A more conservative path to REI?
Old Hickory, TN · Member since 2012 · 31 posts · 6 votes
All,
I'm a young guy who hopes to get started investing in the next couple of years. My mindset (and my wife's) has always been to avoid debt like the plague. This of course creates a conflict when trying to use other people's (bank's) money to finance a deal.
How many of the pros out there have a similar, no-debt approach? Thoughts? To those who do see, and use, the benefits of leverage, where is the sweet spot where you are making good return without being over-leveraged?
Thanks!
Daniel Walker You sound like a fan of Dave Ramsey. I too am anti debt. However, I would have never been able to buy this many houses without some debt.
You could grow your business slowly by paying cash for your properties. While I avoid car payments and credit cards, I'm ok with debt on real estate since it (hopefully) goes up in value. I would never finance anything else.
Hi Daniel,
My natural leaning is also to avoid debt. I think that the folks that discussed good vs. bad debt gave some really good advice. That has been the transition in my thinking: from debt=bad, to considering it on a case by case basis, and crunching the numbers.
Is this comparision accurate?
Kind of, but as you said, it does depend very much on the purchase and rental prices. Suppose, you take a property with a fairly low margin - let's say a SFH that you can purchase for 100K, that will rent for 1200/month.
All cash:
Purchase Price: 100k
Gross Rent: 1,200/mo = 14400/year
Expenses = 7200/year (50% rule)
Cash Flow = 7200/year
Return on Investment: 7.2%
Financed:
Purchase Price: 100k
Cash down: 25k
Amount Financed: 75k 30 years @ 4.5%
Gross Rent: 1,200/mo = 14400/year
Expenses = 7200/year
Net Operating Income = 7200/year
Debt Service = 507/month = 6084/year
Cash Flow = 1116/year
Cash on Cash Return= 4.46%
Mortgage Paydown (1st year) = 1613
Total Return (1st year) = 2729
Return on Investment = 10.9%
So in this case, you have to consider the mortgage paydown before the leveraged property outperforms the all cash property. Although the mortgage paydown is a real part of your return, you obviously have to wait for quite a while before you see the benefits of it. Though if one's plan where to acquire some leveraged properties, and then pay them off early, then it becomes a bigger factor.
One thing worth noting is that in the example above, the cash buyer is not able to use his cash as an advantage at purchase time. He still has to compete with the buyers using leverage. So, here's a third scenario. Suppose a similar property was in really bad shape, and needed lots of work. Now the cash buyer is able to use his cash as an advantage. The leveraged buyers drop out of the market, since they can't get a loan on a property with these problems. Less potential buyers=less demand=better deal. Suppose, the property could be had for 40k, but required 25k of rehab to get it to the point where it could be rented for 1200/month:
Purchase Price: 40k
Rehab: 25k
Gross Rent: 1,200/mo = 14400/year
Expenses = 7200/year
Cash Flow = 7200/year
Return on Investment: 11.1%
This all changes when the margin on the property changes. For example, if instead of buying a SFH for 100k that rented for 1200/month, you bought a duplex for 100k that rented for 1500/month. Everything changes. The cash purchase yields 9%, the leveraged 11.7% (18.1% including mortgage paydown), and the rehab and rent scenario 13.8%. Basically, assuming 75% LTV, then every additional dollar earned by a leveraged property increases the return by four times the amount it would on an all cash property.
Another factor that affects the leveraged vs all-cash equation is taxes. If a person bought 4 leveraged properties as opposed to one property with all cash, then they would have 4 times the depreciation to reduce their taxable income with.
Hope this helps!
-Harry
One thing to note is that yes leverage certainly amplifies your return but it works both ways. If you put 10% down and the value of your property drops 10% you just had a 100% loss. If that happens you can then be locked into a property even if you expect values to continue to drop. Lots of people we caught by that on the last downturn. If you pay cash or put a decent down payment you have the choice to liquidate if you feel it is necessary. That would have been a good option for a lot of people in 2008 when the market was turning.
On the other hand paying cash can make you a target of lawsuits from unscrupulous people who see deep pockets.
This is a great thread!
I'm with you on taking the conservative track. My wife and I decided to buy our first rental last year. We are about to move into a new home and turn our current house into our second rental.
I read a while back you can afford a house that costs 2.5x your gross income. We decided that the conservative thing to do was to only have mortgages out that were less than 2.5x our gross income. That way if something went wrong we were not in a bind and could afford to pay the mortgages without any problems. After we move, it works out that our 3 houses will be around 2x our gross income.
All extra income and profits are/will be going towards paying off the highest interest rental property. Once its paid off we will buy another. Keeping with the same principle of keeping our total mortgages less than 2.5x.
It will take more time but that is alright. Rentals for us are retirement income and eventually for our kids. It will start to snowball after we pay off the first and second.
I think it just comes down to how much risk you are comfortable with taking.