Debt Free Investing
Rental Property Investor · Boone, NC · Member since 2013 · 22 posts · 4 votes
I'm not sure about you. But I'll take $6K a year with little risk vs. $1680 a year with higher risk, such as default. What happens when the $4000 hvac system goes out. With $6K, you still have $2K left. With $1680, you're $2320 in the hole. Then lets say the tenant does a midnight move-out and leave you with a $2000 cleanup. You just broke even, unless you use leverage and you're now $4320 in the hole for the year and you become one of those landlords wanting out and you sell for less than you paid just to get out of the trap. By my calculations, you're approximately 30% down for the year now. And we all know this scenario will happen at some point. Remember the tortoise always wins the race.
I like the power of leverage and I will borrow cheap money whenever I have the chance.
I do think that some people are sugar coating the PITA factor that can come with using bank financing on rental properties though. First you have to qualify to get the loan. Since you abhor debt your DTI should generally be okay but you have to make sure your LTV works (Which if it doesn't you need to reevaluate your investment criteria, so hopefully not an issue!) and you need to still have your jobs. So if your employer decides you don't need the job anymore that can be an issue.
Also after 4 loans it gets a lot harder. After 10 loans it is impossible without finding a portfolio lender or going commercial. You can sometimes pull some shenanigans getting 10 each in your name and a spouses name if you are each strong enough to qualify for 10 loans individually.
So not saying not to do it or that it can't be done. Just pointing out that it isn't a effortless endeavor. Looking at the way some of the previous comments are laid out it is like you would walk into a bank and just say you wanted a loan and they would just start pitching bricks of Benjamins at you no questions asked.
One thought is to get a big HELOC on the current place that you can use to help facilitate future purchases or as a lifeline if something bad happens. Usually much easier to get than a mortgage. Do it while you are living there though as lines of credit on rentals is much harder to establish. Nice thing about a HELOC is that you only pay on it when you use it. So if there is a 0 balance you have no payments but you can have a lot of money available if needed.
Again I am a fan of leverage.
However I will say I have never looked at one of my free and clear rentals and said "Damn I wish I was paying a mortgage on this place!", but I often see some of my leveraged places and think "Man I can't wait until I pay off this mortgage!".
Just saying...
Hey Lance,
It's a good plan, but of course the downside is that it's going to take a really long time.
If you can find properties in need of rehab, it's possible that if you can get them at enough of a discount you may be able to add enough value by rehabbing that your returns get close to what you would get by buying a rent ready property using financing. Easier said than done of course because you are searching a much smaller pool of properties, but it's possible.
Also, there are some middle ground possibilities with regard to financing. For example, suppose you figure that you could support yourself we 10 free and clear rentals (as opposed to 20 or 25 financed ones). One possibility is that you could work on purchasing these properties at a prudent pace using financing. When you reach your goal number, you get the cash flow from all 10 properties, plus the money you have been saving each month for saving for down payments, and throw it at the mortgage of whichever property has the highest interest rate. Then work on the property with the second highest interest rate, except now you have the increased cash flow from the first property that you paid off to throw at it as well. You get a nice snowball effect.
One thing I like about this kind of plan is that you accept the higher risk of the debt only during your younger years when you have your job income to help mitigate it. When you are older, and maybe looking of living off your rental income, you have the lower risk of paid off properties. When it comes time to pay off the properties, you get a big head start due to the mortgages having been slowly paid down while you were busy buying new properties. For example, if it is 10 years before you go into the pay off phase, the oldest mortgage would already have been paid down by almost 20% just from making your regular payments. Assuming modest inflation over those years, the value of the remaining balance would also have devalued by a decent amount, which is another factor in your favor.
Other possible middle grounds:
- Find financeable properties that can be bought cheaper due to needing a modest rehab (paint, carpet, and a few k of handyman fixes). You end up with a more money in the property, but your mortgage payment will end up as a smaller percentage of your rent, so less ongoing risk, and you can make a higher return if you do it right.
- A lot of the added risk of carrying a mortgage can be quantified. If a free and clear property is attractive because x amount of reserves would allow you to carry it for, say, 12 months without a tenant, then just figure out a larger amount of reserves you could carry that would let you go that long with a mortgage. If it works out that you still make a better return with financing even with the extra cash on the sidelines, then it may make sense. This doesn't mitigate all of the risk (e.g. cash flow going negative due to market changes) but it does reduce it.
