’m lucky in the housing market over the next 20-40 years. So that seems fair enough. But what if the market literally goes nowhere in the fifteen years you were able to hold it – you might have made $200 a month from a tenant, and then you sell it for, after expenses, $0. To think that you made $2,500 a year before taxes is fine – that’s a net gain. But to think that you *didn’t make* the $7,500 a year that you paid them in interest payments is really going to smart. So it is a matter of perspective, and based on luck to some degree. You have to be able to go the whole distance. Think about life insurance policies – do they pay out if you die a year after signing up? Yes! But if you think you can stop paying them in 15 years and get your money back, think again. Credit cards that charge a very high interest rate, that’s the same feeling. Is it technically fair? Yes I suppose it is. Do people get roped into a never-ending cycle of owing some corporation money – yes. So there you go, that’s my take on the “who cares what the other person makes” phenomenon. Now, with wholesaling, that is where I totally get your argument. If someone wants to make $10,000 on a deal that earns me $20,000 – great, bring it on. If you tweak it in the way that mortgage payments/compound interest gets tweaked, it sounds less palatable – for example, a wholesaler charging you $40,000 for bringing you a seller in order for you to make somewhere between $0 and $140,000. It’s “fair” but it kinda feels bad in a way.

  2. Always leverage other people’s money. When done correctly as Ali describes, there is less risk and a far greater return on your investment. No question, and great job the article Ali!

  3. Hi Ali,

    Great points and I couldn’t agree more that the biggest RISK is not learning, understanding, and implementing the safe use of leverage. Folks get soooo stuck on credit score. I have great credit and struggle to get mortgages because I have so many. All it gets me is cheaper insurance rates and things like that. (BTW, I know folks shy away from ARM’s but if used properly you can still make a lot of $$ from them, like I did over the last few years with about half my portfolio, the key is cash flowing at either the lowest or highest cap rates, and having enough reserves ) But what your article really makes me think about is how much $$ I would have lost if I hadn’t tapped into the millions of $$ in equity over the years. Paying down mortgage debt (good debt) just never made much sense to me. It just tells me it’s a psychological thing, or you don’t have investments paying a higher returns than the current mortgage rates, or maybe you just don’t understand the tax implications. It’s a huge,huge, lost opportunity cost.

    Best,
    Dave

    • I couldn’t agree more Dave. I think it is very much psychological. Unless someone in these comments brings up the ultimate whammy of a point that counters everything I said and what you say. We shall see :)

  4. Nice analysis Ali,
    I have a couple clarifications. If someone bought a house and financed it 20 years ago on a 30 year note and have not refinanced then they should have a decent amount of equity available to get back after a foreclosure or make it available to sell before that point comes. So all should not be lost in that case.
    I believe you are in California which has been a non-recourse mortgage state for a while. I am not certain if that is just for primary residences or all mortgages. I would imagine that commercial mortgages are recourse as well. I live in Wisconsin and outside the federal exemption for the last couple years, we have recourse loans. I don’t have a problem with that in that if I use someone’s money I should pay that back even if I fail in my business venture. My commercial notes require a personal guarantee as well.
    The last two points were just commentary from a different region. The one disagreement I will habe is that you said vacancy and repair risks were equivilent because the leveraged 5 houses path has more cashflow. I think this might be ok for someone who has other reserves but would be rather risky for a begining investor. If you have 1 roof need replacing, plumbing problem in another, causing abnormal vacancy issues in both. Now the furnace goes out in another. This not only causes a large monetary strain but also lots of time and mutiple locations. With issues like this along with 5 properties leveraged at 80% loan to value, one might have a much harder time getting a loan to make it through. The guy with one property and even if all this goes wrong the guy is in a better financial position to get a loan on the unleveraged property to take care of these issues. This is the risk of high leverage in my opinion.
    I try to mitigate risk by setting up prudent business management systems. This allows me to streamline required tasks and efficiently handle several unexpected events at the same time. Having adequate reserves is paramount in the analysis as well. Another factor could be the leveraged state of the property making one a less desirable target of a lawsuit.

  5. Wow Kyle, nice thinking on the lawsuit angle. That is rarely discussed I think. And true, there are a “lot of balls in the air” with four properties instead of one. More diversification, yes, but either more property management expense or more time/effort. Agreed that reserves is uber important. In fact one could argue that over 30 years, if you a) never had to sell, b) didn’t by a lemon, c) kept up with minimal maintenance, d) and had a mountain of cash in reserve, then 1) the property will certainly appreciate and 2) your mortgage will certainly get paid by your tenants.You can’t lose a house to a foreclosure if you have a tenant 11 months out of the year and adequate reserves, it just won’t happen. I guess barring some kind of apocalypse that Ali referred to – be it of the vengeful God type or the America’s unsolvable debt problem category.

  6. Good article Ali

    A point to clarify. You stated you only risk 1/5th the sum total? How do you figure that. If you are in a hard money loan or a private investor on a house, it goes south, they foreclose. They will still come after you for any of the remaining balance you owe.

    Doesn’t that leave you 100% on the line?

    • I am pretty sure she is assuming you made a 20% down payment with your own money…Assume your Favorite Great Uncle just passed away and left you with $100,000. Do you buy one house worth $100,000 with all that cash? Or do you buy 5 houses for $100,000 and make 5 down payments of $20,000 each?

      How about you buy 4 houses and keep $20,000 in the bank for emergencies?!

    • Samantha, yes Wes clarified it below. And if you have a non-recourse loan, they can’t come after you for more than just taking the house. i.e. can’t come after you for monies owed, they just take the house instead.

      • Ali, is that just a paragraph that says RECOURSE or the lack of such a paragraph, or does it say NON-RECOURSE. In other words, how do you determine what your mortgage dictates will happen?

  7. If the only risk here is to my credit score, can I somehow cut to the chase and rent that credit score instead of messing with rental properties?

    • Dawn Anastasi on

      You can absolutely do this. Have someone else buy a property and put your name on the loan and they pay the mortgage payments. They pay the mortgage and pay you a small fee for using your credit.

      • And if they default? What if I ask them to pledge their other assets as a collateral? In that case they default and I sell these other assets to pay for whatever expenses I may incur during foreclosure. Hmmm…. Interesting concept

        • Dawn and Mike…. I can definitely say I wouldn’t “rent” my credit score to anyone! Heard way too many horror stories on that. If my credit is going to go south, it’s going to be because of me and no one else. But what you can do, a tweak to your suggestion Dawn, is you use a buddy’s money and you take the mortgage in your name. I’ve done that several times.

