Debt free rental properties
Knoxville, TN · Member since 2013 · 29 posts · 2 votes
I currently own one rental property and planning one more by the end of year for cash. What are the advantages and disadvantages of doing this as opposed to financing.
Simplest answer, You are trading higher returns on investment for more risk.
David,
Do you know that a mortgage interest write off is still a loss to you? You are just not paying tax on an expense (i.e. Interest) just as you are not going to pay tax on the expense of mowing grass on your rental.
Using your statement, should I mow my properties more often for the tax write off?
Writing off the interest deduction doesn't requires any effort. Why would you want to pay taxes when the write off is available?
I have set up a credit line using the equity in my properties to allow me to make "cash offers." This allows me to get the best deals. Once the purchase is complete, I then take out a loan. Interest rates are so low I would rather have the cash on hand.
I think it depends on personal goals and situation. For the record, I am a debt guy who has bought with financing and cash. IMO, buying cash is a good thing. Leaving cash in the property is a not so good thing in my personal situation. I refinance to get cash back out to support additional purchases. When you buy cash and leave your money in the property, your invested money gets old, wrinkled, fat, and extremely lazy. It is not working as hard for you from a CoC perspective. When you introduce cheap debt / good terms along with a good purchase, your money is on steroids all of sudden.
In my cash flow analysis, I figure the tax benefit as 1 part of determining if it is a good deal. If it's not part of your equation, you might be leaving many good deals behind.
There are a number of points being made regarding the market falling and being left with debt to pay. I would suggest that before you buy any property you look at the position in the property cycle that the property is in. All investment markets operate in cycles, and property is no different. If you are buying at the bottom of a cycle then it would be a safe bet that the movement in that market would be upwards. If, however, you buy at the top of the market then chances are that any movement would be downwards.
If you are new to property investing I would suggest learning how to determine the current position in the property cycle your prospective purchase is in. By understanding the cycle you can effectively buy property when it is low, hold it till it increases in value, sell it and then buy another property in another market which is at the bottom of its cycle.
In my market in Australia the cycle tends to run between 7 and 8 years from point to point. One full cycle will take between 7 and 8 years on average. So, with this in mind if I buy at the bottom of a cycle, i.e. in an area that has been dropping for the past couple of years, I would be looking to on-sell in three to four years after purchase. By turning the property over in this way I can get a better return from my capital.
When making investment decisions you would be well advised to measure returns in relation to risk. This is called the risk reward ratio. When using debt to acquire assets such as property it allows you to improve the risk reward ratio on your capital investment. That is to say you can secure a higher rate of return on your cash investment amount if you gear the investment, provided you have analysed your risk reward ratio.
One other method of measuring the performance of an investment is known as the Internal rat of Return (IRR). This is a calculation based on the series of cash flows that the investment will return. Whilst this may seem a little complex for some I would suggest you consult with your accountant or financial adviser in regards to helping you assess the IRR of your potential deals and to help you understand risk reward ratios and real returns on capital. This is especially helpful when you are considering which of two or more deals you would put your cash into. Cash is usually a limited resource for many of us so looking at the best option in regards to yields, or returns on our money if you like, is the way to go.
If you do however choose to use debt to improve your cash on cash return then don't forget to have surplus funds available to cover all costs for an acceptable period of time should the property be vacant. My rule of thumb is that I will gear a property and retain a capital account with sufficient funds to cover all costs on the property for a period of 6 months should the property be vacant for any length of time.
This may all sound a little over the top, but investing your hard earned money, or that of other people deserves good advice and strong financial management. If you don't have these skills work with a good accountant or financial planner to help you set up good money management systems and habits. Simply paying all cash may be safe, but it may not always provide you with the nest return on your capital.
Happy investing and may all your deals be profitable!
I currently own one rental property and planning one more by the end of year for cash. What are the advantages and disadvantages of doing this as opposed to financing.
Buying with cash has one huge disadvantage - eventually you run out of it.
The only way to sustain it, and it's what we do, is earn a lot of money outside RE that pays for new houses.
The deals we like these days are good old owner financed. Run the numbers so it's a 4 year note (you'll make next to nothing, maybe even a small loss each month), but you want that note paid off as quickly as you can.
We have one couple in a owner financed house, there rent has paid for half the house, they were thinking of moving recently - guess what - we stopped that in it's tracks by offering a third year lease with lower rent. We will 'lose' $600 over the year because of this, but the house will be 1 year closer to being paid off. (Plus if they move, then we'll lose 1 month of rent on the property as we turn it over, which is $600-800. So either way, I'm not really losing anything). But these nice people have nearly bought me the house. Which is very nice of them.