Hope this helps. Good luck!
-Harry
Welcome. Your in a top emerging market.
Locate and attend 3 different local REIA club meetings great place to meet people gather resources and info. Here wholesalers will provide deals and you will meet rehabbers
You might consider Niche or Specialized Housing like student housing. Rents can be 2-4 times more. Remember you don't have to own a property to control it.
Two Great reads, I bought both J. Scott The Book on Flipping Houses,The Book on Estimating ReHab Costs http://www.biggerpockets.com/flippingbook
Good Luck
Paul
There is good debt and bad debt.
If you insist upon debt free investing calculate the dollar amount of assets it will take to create your desired income after taxes using a rate of return you can consistently achieve.
Example: 10% return before taxes will generate roughly $60k in annual income after taxes, it require $ 1,000,000 in assets assuming 40% taxes.
$120k requires $2.000,000 in assets.
If you can do that without debt in a reasonable amount of time then implement that plan. The key is the "reasonable amount of time."
I am not that fortunate so I prefer to use debt responsibly to grow my assets then I can choose to pay down debt later if it makes sense, Once my required asset level is achieved.
Lance,
There are a number of intangible factors many tend to forget. Yes, you can get a higher cash on cash rate if you use leverage. But, it comes at a higher risk and to actually realize the benefits of those higher cash on cash rates you have to hold 5x as many properties using the 20% down verse all cash example above.
I didn't notice anyone talking about the additional effort you will have to expend to realize those higher 'returns'. Add that time factor, especially while trying to raise a family and you will probably find you don't actually see those higher returns materialize.
Now, here is where the match meets the dynamite... the cash on cash rate is not all that important when evaluating two similar investment possibilities. People like it because it is easy to calculate and reference, but at the end of the day it is a marginal evaluation tool at best.
To your original question, if you are investing for your future and the future of your family, do it debt free and do it on whatever timetable that allows. If you are trying to build a business to attract partners or investors or to sell off in whole at some point, use as much leverage as you possibly can and still meet the targets in your business plan and prospectus.
From what little you have shared so far, if I were in your shoes, I'd continue to build a portfolio of real estate and other investments and I would do it without debt.
Am I thinking about this wrong?
Having no-debt investments Does cost you money - because clearly you would have to un-invest money in order to be able to re-invest it somewhere else.
So if I am making 10 or 15% on the money now - my cost of buying a house debt-free is 10 or 15%. Financially speaking; it is no different than if I had to get the money by borrowing it from a bank at 10 or 15%. Is it?
Unless you are keeping the money in a wall-safe - using it to buy something costs you the value of the income-stream which is being lost. Doesn't it?
How does leverage produce a higher return on investment than paying in cash?
stephen
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Having no-debt investments Does cost you money - because clearly you would have to un-invest money in order to be able to re-invest it somewhere else.
So if I am making 10 or 15% on the money now - my cost of buying a house debt-free is 10 or 15%. Financially speaking; it is no different than if I had to get the money by borrowing it from a bank at 10 or 15%. Is it?
Unless you are keeping the money in a wall-safe - using it to buy something costs you the value of the income-stream which is being lost. Doesn't it?
How does leverage produce a higher return on investment than paying in cash?
stephen
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Positive leverage produces a higher return because you control more income producing assets with your cash, and even if you are paying interest as long as you have a net positive cash flow you can make more income instead of paying all cash.
How does leverage produce a higher return on investment than paying in cash?
Arbitrage. You borrow at a lower rate than you generate with the borrowed funds.
How to make a million dollars in 3 steps.
Step 1) borrow a million dollars
Step 2) acquire income producing assets and manage them well.
Step 3) have your tenants pay off the million dollars in debt.
You will now have $1,000,0000 networth
If you get appreciation, that's a bonus.
Again I like leverage. :)
Using leverage doesn't inherently give you better returns. It of course will depending on the exact numbers and the returns you are getting on any given amount of invested capital.
Buy a house for $100K put $25K down. The place rents for $1,300/month using the 50% rule you are left with $650/month before financing. Get a 30yr fixed at 5% on the $75K balance for a payment of $402.67. You have a monthly cash flow of $247.33 or $2,967.96 a year for a CoC of 11.87%.