  8. in a scenario were the economy collapses and people lose their jobs and cant pay rent. the all cash purchaser is going to be just fine. where as the leverage-person will lose many of their properties. in 2008 I watched my uncle’s 20 properties go under because he leveraged them and when he lost most of his tenants the bank took them one by one. I agree that a credit score is worthless. especially to the all cash purchaser. Having bad credit though would definitely hamper getting a loan for someone who leverages.

    • Mike S., were all of your uncle’s 20 properties in one area? I can’t imagine that many people not being able to pay rent. It does further encourage though not buying rental properties in a downed or depreciating market! If you put all your eggs in a tanking bucket, of course you could lose it all. 1. buy in appreciating markets and 2. don’t buy everything in one neighborhood.

    • Mike, you seem to have made your uncle’s story your story now. Learn from his mistakes and be smarter than him, i.e. take Ali’s advice about not buying all your rentals in one neighborhood, and then you can take advantage of leverage without fear.

      Also, I’m not sure I agree that a cash purchaser would be “fine” if 20 of their properties stopped paying rent. Even a cash purchaser expects a ROI, and they’d be getting none, on top of a monthly negative cash flow. That’s still a big ouch, no matter how you purchased.

      Lastly, there are many creative financing ways around bad credit, such as private lenders and partners, to name two. As Dave Van Horn said above, his excellent credit gets him nowhere once he reaches the ten house limit, so credit is hyped up to be more important for an investor than it really is.

      • I bring a different mindset when it comes to borrowing. when I rent my paid off starter home in the next year I will be able to get 800 a month for it based on properties similar near me. when I pay my ins+tax+manage fee or whatever I will be making around 675 a month vs. someone who has 6 properties clearing 100 per house. My uncles properties were not all in depressed areas and he did get some back. he (and I) learned an expensive lesson. I really enjoy this debate and I don’t discourage loans cuz you pretty much have to start that way! Thank you for the article Ali!

  9. “The way I see it, if I use leveraging I can buy a property for 1/5th of the cost of paying all cash, my returns are higher,”

    How are your returns higher if your financing and essentially paying more for the house over the longterm via interest? Your cash on cash return might be large, but your essentially still paying more for a property (2-3x more) if you finance it.

    • Closing costs and all of your mortgage interest are tax deductible, so that’s a huge benefit for a leveraged investor!

    • Yes Justin but your returns are based on the amount you put into the property. So after you do all of the math, even after paying all of that interest, you end up making more because of how much less you put into it.

  10. If you are beginning in real estate then for the most part you are going to leverage with a down payment. As you accumulate cash flow, then finally large amounts of cash you would be able to buy for all cash at a discount. Many seasoned investors I know of just go after bigger fish at this point (Commercial).

    • That’s true Gerald, cash can buy you some better deals. Even after I got those deals though I would still pull loans out on them after I closed. Great point though.

  11. Jason Merchey on

    I like the point that Justin brings up. You do pay the bank a lot of the money. It’s true that there is a net gain if you finance and the housing market appreciates, and so folks tend to be happier jumping on that bumper and riding it for a mile or two, and that is as he points out the cash on cash return. However, if you buy 4 houses with 20% down each, say, $200k houses, you may be putting down only say $90k, and so when you get back $500,000 over the course of the loans it sounds awesome, but in point of fact you have given the bank probably $1.5 million dollars in interest that would have been yours had you been able to buy those four houses with cash. Most people can’t buy with cash, so the banks enter the scene and fill that void. However, if one gets a $100k inheiritance, it would be compelling I think to buy one house with it, or two houses 50% down, despite the lure of getting into five houses with 20% down.
    There are so many moving parts (inflation, the market, the condition of the house, and ten others) that it probably works out well to get a nice cash on cash return via leverage assuming the market appreciates; however, the cash flow, the not losing money to those guys in the suits, and the security are compelling reasons to go free and clear. It is rare perhaps, but it shouldn’t be stomped on as an investment strategy. Not that Ali did that, but I’m just saying, leverage has some dark sides, as Justin pointed out. That is partly why I am definitely considering going 50% down on two 15 year notes (instead of all cash on one, or leveraging four). Split the difference.

    • Jason, can you explicate on the “security” you refer to as being an argument for paying cash? Security as far as what exactly?

      For the interest… I see what you are saying but if you calculate the returns against the actual amount you put down, that’s where the cash-on-cash comes into play and it’s still higher (despite high interest amounts) if you leverage. You pay that much in interest but that is in return for putting significantly less down. That’s what you have to calculate against.

      And I mentioned to someone else… I never ever think about how much other people are making in the deal. It’s not relevant to me.

      • Jason Merchey on

        In regard to security, I guess I just mean that owning something free and clear is safer than having someone else own it while you pay them payments hoping someday they turn it over to you as planned. If you’ve ever been foreclosed on, you know what “security” means in this context. Maybe the odds will only be 1% that if you do everything right you’ll be safe; and of course the odds will be 85% you *lose* it if you make one of a couple mistakes. If you’ve ever signed a note and mortgage, you get the distinct impression that the massive bank’s team of lawyers stayed up late writing unique ways to consequence you or even relieve you of the asset should you do a, b, c, d, e, f, g, h, or i. Having a written contract makes you feel somewhat secure, but nothing beats a deed of trust in your hot little hands.

        • Jason, even if you finance a property you hold the deed in your name. The property isn’t in the bank’s name, it is just used as collateral should something go wrong. If you own a property fully paid off, you can still have it taken away from you if you don’t pay the property taxes. Same thing. Houses are an unfortunate beast where no matter what you do, you never truly fully own it, simply because of the taxes you have to continually pay. If you do everything you are supposed to with a property, there is no risk of anyone taking it from you.

  12. I see very little risk in leverage. In fact I leverage everything I can; cars, houses and don’t pay them off early. If you buy for cash flow, have multiple exit strategies leverage is not risky at all, at least to me.

    • I totally agree Mark. Cars though, I’m not a fan of leveraging because those are depreciating assets but depending on the terms, it may not be horrible.

