The other day, I ran across this article: “Case Study: How to Replace a $70,000 Job Income Using Rentals (for the Math-Averse!).” I don’t know why, but the article hit a nerve with me since it implies you need to be debt-free to hit financial independence. I’m going to offer you a different perspective based upon my personal experience. It involves taking on debt, grit, and Dave Ramsey. Now, just in case you are saying to yourself, “Who is this dude giving me advice,” let me offer some background. I started with a beat up-vacant-triplex in 1998 and slowly parlayed that first property into more than 100 units today. The property looked so bad, it made my girlfriend cry. My entire story is featured in the BiggerPockets Podcast Show 86. I’m still buying (based upon my initial goal of buying one cash flowing property a year) until my kids enter college. For instance, I just closed a 11-unit this month. Classic value play. Took me 10 years to buy it since the darn seller kept telling me it wasn’t for sale. Suddenly, it was for sale in October, and he had to close by the end of the year. Go figure. So don’t send me hate messages. I’m no late night “something for nothing” guru and wish to establish some credibility. Oh, Allison, Managing Editor at BiggerPockets, suggested I elaborate on the comments that I made in the thread. Send hate mail to her instead. [Editor’s Note: Don’t even think about it! I’ve set my spam filters to weed out hate mail. 😉 Only send me messages with puppy gifs (or genius real estate content ideas, of course).] My entire portfolio is built on debt — that nasty four letter word that makes the Dave Ramsey congregation hiss. Related: What is a Debt-to-Income Ratio (DTI) and How is it Calculated? I never made more than $50,000 a year after tax when I started in real estate. I had to ninja my way to wealth through leverage, seller carry backs, and equity repositioning. If I followed The Gospel According to Dave, I’d be debt-free after selling my first triplex in order to pay off more than $40,000 in credit card and auto loan debt acquired as a result of a carefree youth. Instead, I tax-free exchanged that deal into two more duplexes. Let’s be clear. Dave Ramsey is awesome at getting you out of financial trouble. Just be careful when he tells you to pay cash for real estate or sell your rental in order to complete his 7-step program. One More Thing… Why would you take advice from a failed real estate investor whose only advice to a new real estate investor is always pay cash? Umm, not all people have the means to pay cash for properties like Dave. We don’t know all the details. From what I can gather, Dave Ramsey had a multi-million dollar margin call on his $4M real estate portfolio, and the rest was history. Now he is deca-millionaire celebrity who brags he only pays cash for real estate. The classic riches-to-rags-to riches hero’s journey. Was the debt the problem? Or was the person taking on the debt and the structure of the debt a problem? Just a thought. All I know is debt, used wisely, is a nice four letter word. It is a tool that allows you to amplify your wealth. In my case, it allowed me to pay off all my credit card debt when I started my real estate journey along with building multiple streams of income in the form of rental units. I had two pieces of debt with Countrywide Financial. I had a big piece of debt with Lehman Brothers. The banks got foreclosed on, and my loans were sold while the properties that held the loans continued to cash flow after debt service, even when the values dropped below appraised value. Today, Bank of America owns the first two, and US Bank took the latter before I refinanced it into better rate and term with a friendly local bank. During this same real estate collapse (the ultimate test for my debt strategy), none of the banks would loan me money. At the time, I had 64 units and continued to cash flow due to the fixed/non callable debt structure. I was annoyed. Here I am cash flowing $200 a month here, $300 a month there, with all these units carrying great debt — yet no banker would loan me a dime. All the people who took on too much bad debt wanted to rent from me after losing their homes. But I couldn’t buy any more properties since the bankers were hiding under their desks. If debt is such a bad thing, why do you think I wanted to take on even more good debt during the worst real estate collapse in our lifetime? From what I can gather, the point of Erion’s post is “no debt” is smart and the fastest way to replace $70,000 in wages is to own 10 free and clear properties. I’d like to offer a counterpoint. Related: The Dave Ramsey Dilemma: Should Real