Buy a house for $25K all cash. The place rents for $500/month then using the 50% rule you are left with $250/month which is your cash flow with no financing. That is $3,000 a year for a CoC of 12%.
These are pretty realistic numbers for houses at these price points so there was no benefit to buying the higher priced place with debt vs. the cheaper one with cash. In fact both your cash flow and CoC are slightly better without leverage and obviously your ROI on the 2nd one kills the first one. This is of course in addition to the fact you also don't have $75K of debt you have to pay if you have a tenant or not.
This isn't a debate on the merits of buying one type of property or the other, since there are many other considerations. Just pointing out that based on purely the numbers it is quite possible to get the same returns (or better) making a cash investment than a leveraged one.
Using leverage doesn't inherently give you better returns. It of course will depending on the exact numbers and the returns you are getting on any given amount of invested capital.
Buy a house for $100K put $25K down. The place rents for $1,300/month using the 50% rule you are left with $650/month before financing. Get a 30yr fixed at 5% on the $75K balance for a payment of $402.67. You have a monthly cash flow of $247.33 or $2,967.96 a year for a CoC of 11.87%.
Buy a house for $25K all cash. The place rents for $500/month then using the 50% rule you are left with $250/month which is your cash flow with no financing. That is $3,000 a year for a CoC of 12%.
These are pretty realistic numbers for houses at these price points so there was no benefit to buying the higher priced place with debt vs. the cheaper one with cash. In fact both your cash flow and CoC are slightly better without leverage and obviously your ROI on the 2nd one kills the first one. This is of course in addition to the fact you also don't have $75K of debt you have to pay if you have a tenant or not.
This isn't a debate on the merits of buying one type of property or the other, since there are many other considerations. Just pointing out that based on purely the numbers it is quite possible to get the same returns (or better) making a cash investment than a leveraged one.
Just to give something else to think about -- especially to those who believe that leverage is inherently bad -- here is a scenario to consider:
Let's say I was to offer you $100,000 at 1% simple interest for 5 years, with interest payable on the back end (no other terms/conditions). This would cost you $5000 in interest in 5 years when you repay the money. You know that today, you can put the money in a 5 year CD at about 1.6% APY, and earn about $8200 on the money from the bank in 5 years.
That means that in 5 years, you'll return the money to me with interest, and keep about $3200 for yourself. There's no risk, assuming the US economy doesn't collapse in that time period (in which case, you have bigger financial issues).
The scenario I described above is leverage. And if you wouldn't take that deal, you probably don't like money as much as you should.
Using leverage for real estate holdings is obviously a bit different (more risk, more potential reward), but the underlying mechanisms for generating higher returns than what you can get with your own cash are exactly the same.
Based on that, it's hard to argue that leverage itself is "bad". The additional risk may not be right for some people (some people want as close to zero risk as possible), but again, that doesn't mean that there is anything inherently bad about the underlying mathematical idea of leverage.
Lance, in answer to your question about where I keep emergency reserves, I just keep it in an online savings account (Ally is who I use right now). I keep one account for security deposits, one for taxes, one for capital expenditures, etc. It's pretty easy to set up multiple accounts, and I like separating it all out. In Texas, you don't have to segregate security deposits (unlike in some states), but I do anyway, since it's really not my money and I don't like to think of it any other way.
The reality is some people can't buy real estate without incurring debt. The only way they can buy and hold rentals is by using financing. This does increase their risk, this does reduce their profits because financing has a cost. But it still may be better for them than not buying the rentals at all.
But, when someone buys rentals while carrying balances on their credit cards they are playing with fire and will get burned, it is just a matter of time.
Where I have seen people get themselves into trouble is with overly optimistic forecasts leading them to justify taking on way too much debt.
The other thing to remember is those using financing will never be as nimble as those of us who don't. That is a simple fact of financial life.
As for the good debt verses bad debt debate, just remember that is pushed by a man whose first book was a total lie. Any debt is worse than no debt from a financial stability standpoint. It is basic math.There is a reason the most popular poison pill used by companies who become a takeover target is debt.
For those starting out, use debt if needed. For those building their empire, use debt when it makes sense. But, your focus should be to get that debt paid off as quickly as possible to reduce your overall costs. Every day you carry a mortgage on a property is another day you are working for someone else.