  13. It is my belief that wealth is created with leverage. You will cash flow more with 5 mortgaged houses in Ali’s example than with 1 free and clear house. Your risk will be spread out. Managing 5 properties vs. 1 is so simple it’s not really an issue. You can manage 5 properties a couple hours a month. As long as you are truly cashflowing on each and every property you buy, the risk is very, very low. I think it’s more risky to have that much cash allocated to one asset. It is extremely conservative behavior to insist on a free and clear rental property, especially one that has positive cash flow. If you have an interest rate at around 5%, you are effectively only paying around 3% after the tax write off which means you are getting a 3% return on that $80k that can be used for additional purchases that give you 14% returns. It really comes down to comfort zone. It’s also pretty rare for someone to have that much cash to play with. Of course interest costs a lot, but the tenants are paying for it and we get the tax breaks and tax planning is so important.

  14. Marion Edwards on

    Great article. I’m a huge fan of the Dave Ramsey system for getting out of debt, but I want to invest in rental properties and don’t have the time or the cash flow to simply save and pay all cash. I agree that risk is the biggest part of the formula for making a determination to use leverage, but who has a crystal ball that works well in the economy of today? Both sides of this argument have valid points, but I guess it comes down to the individual and their tolerance for risk, even if it’s just to their credit scores. For me, I’ve decided to take the risk of using financing until I have the means to pay all cash.

      • Marion Edwards on

        Ali. Just from my own indivdual perspective, I see risks, no matter how you acquire rental properties. Leveraging has it’s own special risks because you’re borrowing money on the premise that you bought the property at a reasonable price, in an area where the rental market supports your estimate of a vacancy rate, that the propefrty won’t eat your lunch with unforseen repairs and/or needed renovations, and that it will cash flow enough to at least cover PITI, and hopefully some percentage of profit. I’m no expert, but I’m learning new every day, so I’m in with my eyes wide open. I’m leveraging now, despite my percieved risks (valid or not) and this is why I’m following threads like this on Bigger Pockets. Thanks for the articles and Blog posts you have submitted. I think I have read just about all of them.

        • Thanks Marion! Glad these are helping and thanks for contributing. I always want to hear everyone’s thoughts on these kinds of topics and you have some good ones.

          My response to yours though would be- the risks you mention are more specifically risks with rental properties in general versus leveraging or paying all cash. Which is a good thing. It’s all whether or not a property goes haywire. If it does, how you paid for it determines how big of consequences.

  15. Jason Merchey on

    Yah, Wes, that sounds pretty darned safe. If you cash flow at least a couple hundred bucks each. And you chose them well. For example, I am going to buy an infrared camera this year to try to provide even more data on the condition of the house. If you get a cheesy home inspector – someone your Realtor likes to do business with but that’s all – and you miss something big, there goes half of your $20,000. It’s also worth remembering that buying from a bank over a 30 year period is a very long-term proposition – you have to stay in it to win it. They can take it from you in the 29th year. Or if your bank is too big to fail and the worst happens, who knows quite what could happen. We are obviously in a pretty precarious place with both our sluggish economy, banks and Wall St. pushing Congress around on common-sense laws that would lead to a safer economy, and the massive federal debt.

  16. Chris Gourdine on

    Ali, thanks for your article. My thought is that the biggest risk in using leverage is a drastic loss in the demand for the particular property. Using this thought process, I lean towards highly desirable, yet widely affordable properties for rental and lease-to-own. Demand seems to be closely aligned with price range for the rental, property features (# beds/baths, garage, size of kitchen, layout, etc.), school district and other location factors, especially for single family homes. As a new investor I interviewed people who succeeded and failed in investing and one gentlemen purchased a lot of rentals with leverage in a chronically poor area with bad schools. Pre-recession everything was fine and cash flowing. However, this area was devastated with high unemployment when the recession hit and he faced one foreclosure after another. This was a drop in the demand for rentals in that area. So, it seems a key factor when using leverage should be selecting properties for their long term demand factors. Though this is important for any investor, people using leverage are essentially betting that someone else will month in and out put up the money to pay the bank, which comes down to demand.

    For the case of one responder who said owning properties outright is a hedge in the event of a near total economic collapse, that is is mostly true, but no matter leveraging or not, property taxes and insurance will always be an expense for any property, and the person owning properties outright will still have these expenses with no tenant in place to pay them. So the cash buyer still has some financial risk, which of course can be offset with cash reserves. I would say the difference in using leverage or not should include being more conservative in property selection and the size of required cash reserves in case of prolonged vacancies.

    • I absolutely agree Chris and you make some killer points. I am huge on only buying in growing markets (strong, growing markets) for exactly the reasons you mention. Diversifying helps protect too in case a market collapses (because technically even the strongest could fall), and you are totally right about still having to pay taxes and such even if you do pay all-cash.

  17. You’re preaching to the choir with me, sistah! I have always used leverage and I will always continue to use leverage. Like Mark Ferguson, I leverage everything I can. I can’t imagine where I would be without it. It quite simply has transformed my life.

    The people that don’t seem to like leverage, in my experience, are usually either very, very conservative, paranoid, or control freaks. If you buy cash flowing rentals in solid neighborhoods, set enough money aside for reserves, and take advantage of all the glorious tax write offs the IRS affords we investors who use leverage, it’s definitely the way to go.

    • I absolutely agree Sharon. And after 22 comments, not one person has answered my question of ‘what is actually the risk with leveraging?’ :) I fully believe you can’t get to financial freedom without leveraging, there are plenty of smart ways to do it, and I agree on your assessment of those who won’t leverage. There is nothing wrong with any of those traits at all, and I’m always in favor of everyone doing what they are comfortable with, but instead it is just more factual reasons of why people won’t leverage.

