What is missing from this list?

Question

I know a somewhat minimal amount of investing in RE thus far. I know only from reading a lot of content here, a couple of books, and a firm grasp of economics.

Nonetheless, I am trying to assess these two options. So please, weigh in:

Advantages of buying homes in cash:

1) More pull when it comes to sellers who need the money quickly.

2) Less risk, as properties are far less likely to not cash flow.

3) Less properties to manage in proportion to capital invested.

Advantages of buying homes with other people's money:

1) Potentially low start up costs

2) A better cash on cash return

3) The accumulation of Real Estate is quicker (for those with little cash)

4) A hedge against inflation.

So, which do you prefer, and what am I missing for either list?

ALL criticism is welcome!

Dion DePaoli · Answer

First Josh, Happy Holidays and Thank You for your service.
	
	Advantages of paying cash:
	1) More pull when it comes to sellers who need the money quickly.
	Spot on.

2) Less risk, as properties are far less likely to not cash flow.
	That doesn't follow.  What you pay with, is simply what you paid with.  Technically speaking you could pay with seashells.  That has nothing to do with whether or not the property is likely to or not cash flow.  You can over pay for a property with cash easier than you can over pay with financing since with financing you have a lender double checking the numbers on the deal.  
	
	3)  Less properties to manage in proportion to capital invested.
	That is true, you will be able to buy more combining debt (financing) with your equity or combining other people's equity (OPM if you will) with your equity.  However, I would still say to some degree it is relative to how much money you have and the prices you actually pay for something.  If you have $50k, you can finance $100k purchase and own one property.  You can pay cash for 5 $10k properties.

Disadvantages of paying cash:
	1) Potentially low start up costs
	I think what you mean here is 'lower' [than cash] start up costs.  False.  When you close on a property with financing you will have the costs of financing that need to be paid.  Those include document stamps and recording fees along with costs of the loan for underwriting and review.  Buying a property with no financing is one thing, in that sense, buying a property with financing is two things.  Cost of property and cost of finance.
	
	Can you make a smaller amount of money do more when you finance?  Yes since you borrow the rest of the money you need to do what you are doing.  If all things are equal and you have the money to pay cash and we are just talking about costs to the transaction, finance is more.
	
	2)  A better cash on cash return
	False.  This is the same as number 2 above.  The return is based on the profit and your cost basis.  How you pay may have a small influence, for instance you might get a little bit of a discount paying cash, but cash deal as I mention above can be overpaid giving you a worse cash return.  The return is more a function of the operator and not the method of payment.  If you cash for a property and put no tenant in place, you make no money from rent, as an example.
	
	3)  The accumulation of Real Estate is quicker (for those with little cash)
	That also would not necessarily follow.  If I pay cash, I can close tomorrow if I have cash.  If you have financing, you have to wait for the lender to approve your loan.  So, in that idea, cash can move quicker.  That is also why number 1 above is the right answer.  To that degree, the faster you do what ever it is you are doing, the sooner you will be done.  
	
	4)  A hedge against inflation.
	Certainly a common idea that get's thrown out there.  It is a bit misleading though.  The act of simply holding debt is not in itself a hedge against inflation.  Inflation is your money loosing purchasing power.  When you carry debt on investments you are making your money work more.  The production of the profit you are making is the actual hedge.  The profit can certainly come from simple appreciation, but as we have seen in the recent past (2008 - 2010) real estate values can fall.  So the idea of hedging is actually creating income which can be realized immediate like in rent or deferred like in appreciation.  That does not mean that all assets always go up.  Certainly deprecation can occur and rents can fall.  When rents fall, things like Lehman Brothers happen and the real property market declined.  Think of all the underwater mortgages in the US since the crash.

For the record, the best hedge against inflation is simply investing in a market going through deflation.  Since often it is hard to see that coming putting your money to work in some fashion is a hedge.  By putting to work, I mean generating a return somehow from something that required an input of your capital.  Whether that is real estate or widgets.  So then the measurement of that hedge is simply the return on your capital adjusted for inflation.  The idea of hedge is more of a portfolio idea around diversity.  Investing in assets that respond in opposing manners.  For instance, equities tend to go up in value when fixed income goes down.  
	
	Often times in RE investing folks talk of hedging but really are not doing it.  It takes some pretty active management to do so.  You need to roll the dollars you make into other things that continue to make dollars but may respond inversely to the each other with certain market conditions.  So you end up managing a macro investment and micro investments.  An administrative burden to say the least.  Currently our rate of inflation is around 1.2%.  So as long as your invested making more than 1.2%, whether with debt or without you are hedging (out running) inflation in some degree.  
	
	Holding debt allowed your $10 dollars to be invested and make you 15% opposed to being invested and make you 2%.  The debt itself doesn't make you any money, it allows you to make money.  So debt is not an inflation hedge, the real estate (in our case) is the hedge, the debt is the leverage which makes your money make more money at a faster rate than you loose your purchasing power.

Bill S. · Answer

I know it's not talked about much due to the burst of the bubble but appreciation is missing from the leverage side. $100K used to purchase $500k that appreciates 3% yields more than $100K appreciating at 3%. Unless you purchase in absolutely the wrong area and you hold 30 years chances are very good you will see appreciation. Perhaps that is part of your "better cash on cash return" but usually I don't count appreciation in returns.