But, when someone buys rentals while carrying balances on their credit cards they are playing with fire and will get burned, it is just a matter of time.
Where I have seen people get themselves into trouble is with overly optimistic forecasts leading them to justify taking on way too much debt.
The other thing to remember is those using financing will never be as nimble as those of us who don't. That is a simple fact of financial life.
As for the good debt verses bad debt debate, just remember that is pushed by a man whose first book was a total lie. Any debt is worse than no debt from a financial stability standpoint. It is basic math.There is a reason the most popular poison pill used by companies who become a takeover target is debt.
For those starting out, use debt if needed. For those building their empire, use debt when it makes sense. But, your focus should be to get that debt paid off as quickly as possible to reduce your overall costs. Every day you carry a mortgage on a property is another day you are working for someone else.
Let's say I was to offer you $100,000 at 1% simple interest for 5 years, with interest payable on the back end (no other terms/conditions). This would cost you $5000 in interest in 5 years when you repay the money. You know that today, you can put the money in a 5 year CD at about 1.6% APY, and earn about $8200 on the money from the bank in 5 years.
That means that in 5 years, you'll return the money to me with interest, and keep about $3200 for yourself. There's no risk, assuming the US economy doesn't collapse in that time period (in which case, you have bigger financial issues).
The scenario I described above is leverage. And if you wouldn't take that deal, you probably don't like money as much as you should.
Using leverage for real estate holdings is obviously a bit different (more risk, more potential reward), but the underlying mechanisms for generating higher returns than what you can get with your own cash are exactly the same.
Based on that, it's hard to argue that leverage itself is "bad". The additional risk may not be right for some people (some people want as close to zero risk as possible), but again, that doesn't mean that there is anything inherently bad about the underlying mathematical idea of leverage.
I used to do stuff like this all the time back before I really knew how to invest for real returns, but pretty smart for a "kid" I think.
Back when getting Credit Card advances had things like a 3-4% fee with a MAX of $10 I would take 5-figure advances at 0% for like 13months, pay $10 and put them in 12 month CDs that were getting like 4-5% at the time. Total arbitrage.
Now you usually get these with fees of 3-4% with a Minimum and NO max on the fee, and if you can find a CD getting 1% that is amazing, so this particular game doesn't work anymore.
However I still use this all the time to help fund a quick turn RE deal (Not rentals as much since you aren't likely to get the money back before the bill is due) since it is way cheaper than Hard Money.
Yes that basic math is correct that you would divide your annual cash flow by the cash investment.
Lets talk about some of the things you have in there.
First do you have an account that is yielding a safe consistent 8%? IF you do tell me where it is as I would like to put all my cash in it and probably sell most of my other investments and put the proceeds there since an effortless 8% is worth more to me than a PITA 12%...
Disregarding the 8% return account stuff I would not think that buying the $100K house with cash is a great investment, you are only getting 7.8% return. You would be much better off buying 4 of them with $25K down payments...
You would also be better off, purely by cash flow and CoC, buying 4 of the $25K houses.
If I had $100K I would be much more likely to try to use that as a down payment on a bigger $400K apartment complex. I think that there are a lot of places you can get 10-20 units that will cash flow pretty well. Totally pulling numbers out of my a$$ lets say you find a 10 unit for $400K and the units each rent for $650/month. Using the 50% rule you are left with $325/unit for a total of $3250 left after expenses total each month. Say you get a commercial loan for the other $300K at 7% with a 30 year amortization and a 10yr balloon. Your payment will be $1,996, leaving a cash flow of $1254 a month or $15,048 a year. This gives you a CoC of just over 15%. So a better return than either the bunch of super cheap cash houses or the leveraged "nicer" single family places.
BTW in my original examples I had an unwritten assumption that the investor only had $25K of investable capital so the options were a really cheap house for cash or a down payment on a leveraged investment. And no ability to get into bigger deals with out a fair bit of creativity to stretch those funds a lot farther.
He is talking about Robert Kiyosaki and Rich Dad Poor Dad. Basically he pretty much admits that he made up "Rich Dad" as a conglomeration of different mentors and successful people and just good stories to make his points. He made his point so just because he didn't have this one super mentor doesn't bother me.