  18. Jason Merchey on

    I know this thread is about “risk” not “reward,” but since I am literally chewing on this very issue these days, it quite interests me. I have done some calculations using Daniel Kleymann’s Rental Evaluator. I imagine any similar program would work. My point is to illustrate that the reward for leverage is solid. If a cash purchase has a certain “comfortable-ness” to it, leverage has the potential for significant returns on investment to it. Now, this is based on some assumptions such as a) not taking out a predatory loan or making a stupid decision, b) being able to go the entire distance with some kind of reserve or Ace in the hole – again, the first fifteen or twenty years depending on how the market goes you could be underwater with the loan and if crisis strikes or you are stupid you could see the down payment and the principal payments slip through your fingers (if for example the market isn’t great and it takes 6-7% to sell and you’ve pretty much just made interest payments so far in the life of the loan). BUT HAVING SAID THAT, if you do make good use of a loan, here is how it turns out to invest at about the median house price in my community ($190,000):

    CASH PURCHASE on one property:
    a) after-tax cash on cash return: 395%
    b) net profit from rent and a sale in 30 years with about 3% appreciation: $565,000
    c) 1st month’s cashflow: $870

    HYBRID PURCHASE: 50% down over 15 years at 3.5% on TWO properties:
    a) after-tax cash on cash return: 667%
    b) net profit from rent and a sale in 30 years with about 3% appreciation: $1,100,000
    c) 1st month’s cashflow: $440

    USING LEVERAGE ON FOUR HOUSES with 20% down, 4.6% APR for 30 years
    a) after-tax cash on cash return: 975%
    b) net profit from rent and a sale in 30 years with about 3% appreciation: $1,700,000
    c) 1st month’s cashflow: $325

    So cash flow is better up front with cash, and the more leverage you use the higher your return is. Now, I know this isn’t going to come as news to most readers, but I calc’d it just yesterday, and I thought it was a fair counterpoint to some of the very conservative views I was espousing in this thread so far. In a word: yes, responsible use of leverage stands a good chance of making killer returns, might be safer in regard to diversification, will be harder to manage, will have slowly increasing amounts of cash flow, and will make your parents think you’re a genious investor after 30 years of holding and maintaining correctly. Cash purchases are a bird in the hand, not four in the bush, but are fairly boring.

  19. Hi Ali,

    The risks in leverage lie in your basic assumption that you can get a non recourse loan.

    I live in Virginia where non recourse loans are few and far between.

    If you are at risk for your loan, and the loan goes bad on any of those hypothetical five properties in your example, the lender will foreclose on that property. It won’t bring much because it will be sold at auction without proper marketing. The bank will get a deficiency judgement against you, which they can use to force you to sell those other houses. (which of course won’t bring fair market value because of the forced sell/auction process)

    I know this is a horror story, but one faced by many people in the last 5 years or so.

    You stand to lose not only your $100,000 investment, but all of your assets.

    That is the risk of leverage. While I have used leverage in the past, and still do so today, it should be done with a full awareness of the risks.

    • I totally agree Terry. And you bring up perfect points about the danger of recourse loans. I would encourage every investor to deal only with non-recourse loans to avoid that risk. I don’t know about every state, but I would just keep looking until you find the non-recourses. If you absolutely can’t get one in your own state, I’d plan to buy in other states where you can.

      • I will search for other states where you can get non-recourse loans. They are not available here in Virginia. Even the loans I get in my business name, the banks require me to sign personally.

        The other major problem, the only fixed interest loans I have been able to find, are the loans that qualify for government insurance. These are limited to homes you have in your personal name, and you are limited to 4 of those. For liability considerations I would rather own rental homes under some time of business entity.

  20. Ali,

    I’m a leverage-to-the-max type. My favorite four words in investing are: leverage, arbitrage, velocity, and abundance. Getting real estate loan (OPM) really hits all four of those.

    With real estate interest rates still near historic lows, it is easier to arbitrage the difference between your Cap Rate (Income) and Mortgage Interest Rate (Debt). Why walk away from that?

    Additionally, a benefit of leverage (debt) is that fact that you effectively get to short a debased dollar. Inflation is a leveraged investor’s friend.

    $500K borrowed today is going to be a lot easier to pay back in twenty years when it’s really only worth $300K then. Inflation – which most believe is inevitable with QE – makes it easier to pay back the dollars borrowed with the diluted dollars of the future.

    I don’t see much risk to leveraging. In fact, “opportunity cost” is one form of risk. So if you DON’T leverage, you’re at higher risk.

    As Robert Kiyosaki says, “Savers are losers. Debtors are winners.”

  21. Jason Merchey on

    Keith, you make a good point – until you added that probably incorrect and definitely stupid-sounding Kiyosaki quote. He is like the Dr. Phil or Al Roker of the economic world.

    • Hey now Jason. Easy killer. Everyone has preferences on who they learn from and respect and whose quotes they want to use. I’m a huge Kiyosaki fan and I attribute a lot of my success to principles I learned from him.

    • Thanks for the comment, Jason. The Kiyosaki quote is correct; though I believe that it is meant to be polarizing.

      Savers get 0.8% on a five-year CD in 2014. They are pummelled by inflation. That’s Kiyosaki’s definition of a loser.

      Debtors secure good debt when renters pay the debt for us. OPM from both renters and banks provide the aforementioned investor rate-of-return metrics and inflation hedging.

      Your inquisitiveness and critical thought is appreciated, Jason.

  22. Leverage is more risky in terms of being able to meet all your obligations on the property because there are more and larger obligations against the property.
    It is a risk vs. reward call, and usually if you can use debt wisely it will make sense to take on the risk.

    In your example there is a pretty hefty margin so the chances of getting totally screwed on it aren’t that high. The biggest risk on that one I see is being overzealous in the projections and getting a lack luster return. The <33% expense ratio is pretty low with management (and one thing I know about you is there is not a snow balls chance in Hades you are assuming self management. :) ) even with optimistic values for vacancy and repairs, and no CapEx reserves.
    Lets say the expenses end up being more like $500 and you end up having to rent it for $1,050 instead. Down to ~$100/month in cash flow and your CoC goes down to about 4.8%. Same thing on the all cash purchase and the CoC is actually better at about 6.3%.
    Now this is probably the realistic worst case and slight changes (say expenses of $450 and rent of $1100) get leveraging back to a better return.

    I'm kind of an all or nothing type. I want to have stuff pretty much free and clear or have it cash flowing with 100% leverage. If I have the risk of leverage I want to have has little money as possible in it.

    BTW on the point about the worst thing happening being that you kill your credit, if your go to strategy is to buy small residential rentals using bank financing that is kind of a big deal.

    • Ali Boone

      Haha Shaun… you know me so well :)

      You bring up excellent points and you are correct. The margins could get hairy with leverage. And if you are trying to get a ton of small residentials, yes you need credit for the mortgages. My vote there is get all the mortgages you can before you lose ability to get them ;)

      I do like your all or nothing thought though. Makes total sense.

  23. Definitely a controversial topic Ali, I’m intrigued!

    Honestly, I don’t think there’s a right or wrong answer. Deciding whether or not to use leverage will depend on each individual. At the end of the day, it’s all a difference in perspective.

    From my own experience, I’ve been on both sides of the coin. And, I will tell you I’ve been in situations where I’ve had to weather the storm using capital to cover vacancy costs — it’s not fun at all.

