My First Time...

Once I started buying rentals I knew I was hooked. There's a certain bit of empowerment that comes with being a landlord. The feeling that someone else looks to you to provide something for them and that they are accountable to you. But before all that could happen I had to close my first deal and I had to make my first big decision: finance or pay cash.

When I got out of the stock market I had lost a considerable amount of money but still had about 55K left. This amount ended up being exactly what I needed to buy my first unit, a 2 bed / 1.5 bath with existing long-term tenants. When you have cash you have power. You have power to close quickly (tomorrow if you wanted to because, hey, you don't have to ask anyone for a loan!). You don't have to get insurance on the unit (although it would be extremely unwise not to), you don't have to have it inspected (again, it's definitely worth the little bit of money to do it), and since you don't have a mortgage with escrow payments you can invest the money that would have been taken out every month for property taxes.

Plus, it's kind of cool writing a $55,000 check. Ever done it? Makes you feel big time...until you realize that you've just made a huge mistake.

Looking back I should have known better. After all, I'm a finance major and I've got a pretty good grasp of many complicated financial concepts, let alone simple ones like the concept of leveraging. This is a word we see thrown around a lot, leveraging. But what exactly is that?

Leveraging, simply put, is using someone else's money. Typically this is a loan and it comes in many different flavors. Most commonly we get loans from banks and use their money. There are also hard money lenders, personal loans from family and friends, money from other investors, and some other ways too. No matter how you look at it the common denominator is that you're using someone else's money along with a smaller portion of yours.

So, if I could go back in time and do it all over again, what would I have done differently? Leverage, of course!

I had $55k and I also had great credit, even after the '07-'09 meltdown. Using my creditworthiness to my advantage I could have gotten a plain ol' conventional loan with a 75% loan to value ratio (LTV). Basically, I would have had to put down 25% down on anything I bought. So that $55k I had? I could have bought $55k x 4 = $220k worth of assets if I had taken out the loan.

In my market I can buy a lot with that kind of money. Since then I've bought several condos at $49k apiece. So, had I taken out a loan, I could have bought 4 units instead of 1! Of course I'd have had to pay a mortgage but I still would have made a LOT more money. Check it out...

Scenario 1 - Pay $55k cash for 1 unit

Mortgage (P&I) = 0

HOA dues = $145

Monthly taxes = $65

Monthly rent = $725

Insurance = 0 (covered by HOA)

Lawncare = (0 covered by HOA)

Total monthly profit = $515

Scenario 2 - Pay $55k down payment on  $$220k loan = $165k (20 yr fixed rate at 6.5%)

Mortgage = $1,230

HOA dues = $435

Monthly taxes = $260

Monthly rent = $2,900

Insurance = 0

Lawncare = 0

Total monthly profit = $975

Total 1 yr Return on Investment (ROI) scenario 1 = $515 x 12 = $6,180/$55,000=11.2%

Total 1 yr Return on Investment (ROI) scenario 2 = $975 x 12 = $11,700/$55,000=21.3%

Assumptions:

1. Closing costs are not factored in here for ease of calculation. But we would have had to add around $6k unless we got the seller to pay that for us (very doable in today's market)

2. I used a 20 year amortized note for this example because this is what I actually have. A 30 year note only shaves about $100 off the mortgage so that doesn't help us much anyway. For commercial properties I just expect that I'll have to pay 25% down and will get a 20 year term

3. I didn't assume vacancy or maintenance costs, again, for ease of calculation. For planning purposes I always assume at least 5% vacancy and 10% maintenance. However, for these scenarios I only want to illustrate the power of leveraging so these costs aren't important.

Considerations:

1. We see what HOA dues did to our ROI. Sure, lawncare, insurance, and water are included but that doesn't help me out, does it? My tenants love it but my returns suffer. Now I look for properties that don't have HOAs.

2. Risk is spread out. At first glance one would be tempted to think that having only one property afforded the least amount of risk. But in reality that is akin to putting all your eggs in one basket. You're either 100% getting paid or you're 100% not. Having more properties spreads that risk out, and the more units you have the better prepared you are to absorb vacancy costs or tenants who aren't paying.

3. Year to year the disparity between scenario 1 and scenario 2 profits would grow wider apart. Why? Because if we assume that rent is increased each year scenario 2 gets profits equal to four times the rent increase (because there are 4 units!)

4. Taxes! Without a mortgage I would still pay property taxes and claim the depreciation; but with the note I get to add a deduction for interest paid on the loan! Don't forget the value of your tax deductions--they add up big time!

So what have we learned? Well, for one, we typically want to leverage our money whenever we can. By doing so we gain control of more property, spread our risk, and make far more money over time. Eventually I took out a home equity loan on the property that I paid cash for to buy 4 more just like I described here and it's worked out great! As a side benefit, I've gotten pretty good at property management which is something the bank is interested in. They ask me every time how I intend to manage my property and the more units I successfully manage, the more credibility I have in their eyes. That just makes it easier for me to borrow more money later...and I'll need it to get to my magic number of 30 units!