@Ned Carey - chime in on this...
The answer is super multi-prong, with a lot of caveats. Not the least of which are your risk-tolerance and economic cycle in life. I will not give you the answer - that's for you to rationalize. But, here are a few thoughts:
Wealth in RE happens over a long period of time through a process of leveraging (bridging) of appreciating assets. The key to this process is "appreciating assets" - that's thought #1.
Thought #2 - are you at more risk by paying all cash, or with leverage. Intuitively, people think that not having a mortgage payment is safer. But, can you also look at paying all cash as putting all of your eggs in one basket? How does that make you feel?
Thought #3 - one of the necessary elements in a fiat banking system is velocity of capital. The faster money moves, the higher the delta you can achieve. Sitting money is sitting duck - how does that make you feel?
Thought #4 - Would you rather buy cash flow, or would you rather create it? Same can be said for equity?
Well - that's enough to get going. Notice - I did not mention returns at all; we haven't gotten to that :) But, there is not a single measure of investment return that would dictate cash purchase. I am not saying that this is a reason you shouldn't do it - your motivations may be something other that investment returns. But, there it is...
Thoughts, @William Chrisman ?
@Jai Reddy @David Cooper A mortgage interest tax deduction example. Assumptions: 25% marginal tax rate; $10,000 annual interest expense. Tax savings = $2,500. You are sending the bank $10,000 to keep from sending the gov't $2500. Yes, take the deduction if you have already borrowed. Of course! You could send me $10,000 and I will give you $2500 back, too :) Do not borrow solely in the name of sophisticated tax savings! There is no such thing as a 100% marginal tax rate (yet!). Hope this helps.
There is risk vs return relationship.Cash only is less use financial leverage,hence no magnified returns however in a softening market with increasing vacancies, you sleep better when you own the SFR free and clear
@Jai Reddy @David Cooper A mortgage interest tax deduction example. Assumptions: 25% marginal tax rate; $10,000 annual interest expense. Tax savings = $2,500. You are sending the bank $10,000 to keep from sending the gov't $2500. Yes, take the deduction if you have already borrowed. Of course! You could send me $10,000 and I will give you $2500 back, too :) Do not borrow solely in the name of sophisticated tax savings! There is no such thing as a 100% marginal tax rate (yet!). Hope this helps.
very well put! You lose money when you have debt just to avoid taxes. Dont look at the tax savubgs, look at The money going into your pocket.
Some observations for someone who has always had to pay cash.
The need to service debt affects the way you run your business. You are that much more eager to fill the rental and that much more likely to take chances with your tenant screening process.
You are also that much more likely to nickel and dime your contractors, skimp on or delay upgrades you should make, mismanage a landlord/tenant situation or ***** about your property manager keeping late fees instead of you.
By all means borrow - I would draw the line at leverage because that means that the value of the assets you are controlling are beyond your means, which means if anything goes wrong you will not be in control of the situation.
So yes borrow, but my rule of thumb would be to ensure that your monthly repayments could still be comfortably made if you lost half your rental income overnight.
There's some great discussion in this thread. I'm grateful for the dialogue as I'm really considering my next steps. Either pay down existing debt or get MORE debt and buy another property. The tax write-off math doesn't add up over the long haul because, as one post said, you're paying $10,000 to save $2,500. However, some debt seems to make sense. For example: If you leverage modestly (50/50) you can buy more property with fairly reduced risk to absorb market changes or other factors. So, at the end of the long haul you've had renters pay for more properties. 1 property with no debt means cash flow. 5 properties with SOME debt means cash flow plus bigger equity over the long haul. Of course there are more headaches with more properties but you're also not putting all your eggs in one basket. One fire or natural disaster won't wipe out your entire income/potential. My formula seems to be:
Low debt (50/50?) - It is called a balance sheet after all
Multiple properties in multiple locations
Slow and steady to build the portfolio
Don't be afraid to trade out of a loser
Most folks have covered this matter great. Currently the interest rates are so low, I do not see not using credit. Most of my purchases are under the min. amount for a loan or in need of a rehab, so I buy for cash, refinance them to get cash out, then go find the next property.
Having a good cash reserve is king, but do not let these low interest rates get away. Lock up the money while you can. I still remember a 12.5% loan for my home in the 80s. I bought my first rental at 15%.
If you fall in love with cash only investing be prepared to lower your goals and increase your wait times. Leveraging and the associated tax benefits are the biggest reason real estate appeals to people. Its like getting the casino to back your play or borrowing money from Morgan Stanley to invest in Morgan Stanley.