    With that being said, I’ve eventually leaned towards the free and clear route. Yes, it may not have some of the advantages of using leverage but it’s much more slower and manageable for me. And, this is the route that has helped me to get to where I am today.

    Vacancies don’t phase me as much anymore. There is not as much pressure to fill them as before. I can take my time and go on as I please.

    Many wealthy folks I have met have gone the leveraged route in the past (as did Dave Ramsey) but at one point it killed them both financially as well as psychologically. I’ve also met some who have gone the free and clear route and have done well. On the other hand, there are others who have used leverage and have been successful. I guess, it can be different for everyone.

    For me personally, leverage has both helped me as well as harmed me — it’s definitely a double-edged sword. Though, it can be a starting point (as was for me) to help conserve and build up capital. Going back to the free and clear route has definitely been less burdensome and stress free. So I will say, a combination of both can work.

    With that being said, I still remember the advice of a very wealthy businessman. He told me that the key to being rich is not to have any expenses. The meaning of “rich” can be both from a financial standpoint as well as a psychological one. From the moment I heard it, I’ve heeded this advice and my financial as well as my personal life has definitely improved threefold.

    Very thoughtful write-up, Ali. Happy New Year! :)

    • Ali Boone

      Great input Rachel! And I totally agree that at the end of the day, everyone should work within their comfort levels. If free and clear is psychologically better, then I say go that route for sure. Or the reverse, either way.

      Great advice as well! Very true.

  24. Yah I think we are uncovering some very good, nuanced details of all the issues surrounding leverage – and the opportunity costs that are present with using cash.

  25. I am about 80% into using leverage to buy four properties (if the banks will cooperate with me) instead of one cash purchase. My wife still has to sign on, and I’m still continuing to flesh it all out with my accountant and my financial planner and mortgage banker (as you can tell, this would be my first mortgage after three cash purchases). More on that later in case this thread is still hot.
    I do have a concern though about costs. Due to bad luck and poor oversignt of my property manager in 2013, I saw a profit of about $4,000 in 2013 on a duplex. If it weren’t for the chick trashing the place, that probably would have been $7,500, and so on. With my other property I rent out (the third of the three I referenced I live in), a tenant missed a month and instead of kicking him out because it was a one-time occurrence (temp. job loss) I just signed another lease with him for 12 months x 108% of the rent, so I’ll make that up in 12 good payments, which I put the odds of occurring at like 80%. So that was technically a vacant month in 2013. And in both cases, I paid $600 for an American Home Shield warranty, which was basically a loser. Had to install two dryer ducts because stupidly I didn’t realize when I bought the duplex that there were washer hookups but no dryer vents! And in the condo I referenced, I’ve got $335 a month in HOA dues (this was my first home, and I realize that condos aren’t probably a great investment property, but hey the value has dropped below the price at which I got it in 2010 so I hate to sell it), and, finally, I failed to maintain the HVAC in the condo and a condensate drain line stopped up and leaked onto the HVAC closet floor for probably months and ruined like 20 or 30 square feet of drywall. So long story long, I didn’t have a great year in 2013 due to bad luck and laziness. So, the two properties did cash flow, but only about $8,000. If I had two mortgages, it probably would have been a stinging loser of a year. Which also highlights the importance of choosing an investment that a) isn’t in the ghetto and b) isn’t a condo and c) not falling asleep at the wheel or d) not trusting your property manager to a certain degree and e) having reserves enough to make up for that one year when you have a $5,000 AC compressor, $7,500 roof, or a $4000 septic drain field to replace. I am coming to believe, I think, that leverage allows you to do very, very well after 20 or 30 years if you have the right property and if you watch that basket of eggs. As I learned from my ill-conceived purchase of a life insurance policy that I eventually dropped, you have to go the whole 9 or you lose. Of course, the more equity you have, the better your chance of selling it successfully and avoiding the financial guillotine, but still, banks will cut you off at the knees if they get a chance – to some degree.
    So all in all, I really like this thread – it came at a perfect time for me in my professional process. I will probably get my first piece of leveraged real estate in a month!

    • Jason, you highlight perfectly things to watch out for in owning investment properties and things that can pop up unexpectedly that really hurt a bottom line. Sounds like you also learned quite a few lessons yourself! :)

      But yes, you are right…quality of the property, buying right, and maintaining correctly are critical in making a profit.You are right that had you been leveraging, you may have ended up in the negative for that year. However, if you think about it…. you paid cash for these properties, which means you paid a heck of a lot of money out of pocket. Had you leveraged, and had one bad year, yes you may have been in the negative but that negative amount wouldn’t even come close to what you paid upfront for buying the property outright. This is something people don’t see… yes, you would have paid out of pocket a lot more in a bad year with leveraging, but if you paid cash for the property, you already paid that much plus way more out in a previous year. So in my opinion, you still would be less out of pocket in a bad year with using leveraging than paying all cash upfront.

  26. Oh, I would also be interested in anything anyone has to say about a home equity line of credit. I ask because if my D-I ratio isn’t looking good after a couple purchases due to the lag between buying, getting an tenant in, and filing taxes (they use tax returns to gauge income, whereas the debt shows up on your credit fairly quickly, making your D-I ratio screwy for a while). Anyway, one person suggested I could use equity in my home to make a purchase, let is season for 6 months, and then pay the HELOC back using a refi. Basically taking a loan on a property in reverse, alleviating the D-I ratio issue. This bank allows 10 properties, so if my credit score holds and my D-I isn’t an issue, I could be lookiing at a sweet retirement by using leverage. So basically, is a HELOC a safe thing to use as a 6-8 month bridge loan would you say?

  27. I am going to re-post a forum post I posted here. That may be kind of cheesy, but I think it’s fair because this is a case in point that I think can clarify my thinking if I can get some opinions on it. It’s a scenario. Here goes:
    I got a calculator called Rental Valuator. I like it. It’s a teenie bit above my head, but I think I get it. When I plug in a property purchased today for 25% down, 30 year term, fixed interest, 60% income/40% expenses, appreciating at 3% a year over 30 years, vacancy of 4%, and rent and costs of doing business rising concordantly (3% annually), I get a “cumulative cash on cash return” of 1000% before taxes. I take that to mean the value of the property in regard to cash flow and appreciation and debt paydown VS. my 25% down payment doubled (from 0% to 100%) then doubled again (from 100% to 200%) and so on to a factor of 10, which basically beats the pants off of say, investing that $50,000 in stocks and seeing a 5% per year increase, for a total of 150%, or a factor of 1.5.

