When listening to the recent podcast (episode 263) with Bruce Petersen, Bruce mentioned that you should never try to pay off a loan on a property. He is mainly involved in much larger scale things than most people are, but I cannot understand why you wouldn't want to pay it off sooner than later, other than I have heard people say that you could be using your money else where. How would it differ depending on the size/price of the property? Does any one have any insight on this?
Basically the thought goes like this. If my interest rate is 5 percent and I pay that off, my return on investment is 5 percent. Most people assume they can beat this at 10 plus percent ROI, so they keep the debt and invest that money elsewhere.
What most people don’t talk about is the downside of leverage. If you are over leveraged then you can lose your shirt. I tend to be somewhere in the middle. Once interest rates hit 6 percent next year people will have a harder time making this argument.
Would you rather earn 6 percent for peace of mind or 10 percent and potentially lose it all? That’s an oversimplified way of looking at it but that’s the gist.
I think a happy medium is pay off some debt and leave others.
@Henry Hodges First off, @Caleb Heimsoth is right on the money that most people want to play "interest rate vs. ROI arbitrage". As long as you can stomach a downturn, have cash reserves, etc. it's a smart play. For me the biggest advantage is that mortgage interest is still a tax deduction. I don't really want "free and clear" properties because then I'm just paying the gov't a portion of the profit. For the most part, depreciation isn't going to offset you net income entirely. So if I can get a tax benefit and I can play some form of ROI arbitrage then I'm doubly ahead of the game.
That said, I'm not a believer it "max out debt and leverage as much as humanly possible!" because there will be some rainy day. It won't be today, it might not be next year, but someday it will come.
@Henry Hodges Debt allows tax write-offs that an all equity deal does not. Regardless, managing leverage is a continuous balance. Most sophisticated investors, even if they can, are not paying off their entire loans. They re-fi or get financing on their equity to help them acquire more assets or diversify their holdings.
I’m going to try to go extreme here.
Continuing on with the 5% interest rate. Instead of paying it off, if another property was bought and it was a terrible deal 5% cash on cash. The equity pay down and appreciation would still make it better than paying off the mortgage of the other property. How’s my logic?
Bruce can't provide the returns that his investors require without the use of leverage. Maximizing IRR on your money is one of the benefits of investing in passive syndications (done safely). Many active investors loose track of their ROE over time...that does not happen in a syndication.
Real estate is also expensive right now due to low interest rates (among other things); so, having to pay high prices without getting the benefit of the cause of the high prices is simply paying too much.
As others have mentioned, carrying prudent levels of leverage and reserves is a given.