I Know Leverage Is Great, But Are Paid Off Rentals Bad?

Question

Obviously borrowing money increases you % returns cash on cash, but I have a couple rentals that are completely paid off and reading the forum is making me feel like I'm doing it wrong and should be refinancing and BRRR'ing the properties. Should I be cashing out my paid off properties and tapping into equity to borrow more or should I just be happy with the cash flow and peace of mind of paid off properties?

Is it just not wise to pay off a rental property with these low rates today? I guess I'm a bit old school and have this what if mentality and just like paying down debts quickly to save on interest.

Thomas S. · Answer

I am in agreement 100% with Andy's assessment.

For myself I leverage 100% where ever possible on cash flow properties. The economy has no effect on my ability to carry the properties and a devaluation, provided I hold long term, is only a loss on paper.

For myself I place a very high value on the opportunity value/cost of cash. Investors that bury their cash in a income property are only saving the interest on a mortgage which in todays market is negligible, average 5%. I place a minimum value on cash/equity of 10% as that is a very easy return to achieve on investments today. This translates into a 5% loss on a investors cash if it remains dead in a property.

Money wise a property must be able to cash flow with 100% financing otherwise it will never cash flow. Paying down a mortgage or leaving equity buried in a property does not increase cash flow as the equity must earn a return separate from the property itself. Equity is a separate second income stream.

Investors that place a value on cash and realise it must earn it's keep, or is costing you money, will assess it's opportunity value at a minimum 10% and will deduct that off of the top of the rental income ahead of all other deductions. $100K in equity is generating a income of $833 on the property and is deducted from the rent first. The remainder is the income generated by the property. Thus you can see that having equity in a property is very costly and if not accounted for, assuming mortgages at 5%, is costing the investor $417/ month/ $100K in lost income.

That equity should be out earning it's keep in another investment not simply stagnating in a property devaluing the properties income. The biggest mistake investors make is in believing equity increases cash flow, the opposite is true assuming a investor values money, which is why a property must cash flow with 100% financing or it never will.

What you choose to do with equity is a decision based on your business philosophy. It's only money so if you already make enough there is no reason to care.

Andy D. · Answer

@Danny N. Oh boy, you're opening a can of worms here! ;-) It's like asking if beef jerky is yammi or not! LOL

As far as I am concerned there is no "right or wrong". It depends on your situation and what you are comfortable with. I prefer to leverage as I'm in a high tax bracket. Every dollar I can save on that end by deducting things (that make me money!) is worth my money, literally. I like to make my money work, especially if it's not really my money but the bank's.  As long as the return from that borrowed money is higher than what you pay for to get that money (= debit/loan interest)  then you are making money - leaving aside the associated benefits from (further) deductions and whatnot (potential rise in vaule and so on).

I do disagree with @Audrey Ezeh as regards her statement "it's the leveraged ones that will suffer more in the down turn". No, they won't. Why would they (as investors). As long as the overall personal situation is right and you are making money from the leveraged properties up to (and preferably more) the amount that is owed on a monthly basis then all is good. This is true for investors.

It will, most likely, not be true for non-investors, i.e. owner-occupied properties where people have the tendency to over-leverage and then are way over their head when something goes wrong (= lose their job) while at the same time having no reserves but additional debt (credit card, car loan, etc). Yes, these people will have a problem. Not us investors if and when it's done right. So while the above quoted  statement is true, it is not true in the general way it was written. There is more than just black and white.

Soooo, what should you do? You need to decide. I, for one, just pulled out some 100k from a property by refinancing as it has increased in value a lot. Why? Because

a) I can support the increased mortgage payment from that property alone, not to mention by "subsidizing" it via the cash flow from other properties and income sources if need be

b) the value currently allows me to do so; maybe no longer 10 months down the road and

c) because I now have an additional 100k sitting in my bank account that I can use to scoop up a good deal if and when one comes by.

This money is cheap. Yes, it doesn't earn me anything while waiting in the bank account but also inflation is still low. And I don't plan on having it sit there more than a few months. It will get invested. But I'm ready for the opportunity. You are probably not in that regard, are you? ;-)

Oh, and should anyone cringe at the point b) above: I don't care if the property is worth less in 10 months than what I currently owe. I can pay the mortgage. This will not change. I just wait for the value to go back up while at the same time making positive cash flow. Every. Single. Month. And if something bad happens I have enough reserves. During all this time I am using the money I pulled out to by having bought something else that makes me even more cash flow.

I yet have to come across a situation where someone is telling me that this doesn't make sense financially.

Very long story short: It depends on the risk appetite, the overall personal (financial) situation, the type of investment (they do need to be good ones!) and yes, maybe a bit of luck too.

But I am indeed going to say this: for those who do not have sufficient financial reserves, do not over-leverage. And no, unused equity in a property is not "reserves". Only if and when you pull it out. The value could drop significantly tomorrow and then your "untapped reserve" is gone. We have seen it not too long ago.

Audrey Ezeh · Answer

I guess it all depends on your long term goals...If you are pretty content with your portfolio and cash flow and risk level then don't be swayed by the crowd. If your goal is to grow your portfolio and you don't have a lot of cash to play with then pulling out equity might be a great option! With all the talk about a bubble and a crash being imminent, it's the leveraged ones that will suffer more in the down turn. That may be a good time to refinance and go shopping :)

Gail K. · Answer

I sleep better at night knowing all my rentals have been paid for.  I bought them all with either cash or a small HELOC.   We have 16 SFH that we manage (I do most of the managing since I am now retired) and I'm not interested in purchasing more.

This type of investment is just fine with me.

Gail

Audrey Ezeh · Answer

Hi @Danny N. After reading comments from @Andy D. and Thomas S. (guys I love reading their comments and have a ton of respect for) I went digging further and found 2 great articles that might help you decide what to do. I'm sold on leverage but of course doing it smartly!

https://www.biggerpockets.com/renewsblog/2016/08/0... (The comments on this one are golden...there is a lot so get comfy lol).

Then this from Dave Van Horn

https://www.biggerpockets.com/renewsblog/mortgage-...

Both articles make a great case for why leverage is good!

Best of luck no matter what you decide... :)

Bob Derwin · Answer

If you are building wealth, leverage and purchase more.  If you are living off of your wealth, enjoy the added monthly cash flow and peace of mind that paid off real estate provides.

Daniel O. · Answer

As already alluded to above, it really depends on your personal situation and your goals. If your goal is to grow your portfolio, then yes, leveraging the equity you have in your existing properties might be a good strategy PROVIDED you have enough reserves to not be making yourself vulnerable to unforeseen events. But another consideration is your age and what you want to be doing with your time. If you are nearing retirement and just want the passive income from your existing rentals to fund your golden years, maybe it makes less sense. The more properties you have, the more involved in running them you need to be. You still have to manage a management company. So the question is, what do you want to be doing with your time?

I Know Leverage Is Great, But Are Paid Off Rentals Bad?

Most Popular Reply