    My question is, am I misinterpreting something, or do leveraged returns really skyrocket like that even in a gently-appreciating housing market? It sounds almost too good to be true. My second question is, it would seem that any rent increases of 3% a year would be cancelled out by expenses increases of 3% a year (thus causing me to feel skeptical). Are those two percentages equal, in other words, will they cancel each other out, or do I have that wrong? You can’t boast increasing rents 3% a year for 30 years if your insurance and roof and HVAC and so on all cost 3% more per year. Also I will have paid more than $100k to the bank just to finance it, so there goes that money. Also is it safe to assume that over 30 years one will see a doubling in property values, or is there something wrong with that assumption?

    As far as the ease of ownership, yes, there is a lot of management and upkeep, and yes missed payments can lead to a foreclosure, but if I go all 30 years and can sell the $200k property that I paid $50,000 for up front for $400k, it seems like a bombshell of an investment. Well, minus taxes on income and taxes on the sale. Am I making any mistakes in my understanding?

    • Not really Jason. Although you asked a lot there and I may have missed some of it. The only misconception you have is assuming you can raise the rents 3% a year. That rarely happens.

  28. Hi.
    You mention that if the house is foreclosed on, the only thing that’s lost is your good credit score, but won’t you sometimes still end up owing the bank money for the home?

    • Hi Kay, no you usually won’t. They take the house from you and that essentially counts as the collateral. Plus, you are likely to not have the money to pay them if they wanted it anyway. You in theory got in that spot because you didn’t have money to pay the monthly mortgage payment, so you doubtfully have any money they could go after anyway. The loan is secured with the house. But don’t quote me on all of that either.

      • Ali,

        Hope you are somewhere warm, its cold here in Virginia.

        This is a restatement of one of my earlier comments. Where I live, the banks make you sign personally on the loan. If they have to foreclose, and there wasn’t enough money from the auction to pay them back plus interest, plus all the penalties they levy, they will get a judgement for the remainder and if you have any assets, go after them. The only thing safe from them would be any retirement funds you have.

        So unless you can get a non-recourse loan somewhere, or just don’t have any assets, there is a risk to financing your purchase.

        • Can someone tell me more about the popularity of recourse vs. non recourse loans? I am getting some push-back from my chosen lender on this issue. He is kind of like “I don’t know what to tell you about this ‘recourse’ vs. ‘non-recourse’ thing you bring up, frankly no one ever makes this kind of a deal about it – basically you sign the same forms every other person does, and if you foreclose, the lender sues you, end of story.” Can anyone provide some insight so that I move wisely; I don’t want to offend the guy if it is hard or rare to find a non-recourse loan, but if he’s hiding a card up his sleeve I want to expose it.
          Do you think I can ask for the documents ahead of time to view them?

  29. Great post. IF you are smart you will leverage it initially, collect rent throughout the years, and pay it off early using bi weekly payments. If you pay it down earlier than the term you took out, then you can save interest and never lose the house. On average people who focus paying down their mortgage do it in 10-12 years.

    • Well El, the argument could be made that you should take all those extra payments you would make and combine them to create a down payment for a new property instead. Even if you finance the property initially, if your goal is to pay it down rather than buy more properties with that money, it’s still the debate of paying all cash versus leveraging.

  30. Ali,
    Thanks for the post. Awesome topic. I think you did a good job bringing up some important points, but I’m going try to be devil’s advocate a bit.

    I started about 11 years ago right out of college buying investments, so leverage was certainly a big part of my game plan too. The strategy has worked well for me so far, but I think it’s a little much to say leverage is less risky than owning free and clear.

    I see leverage as a wonderful tool that gets me to my goals faster, but essentially I’m willing to take on extra risk for a faster trip up the mountain.

    So you’ve pointed out (and I certainly agree) that better neighborhoods, cash reserves, and better loan terms will mitigate the risk of unforeseen downward spirals in both rents and values, but the problem is I’ll never know for sure that I’ve mitigated the risks enough until it’s too late.

    Did I really save enough for vacancy? Did I really save enough for repairs? What about capital expenditures beyond ordinary maintenance. A new roof? A new HVAC? Even on my rentals in good neighborhoods, I’ve never had $376 in expenses on a $1,050 rental, including reserves, so that example raised a little of a concern for me.

    But even if your numbers are right, what if all the HVAC units and roofs went out at ONE time or vacancies all spiked at ONE time and sucked up all your reserves? You could still be right over the long run, but run out of money over the short run and go out of business.

    This is actually what I noticed happened to a number of investors who went out of business in my area during this last downturn. Leverage, bad predictions on expenses and vacancies, and running out of cash put them under. A group of bad properties started dominoes falling one after another, and since they were highly leveraged and connected with personal recourse (as is the case in most states and most non-occupant loans) the whole thing tanked.

    Interestingly enough, I’ve now seen a lot of leveraged investors go out of business, but I haven´t heard of one free and clear investor going under. That does show me something, and it´s why my goal is to continue getting a sizable chunk of properties free and clear now that leverage has served it’s purpose for me. Growth is great, but a more flexible and stable long-term foundation has become more important to me.

    So to answer your question, Ali, more than anything specific, I think the biggest risk of leverage investing is uncertainty and our inability to predict the future very well.

    Plenty of very smart investors in the real estate world and stock market think they know the right neighborhood, the right town, the right company, etc but uncertainty usually rears it’s ugly head when the game is played long enough. Less leverage makes you more resilient and flexible when the uncertainty strikes (great WSJ article on financial resiliency and uncertainty: http://online.wsj.com/news/articles/SB10001424127887324735104578120953311383448).

    That’s why the best stock investors, like Buffett and other value investors, build big margins of safety, huge reserves of cash, and don’t run their companies with 80% leverage. At some point they know mature, long-term businesses have to reduce debt and increase cash flow in order to remain flexible and resilient. It’s still not zero debt, because even super-strong companies like Berkshire Hathaway and Proctor and Gamble keep about 15-25% debt to asset values.

    So maybe there’s a happy medium to this debate somewhere in those examples. Thanks again for the thought provoking post, Ali!