Estate Investors Really Avoid Using Debt? Let’s Call It the Smartest Leverage Strategy If you are employing the smartest leverage strategy, you will never let your loan to value exceed 70% based upon a conservative appraisal. Sure, the loan-to-value will be higher when you initially purchase the property. But you never pay retail for a property if you are buying correctly. Here’s all you need to know. You can buy a property today at a 80% loan-to-value and then push the value up so it is worth more within a year, and henceforth, it sits at a 70% loan-to-value with some advanced ninja investor techniques. Ideally, if purchased and managed correctly, your mortgage payments will be paid by your rockstar tenants who, in turn, bring your loan-to-value ratio down to 50% or so in 10 years. You don’t do this by paying extra on the mortgage. Nope. You want the excess cash from all your hard work managing your portfolio to enhance your lifestyle and cash reserves today. This makes investing fun. Or, if you are a freak like me, you take the excess cash to buy even more cash flow. The ideal scenario is to let the power of rising rents, coupled with debt outsourcing to tenants, replace your fixed living expenses in 10 years or less. Buy and hold cash flowing real estate is the IDEAL investment. I stands for income in your pocket after all expenses, including mortgage. D is for depreciation — the greatest tax benefit ever created. This is the only write-off where you don’t have to spend money to get a deduction. E is for equity capture as your tenants pay down your mortgage while you create even more equity via value add or buying below market. A is for appreciation. I’m in a slow growth linear market, so it is not something I focus on. Historically, appreciation has run the same as inflation per Robert Schiller’s extensive research. L is for leverage. For 20% down, you control 100% of all the benefits of real estate. If you pay cash, you lose this wonderful tool and tie up all your money in one single transaction. The smartest leverage strategy requires debt. Yet, if your loan to value is 70% or less, I would venture to guess it is pretty hard to get into trouble — especially if your debt coverage ratio (DCR) is 1.25 or higher. What is DCR? It is the amount of income after all expenses that can cover your mortgage. Since your net operating income (NOI) already reflects the taxes and insurance on your property, you do not use the PITI to calculate this. Remember, PITI is principal, interest, taxes, and insurance. DCR is the following: NOI ÷ Mortgage Payment Want more articles like this? Create an account today to get BiggerPocket's best blog articles delivered to your inbox Sign up for free In Erion’s article, the investor with the mortgage received $600 per month in NOI. Divide this by the mortgage payment of $430, and the DCR is 1.43. In other words, 143% of the mortgage is covered from the monthly cash flow. That is one fat DCR. Most business bankers want a minimum of 1.2 to 1.25. The number one caveat with the smartest leverage strategy is you better know what you are doing AND know how to properly run a rental portfolio OR know how to manage the property manager. Now, let’s use the smartest leverage strategy to replace your $70,000 salary since this is the part of the article that caught my attention in the first place. Most people think you need more properties to acquire more income. I believe you need to view this in terms of units instead of properties. In Other Words, Quit Focusing on Properties! Every unit you purchase becomes a unique piece of cash flow that helps you diversify your income stream and service the debt. Got a 4-unit? You have four pieces of cash flow. This is four times safer than owning a single family, where you only have one source of cash flow. Next, replacing $70,000 in W-2 or 1099 income is actually about $50,000 per year after all Federal and State taxes plus FICA and Medicare. For 1099 income, you need even less due to extra self-employment tax. This assumes you are single with no dependents, reside in my high tax state, and don’t contribute to your retirement plan. So let’s reframe this to requiring $50,000 a year in take home pay, or $4,166 per month. You could easily cover this by focusing on small multifamily deals in the 4-15 unit range, where each unit provides $150 a month minimum. I shoot for $200 per unit. So, let’s be conservative. Now, all you need is 27 units. Doesn’t this sound better than the 34-35 properties that Erion mentions? There are countless ways to do this — 14 duplexes, 7 four-plexes, you get the idea. Structured correctly, your real estate income will be tax-free