A twist on Leverage v Cash. I know, I know, but... hear me out

7 Replies

An age old debate, but… with a twist

Hello BP, I am new here so 1st off, hello! I’m hoping to get a little advice. Well, in a round about way.

This is a hypothetical (and over simplified) question with relative numbers. It is being used as a metaphor with the hopes of gaining a little more insight on a real life scenario…

Assumptions:

  1. You have a successful non-real estate business and your life is in order. You have traditional investments, stocks, etc., but have decided you want to start investing more in real estate as well
  2. You own a primary residence free and clear
  3. You have 100k of free capital that you can use to buy your 1st investment property. This money is not needed anywhere else and is just sitting in a bank collecting bank interest
  4. Considering your main focus is your primary business, you feel like you will have time for at most 2 - 4 smaller properties in the 1st couple years while you gain experience
  5. For the sake of this argument, any extra income won’t effect your tax bracket
  6. We are also disregarding the added liability of having 100% equity in a property, although as you will see, it really shouldn’t matter much in this scenario
  7. You have found and are ready to buy your 1st property

Oh, and here’s the twist…

  1. Four unit properties in your area have a purchase price of $1000.00 - $3000.00. The property you are buying is $2000.00. The question is, would you use leverage or pay cash and why. If you found yourself immediately “knowing” the answer, take a minute to think about the details of this particular scenario. Rehashing age old arguments without actually thinking about the reasoning behind those arguments will lead to a less beneficial conversation.

My position is, while I understand the benefits of leverage, cash is a much better choice in this scenario. I’m interested in any good arguments for using leverage in this scenario and in seeing a perspective that I might be missing. Here are my reasons for a cash argument:

  • The only reason to “partner” with a bank is because you don’t have enough free capital to do the deal on your own
  • In exchange for your partnership, while you do retain 100% of the appreciation, you are still giving up a share of your profit/return
  • If for example you net 10k/month in rent on a property, and pay 9k/month in interest, you are paying a 90% “tax” on this income to the bank
  • If the argument is “you’re not paying the interest, the tenants are” and “why would you want to be taxed at up to 50% on that income when you can write off most of it”, then you have to compare apples to apples and say “well I’m not paying the taxes on that income, my tenants are”
  • wouldn’t you rather pay taxes on extra income/return you wouldn’t normally be making, than pay 90% in interest + up to 50% taxes on the remaining 10% you net?
  • Bank interest is not a phantom write off like depreciation, or an expense that you are going to have anyways, like maintenance. You are choosing to add an additional expense in order to free up capital
  • If the concern is not wanting to tie up capital, then please see my 1st point… “The only reason to partner with a bank is…”

Again I realize I am over simplifying here. The point is to gain a new perspective on a stale topic and to bring to light any flaws in my thinking or things I might otherwise be missing.

Thanks in advance for any thoughts!

Hi @Mike Mo ,

Whew! Just finished reading your post. Not sure this is going to answer your question, but here goes:

I am a big fan of using leverage to buy real estate. Cash is a limited resource (for most). The reason why leverage is so important is that you get a higher ROI on your investment as opposed to buying with all cash.

For example (very simplified here), you may pay 100k all cash for a property and be able to rent for around $1k, with a ROI of 12%/year and $12k in cash flow. Or, you can pay 25k in cash, get a loan (75k 30yr fixed at 4.5% interest), have an ROI of 30% and $7.5k in cash flow.

Taking the example one step further, let's say there are 4 of the same property (each selling for 100k). The best option for you would be to get a loan for each property and to spend your 100k (25k/property). In this scenario your yearly cash flow would be 30k with an ROI or 30%. Compare this to yearly cash flow of 12k with an ROI of 12%.

You are right though - if you have no opportunity cost then it really doesn't matter if you pay with all cash.  But there ALWAYS is an opportunity cost (for those who don't have unlimited $).  There are always other options for where you can invest your money.  It all comes down to personal comfort. 

If you have absolutely no use for your cash don't waste your time and efforts investing in real estate. There are far easier, truly passive, investments with better returns than only earning the prevailing interest rates on mortgages. The mortgage interest rates, less any lost tax deductions, is the maximum your dead equity will earn sitting at risk in real estate. Put your cash that you have no use for in a income fund and earn a solid 8-12% return with zero effort. 

The reasons not to park equity is to protect it from real estate market drops, have access to it if you have a use and to steer clear of a non passive investment that will be both stressful and time consuming.

Parking cash in real estate is one step above stuffing it in a mattress or a bank saving account.

If you look forward to the stress and time real estate investing will take, you have absolutely no use for cash and having your money earning it's keep is irrelevant then leverage need not be a consideration.   

Thanks for the responses.

This is a hypothetical with exaggerated numbers to see if there is a point at which most will agree cash is a better choice. This is not my specific situation.

Here you will only be buying 2 - 4 properties the first couple years and have 50 x the capital in savings for the average purchase price of each. You are already comfortably invested in other areas, including stocks, income funds, etc.

Assuming you find a "good deal", with possible forced appreciation for example, is there any good reasons to leverage this first deal?

"is there any good reasons to leverage this first deal?"

No good reason assuming:

Individual is not a investor, has no use for their money, is not interested in it earning it's keep and does not care if real estate prices drop. Under that situation dead equity is a place to hoard cash.

Down side is, as I have already pointed out, real estate investing is about as far from passive as one can get. It's a lot of work, time and effort if you do not want it going off the rails. If you do not stay on top of it, even with a PM, you risk losing a lot of money and sleep.    

Originally posted by @Mike Mo :

Thanks for the responses.

This is a hypothetical with exaggerated numbers to see if there is a point at which most will agree cash is a better choice. This is not my specific situation.

Here you will only be buying 2 - 4 properties the first couple years and have 50 x the capital in savings for the average purchase price of each. You are already comfortably invested in other areas, including stocks, income funds, etc.

Assuming you find a "good deal", with possible forced appreciation for example, is there any good reasons to leverage this first deal?

 Your issue is you are comparing buying one 4 unit property with cash, to buying one 4 unit property with leverage. that's not the correct comparison. If you leverage, you are now able to buy 4 4-unit properties because you only need 25% down. in this scenario you are paying interest, maybe 6%, but because the interest is a write off, you're only actually paying closer to 5% interest. you may have decreased your cashflow per property but ultimately have the ability to get more cashflow from multiple properties in total

@Mike Mo You are, inadvertently, asking 2 separate questions with 2 different answers. The first question you are asking is "would you rather own a $100k property with, or without a mortgage?" Which of course the answer is "without". But then you are also asking "if you had $100k lying around, how would you spend it on real estate?" And the answer, for me, is that I would leverage that to buy a $500k property or multiple properties worth $500k. I would not take my $100k and buy a single, $100kproperty. As @Thomas S. stated, there are many ways to make a better return on your money than parking it in real estate.

So far I've heard... 

- A very convincing argument for why real estate in general is a bad investment

- 2 generalized arguments for why leverage is better (that I fully agree with) but that ignore the specifics of the scenario (the properties are about 2 thousand each and you don't have time for more than 2 - 4 properties in the near term)

- And... received a private message trying to sell me a 100k ponzi scheme haha