    • Thanks for the detailed thoughts Chad. Those are all great things for everyone to think about. I think my confusion though is, how is any of what you mention as potential bad things happening any more risky to a leveraged property than a paid-off property? The only different is the leveraged person still needs to make the mortgage payment every month, but that’s the only difference, no? With your examples of mega repairs and such, I assume you say those in terms of the owner not being able to pay for them. It’s just as possible an owner of a paid-off property can’t pay for them either, so what happens then? They don’t lose the house of course, but then they can’t get tenants either if the repairs can’t be fixed. Then they have an empty house that they are paying taxes on.

      I do absolutely see that the biggest risk with a leveraged investor is that they can still lose the house and the paid-off investor doesn’t have to (unless of course they stop paying taxes, which is possible too).

      I do agree that leveraged investors did lose out much more than any free-and-clear investors during the crash. However, that is most definitely due to people being stupid with leveraging. Even outside of investors, how often was it in the news about all of the primary homeowners losing their houses because of their absurd 100% financing and no smarts or income to back up needing to make the payments.

      I think more of the debate is the different between being smart and stupid. Leveraging is perfectly safe if done smartly and the owner doesn’t over-leverage himself and keeps reserves. There’s just a bigger margin for a free-and-clear owner to be stupid and get away with it. Plus, the free-and-clear owners will never own as many properties as the leveraged ones, so depending on your personal goals for investing you may not have the option to stay free-and-clear all the time. I know I don’t. Besides, to me, dumping $100k of my own money into one property is far riskier than dumping $100k of my own money into 4-5 properties because if one property tanks, I still have 3-4 to pay the hurt and I’m fine. If that 1 I am free-and-clear on goes bunk, I’m out my entire investment. No thank you.

      • Ali,
        Thanks for reply and thoughts.

        I still think the bad things I mentioned (multiple big repair/capital expenses and/or vacancies in one short period) are definitely more risky on a leveraged property than on an unleveraged property. Here is my reasoning:

        1. The issue with multiple big expenditures only becomes an issue when it exceeds your reserves. If both investors (leverage/free and clear) have same reserves, then they both have to get this extra money from somewhere else. Where from?

        If the free and clear investor didn’t have the funds, he/she could borrow the money with a first position lender. Pretty easy to borrow, pretty easy to pay back since the amount wouldn’t be overwhelming and would probably be lower interest rate. This investor could also dip into some other reserve/emergency funds, if available, and the high cash flow of the property would pay it back quickly.

        The leveraged investor? The money will likely be put on a credit card or in 2nd position or from a loan shark. All of these are bad interest rates, and the smaller amount of cash flow on the properties would be eaten up. So then if anything else bad subsequently happens (on the properties, or just in the investor’s life) this already strapped investor will have VERY little wiggle room. This is called digging yourself a whole that’s hard to get out of.
        – A vacant house with a leveraged investor creates negative cash flow, but with a free and clear investor it just lowers the return. The first is dangerous, the second is unpleasant and can be lived with. I’d say vacancy for the 2nd is less risky.

        In the end, though, I agree with you Ali that leverage done right is a smart move. And yeah, most people who lose big with leverage did stupid things. If everyone reads your blogs and learns the way to leverage CORRECTLY, we’ll have no more problems there:)

        Final question. You mentioned real estate goals in last reply. Just out of curiosity, do you see yourself owning properties free and clear at some point? If so, what is the “enough” goal for you? I think that’s an underlying question behind these debates, because a big advantage of leverage is getting us to some end game.

        Happy investing.

        • When people say that leveraging is more risky because of multiple big repairs at once or multiple vacancies at once or whatever all at once, these are very, very rare and doomsday situations. By far the most important aspect of rental property is management and if managed correctly, you have almost 0 chance of this happening. There’s an element of risk to everything, you can get hit by a bus walking out your front door, but we manage ourselves to not walk in front of moving buses. I disagree with the view that a vacant house with a loan creates negative cash flow and a paid off vacant house just lowers ROI. A vacant paid off house is negative cash flow because of taxes, insurance, marketing for a new tenant, bookkeeping, management, lawn care, security system, utilities, etc, etc. The loan payment is only one line item out of about 10 in your ROI calculations. We can “what if” all day. “What if” that free and clear investor can’t qualify for an equity line to make that major repair? Major repairs are gonna happen, vacancy is gonna happen. We have to plan for it leveraged or not. You must have a good reserve. I personally have a $10k reserve at all times (in the business account) and have 13 properties. I know, it’s a little thin but I do have some personal cash reserves and a bunch of credit. I’m also very, very assertive with preventative maintenance and tenant retention. Anyway, good conversation.

        • Thanks for the detailed response Chad! Good things to think about. My only counter to that though is that I don’t really see much of a different still between the leveraged investor and the free and clear. You are only assuming the leveraged investor can’t get the same loans as the free and clear one and I’m not sure that is an accurate assumption. But more so, you mention the leveraged investor creating negative cash flow but it just being a lower return for the free and clear investor. I don’t think that is correct. if you were to calculate the cash-on-cash returns of both in that scenario, the free and clear investor would very much be negative because of his big initial investment.

          What people forget about is that while it looks like a leveraged investor is losing money because they are paying out mortgage payments every month, everyone forgets that the free and clear investor already paid out that same money (less interest, but that is small coin for the purpose of the point being made). The free and clear investor spent his $100k when he bought the house, whereas the leveraged investor spends his $100k (interest still not part of the point right now) over the course of time. So I don’t think it’s true that the leveraged investor is losing, they are still paying out less out of pocket than the free and clear investor.

          The leveraged investor spends $20k for a property. The free and clear investor spends $100k for a property. Something drastic happens and the property is vacant for 8-10 months plus major repairs. Let’s say that equates to $12k in expenses. Now the leveraged investor is out $32k total (ballpark of mortgage payments and repairs). Isn’t that still significantly less than the one who spent $100k? To me it’s still a no-brainer.

          To answer your question, no I don’t see me owning free and clear investment properties. The only one I see me owning free and clear is the one I live in because that’s the only one that will cost me a ton if leveraged.

        • I totally agree Geoff. I hadn’t read your response when I just typed my last one but I was mentioning just what you did… I don’t think a leveraged investor is any more in the hole than a free and clear investor, and in fact I think they remain less in the hole. The only danger, which goes for either leveraged or free and clear and is no different between them, is to have reserves for emergencies. And to that effect, you’re right…if we play out drastic what-ifs all day, life won’t be that much fun. I think that the what-ifs should definitely be considered initially when budgeting for buying a property and reserves but that’s it.

