Investing Using Financing: Solid Idea or Imminent Disaster?

Investing in real estate may not be as sexy as the stock market.

It is a long, grueling process that can take many years before one can realize its true returns. While the return on real estate may ultimately be quite rewarding given the length of time, one is tempted to want the returns now and want the returns high.

That is how I approached real estate investing in Las Vegas from 2012 to 2013. I sought higher returns once the real estate prices in Las Vegas rose, and I was no longer getting high yields in my returns. In the past, I was able to get 10-12% cash on cash returns on my real estate investments, but from 2012-2013 my returns began to fall.

Using Leverage to Earn Higher Returns

Then I began investing in real estate using seller financing. As a new real estate investor I was unable to get a regular mortgage, but I was still able to get loans between 5-7%. Using financing, I was able to achieve higher returns as long as what I paid out in mortgage each month was less than the cash flow I got from tenants.

For example, there is a house that costs $150,000, which after rental expenses can rent out for $900. If I were to buy it with cash, I would achieve a 7.2%.

But if I were to buy it with 20% down ($30,000 investment) with a 5% fixed 30-year mortgage, I would have to pay $644 in mortgage, thereby netting $255 a month, $3,069 a year. If I earn $3,069 a year on a $30,000 investment, I am actually getting a 10.23% investment.

I also set myself up a greater return in future appreciation. If the house were to go up $30,000, I would have doubled my investment return, whereas if I had bought it cash my investment would have only gone up by 20% in value.

The Dangerous Side of Financing

While it almost sounds like we should all leverage our returns whenever possible, getting financing still creates risk for an investor.

Whenever there is a vacancy, a cash buyer only has to worry about paying property taxes and insurance, a small expense. However, with financing in place, the investor has to pay out $644 in principal and interest every month until a new renter comes in.

If the investor does not have a large cash reserve, he or she is bound to get into real trouble. Keep in mind, a $644 payment every month is about 2.15% of the investor’s initial investment. When you think of it this way, an investor can be taking a lot of risk with financing.

Creating a Healthy Mixture of Both

I generally prefer to have a mix of both free and clear homes and seller financed homes. As my portfolio grows larger, I am leaning towards owning more free and clear homes. Another side effect of leverage is that the more financed homes I own, the greater the chance is that multiple homes can go vacant at once.

The long tail risk of such an event, while small, can still cause a devastating loss to my reserves and portfolio. So the next time you consider using financing to leverage your investment, understand that you have to prepare for that rainy day, which inevitably will always come.

Do you use financing to leverage your real estate investments?

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Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.