due to the interest expense, deprecation strategies, and treating your real estate venture as a business, where you are classified as a real estate professional under IRS guidelines. By the way, you better have the right CPA for this to work since the difference between tax optimization and avoidance is about 10 years in prison. As you embark on the smartest leverage strategy, you want to focus on 5+ unit properties with commercial loans that amortize over 20 years and the interest rate is fixed for a minimum of 5 years. Most business bankers will require at least 20% down and want to see a DCR of 1.2 or higher, as I mentioned previously. Some bankers may want 25-30% down. It definitely pays to shop your deal. Moreover, if you have no experience managing rentals, they may require you to hire a professional property manger and/or a partner and a LLC. This not only protects Mr. Banker; it protects you. Keep in mind, in the 5-unit+ multifamily space, the banker loans on the property and the cash flow. Not you. This is a critical point compared to single family rentals. If the deal does not make sense, you won’t get approved and you will be forced to find the right deal that fits the banks parameters. As you get better at this, you can refine your search for deals where the banker is almost begging you for more deals. Again, Mr. Banker loans you money on the property and the cash flow. Not you. Afterwards, he looks at your balance sheet, annual income, and credit score. This is why it makes sense to keep your day job, 401k and IRA, while maintaining decent credit. I always cringe when people cash out their 401k or IRA to raise money. It makes it harder to qualify in the long run if you wish to build a portfolio of more than 10 units. Once you have replaced your take home pay with all these units using the smartest leverage strategy, guess what? Your loans balances are paid down considerably. Related: Used Wisely, Debt Can Absolutely Produce Wealth: Here’s How Remember those 20-year commercial loans? The balances have easily dropped by almost 40% in 10 years. You could refinance those loans for even a lower payment (due to the reduction in principal) and give yourself a nice raise for all the trouble, or you could reposition the equity for more units and even more cash flow. Note how I didn’t even factor in appreciation. If you get lucky and push the appreciation needle higher via value plays, the loan-to-value could be less than 50% after 10 years. The Smartest Leverage Strategy is Not for Everyone If you are debt averse, then go ahead and follow Erion’s plan. It is a solid strategy. Both of these scenarios allow you to achieve a million-dollar net worth and replace your earnings in 10 years or so. I haven’t run the numbers, but feel it would take longer to replace your take-home pay under the debt-free strategy since you are paying off about $800,000 in mortgages and all the excess cash flow is being plowed back into the mortgages. Feel free to correct me if I’m wrong. The debt-free strategy reminds me of the path followed by the Dave Ramsey sect. You live on rice and beans and drive a beater car as you beat down the mortgage debt on your rental portfolio. You are forced to keep your job as long as you have the mortgages and focus on the day where you can scream “I own 10 homes debt-free!” Under this exact same scenario, I could obtain $1M in equity in my market by slowly building up a $3M portfolio under the smartest leverage plan. This equates to 50 units or more, where the loan-to-value runs about 66%. You could improve your standard of living each and every year as long as you still live below your means. Save the extravagances for later when your real estate cash flow more than exceeds your pre-tax salary. Plus, the appreciation and tax benefits are three times higher, as well as the inflation induced rental income gains. Imagine 50+ tenants working hard to pay off your $2M in mortgages because you are willing to offer them the best product at the best price. A true win-win. Best of all, you get to spend the excess cash flow today while keeping your day job. Picture what a few extra thousand dollars a month of ta- free rental income would do to your life assuming you were able to pick up 10 or more units over the next five years. Can you say renting a beach-front million-dollar villa in Mexico for a week in the dead of winter like I do each year? Beans and rice taste way better on the Mexican Rivera. [Editor’s Note: We are republishing this article for the benefit of our newer members.] What do you think? Is it better to own 50 units with reasonable leverage or 10 units free and clear? Let’s discuss below!