          Great comment Geoff. In total agreement. And congrats on your 13 properties!

        • It is impossible to argue if it hits the fan that the leveraged investor has more risk and more expenses to overcome then the non leveraged investor.
          If there is some major repair needed that makes the place uninhabitable (so no rent until it is fixed) and neither investor has the cash on hand or is able to get some other loan (Even though the free and clear investor should have more equity to tap into and a better DTI usually) for the money then they are both SOL until they can save the money needed.
          On this $100K house the leveraged investor needs to pay the same things that the other one does plus with a $80K loan at 5% fixed they pay a $429.46 PI payment every month. If things got totally desperate the free and clear investor can even cancel their insurance, which is a horrible idea but is possible. Not so if you have a loan.
          Maybe that payment isn’t anything that the leveraged investor can’t handle but maybe with no income from the property it is a burden at best and unsustainable for any length of time at worst.
          Now that being said I would never buy a property for $100K cash if I could get a loan on it (well at least not until I had 8 figures ideal in the bank), but it isn’t because there is no risk it is because I understand the risk and am willing to accept it.

          BTW not sure how the interest on the loan is “small coin”.
          On that hypothetical $80K loan at 5% for 30 years you will pay over $74.6K in interest on it. Your payments are 75-80% interest the first couple of years and will be a majority interest for the first ~16.5 years.

        • Geoff,
          ​I get your point about line items, but not all line items are created equal. Consequence of not paying bookkeeping, management, security system, etc are clearly not the same as a mortgage. Even taxes and insurance aren’t as urgent, and they don’t have to be paid monthly. The mortgage is one payment that can not be delayed without serious consequence fairly quickly. A free and clear owner has much more flexibility in tough situations, and that is the heart of the increased risk for leveraged investor.

          This might have never happened to you (or me) but it is not a rare what-if or doomsday scenario. It just happened to a lot of investors, builders, and big Fortune 500 companies a few years ago. And for every investor who went out of business, there were probably 10 who became very unproductive and stressed treading water and “working it out”. What about that opportunity cost?

          Where I would agree, Geoff, is that our entrepreneurship and management skills ARE our biggest risk reducer. Learning and improving these are much more important to worry about than free and clear vs leveraged.

          But that is also a big part of my caution for newbies reading “leverage is less risky.” For people who aren’t as skilled yet or who only remember the headline and not all of Ali’s leverage safety rules (which are great) they clearly do have less room for error when challenges come with big mortgages payments.

          Ali, I would agree with the less money out of pocket argument except that the other 80k is also spent on other properties. So leveraged investor has spent just as much cash as a free and clear investor, and also now has 4 more mortgages, hvac, roofs, etc. Your 32k would need to be multiplied a couple times, and now leveraged investor has spent a lot of cash.

          Rare or not, leverage magnifies the bad times just like it magnifies the good. That increases risk.

  31. Chad, I think you speak wisely.
    As for my journey, I think some of you may know that it has been tracking this blog and associated comments pretty closely – in a neat coincidence! I just got preapproved yesterday for a loan that will buy a median priced SFD locally. If I were to rate my confidence in this move, overall I would give it 90%. It will probably be one of ten leveraged properties that will ideally go more or less smoothly and set my wife and me up for a good retirement in 25 years. I think the confidence level could be as low as 50-60, but we got it up to 90 by a couple methods – nothing is a fail-safe, but it all adds up to a decent bet. We are putting down a full 40%, because according to my projections, in order to stay on top of maintenance and such (at the 60% profit/40% expense level) that is how much we need to put down in order to cash flow at the $200+ per month rate. Ideally vacancies and new HVACs will only eat that away every other year or once every four years. It’s basically a gambit to stay ahead of expenses, raise rents appropriately, keep the place in excellent shape as it ages, do the management and some of the maintenance myself – all for the purposes of providing a family a great place to live, and having a good chance of appreciation. According to the projection, appreciation is better than debt paydown and positive cash flow. I probably wouldn’t do so much heavy lifting and take a 10% risk if appreciation weren’t very likely to surely happen. Based on what I know of Charleston, and of my ability to find and assess a house (I’m a home inspector/former Realtor) and predict maintenance issues, there is a better than average chance of seeing 2-5% appreciation on average over the next 30 years. That averages out to about 8% compounded interest equivalency in the return. The cumulative cash on cash return is like 800%. So it is crucial that the place appreciate and that my leverage work. I could go as low as 20% leverage to get CCoCReturns of more like 1000%, but that puts the cash flow into the yellow alert category if you ask me. But by the same token, 100% cash seems a little unwise, considering that I want to use leverage to have a couple million in retirement dollars and beat the pants off inflation. So 40% down at about 5% interest for 30 years with no prepayment penalty is our strategy. It won’t be easy, but neither would being an attorney or a janitor…
    One caveat: I got into it pretty good with my mortgage lender about recourse. I must have kind of misread the blog along the way and erroneously believed that he would put two contracts on the table – one reading “Recourse” and the other “Non-Recourse,” as though it were a smorgasboard. I was incorrect in that assumption. He was getting a little pissed at me in fact, and was a bit worried that I would be so intent on querying him about how to not have a recourse loan. I basically found out that it’s not going to happen in this State at this time for this kind of loan. OK, lesson learned. I wiped the egg of my face and will proceed. I would like to be up to 100% confident in the success of this piece of leverage, but I can live with 90% because the CCoCReturn is so strong – even at 40% down. And as I said, a little safer. I could probably sell the property the next year if need be. If things appreciate here I am only going to get further and further away from 0. And if you keep six months of mortgage payments in stocks or in the bank, I don’t think you have much risk. But I do want to say that I have soured to leverage a bit having realized that leverage is not possible for me except with recourse. There is a theoretical chance of a deficiency judgment that could force the sale of some other asset. So I think we need to be clear about that as a possibility when talking about the low risk of using leverage. If you factor in opportunity costs, leverage is what my wife and I are going to do, but recourse is the scariest part of the scenario, and I think it extends a bit beyond just a ding on the credit score. It’s a real threat, but I think it is minimal enough in this scenario to proceed.

  32. This is out of order but I ran out of “reply” options on that one chain….

    Shaun, sorry I didn’t clarify… I didn’t mean small coin for the life of the loan, I meant it for the however many months the payment has to come out of pocket and more in terms of it as it was relative to my point. Sorry didn’t make that one very clear…

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