How to think about using leverage to maximize returns

Question

As a example, if you had 200K in cash, you could invest this in real estate with these 2 options.

Options 1: buy a house worth 200k in cash.  No mortgage.   Let's say you can cash flow 1200/month

Or

Option 2: buy 4 houses each worth 200K but using leverage, 75% LTV(50K down payment, 150K mortgage, 30 yrs loan at currently 7% interest rates)

let's say after PITI, you cash flow 0 under ideal circumstances(no major cap ex, no prolonged vacancies)

What is the better investment with higher returns long term?  I think it would depend on the location and whether you plan to hold for the long term or cash out at some point.

decision making can be different in these 2 scenarios:

Scenario A(high appreciation/high rent growth area):  If your house appreciation + rent growth outpace 7%, perhaps option 2 might be the better choice and leverage may amplify your returns.  Although more house means more things that can potentially break and need repairs.  And in "hot markets", there's a risk of property prices going down and you run the risk of being "overleveraged" if vacancies go up.

Scenario B(low appreciation/low rent growth area):  in this scenario, I think option 1 might be a better investment.  at current interest rates, it just doesn't make sense to leverage if you don't expense house prices to go up.

Am I thinking about this correctly? A lot of people say debt paydown is another benefit. I think with 30 yr amortization, the paydown on principal is minimal in the first few years and I don't see much benefit. If you are going to a hold house for 30 yrs, capex expenses also each up much of your cash flow as the houses get older.

Greg Scott · Answer

Here is a simpler way to put it.

#1 priority must be the ability to hold.  Being able to hold in up and down markets, whether you have a great job or got laid off, is important. Holding buys you the option to experience future appreciation.  This is why cashflow is important.  This is why reserves are important.  Those that get crushed in real estate are the ones that MUST sell in a down market.

#2 NEVER count on appreciation.  Your scenario A & B make me squirm.  About 5 years ago on this forum I got into a heated debate with many people about Appreciation Markets vs Cashflow Markets and we were talking Austin TX.  I was the lone voice saying you can't count on appreciation.  Everyone else was saying "high tech jobs", it has to go up. Guess what?  Austin SF prices are coming down.  That said, I only buy in areas with job growth and population growth because you are more likely to get appreciation.

#3 Know your returns.  If you can realistically produce a 10% or 15% return, doesn't it make sense to borrow money at 7%?  Yes!  People talk about paying off their rentals, but if my property is making a 20% rate of return, why would I ever pay off a 7% mortgage?  If I'm good at finding deals, it makes sense to have an ever-increasing amounts of debt.  I hope to die with over $100M of debt!