You can have your opinions of the way the "Rich Dad" empire has taken shape in the last 15+ years, but still think RDPD itself is a good book.
Back on topic it is worth noting that in some situations if you think you HAVE to use leverage to buy rentals that might stall you out. Some people might be un-loanable but have enough cash to get into some stuff.
Maybe you made some bad financial decisions when you were younger but are digging out of that and have a great job and $30K in the bank with the ability to put away another $500/month to invest. However your credit is 580 right now. Do you wait a few years to be able to get a loan or do you get into the game now with a cash deal?
Better example you are an entrepreneur and started your own business in 2011. Like most business you didn't make any money that year. 2012 started out the same way but you got things going in the right direction and started making positive profits by the end of the year, but very small. In 2013 you hit the ground running and things flourished. You made over $300K in profit and there is no reason to think things are going to slow down. You are flush with over 6 figures of extra cash, oh and your credit score is like 780+. Banks won't touch you until at least until around Feb of 2015 if you file your 2014 taxes as soon as possible (Since we all like to file them as soon as possible when you paying close to $100K!) since they will want to see a minimum of 2 years of tax returns with consistent income. Do you wait the 15 months minimum to get that $75K loan on the SFR or do you buy some cash deals? Actually in this case you just say F-it to residential and put the $100K into the apartment complex I mentioned in the last comment as you can get the commercial loan easier.
Maybe you already have 4+ mortgages and qualifying gets a lot harder. You might be able to get up to 10, but they are harder. Maybe you can pay some older ones off if you have good cash flow. Maybe that is when you have to start going commercial with the loans. You might have a fat wad of cash in the bank (You'd have to since to even have a shot at getting the financing you would probably need to have minimum of 6 months of reserves for all the fixed costs like PITI and HOA fees, if applicable, for each place, including the new one. This in addition to whatever cash you will need to bring to the table to buy it) so do you mess around fighting like a dog to get a new loan or use some of that cash to get a new deal?
Anyway point being it isn't clear cut that leverage is necessary, or even possible, to start getting involved in REI.
Well; yes - over time I tend to do about 10-15% on my stock portfolio. Do I think it's safe? Well; safe enough for me I guess. Over the last five-six years of course I have done much better than average but the next five years feel like they might be somewhat leaner for us all than the last five were. Which is why I used 8% in my examples rather than a higher cost of funds.
I work at it - it doesn't fall from the sky - but that is a real problem I have with real estate. That is; it has to be a very fat pitch before it seems worth putting my boots on for. Although something that does interest me is working on the properties - I can do literally anything and I enjoy doing it. Although I would likely hire clean-out and maybe some demo people - nothing about those two interests me very much.
Although as soon as I wrote that I realized that clever-demo-work Does interest me. If there is a way to selectively tear something out in a way which will be a benefit to the job down the road - that would be interesting to me.
stephen
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@Lance Cummins There are a lot of great posts here, from people far more experienced than me. However, I want to point out that leverage is not a Boolean decision. You do NOT have to borrow 80%, or 75% even 50% on a purchase. To be extreme, you could borrow as little at 10%. The simple fact is that your returns will ALWAYS be higher with leverage. That does NOT mean that you MUST use ALL available leverage. For example, of you carry 40% to 60% debt on your current purchase, you have a LOT MORE safety than someone doing an 80% loan, AND your returns are higher. This is slower at building wealth than maximum leverage, but faster at building wealth than requiring all cash or short term payoffs (I believe you said your goal was to pay it off in two years). You can pay off everything and build cash until you find a deal, then leverage your existing houses for 40% or 50% to cut the time for your second investment. You can aggressively pay those down if that lets you sleep at night and then repeat with TWO properties, again leveraging only 40% - 50% on each, to get the next deal, and then repeat again. Leverage does NOT require that you be 75% - 80% in debt on ALL that you purchase. Your risk tolerance should ALWAYS play a part in your decision. But, to repeat, leverage need NOT be a Boolean decision. It can be scaled and controlled, deployed and paid down to take advantage of situations. Managing leverage in this way can greatly, GREATLY, GREATLY!!! increase your wealth in any given period of time while staying relatively risk averse. I hope this helps. Good luck.
Thank you @Bill B. I think the strategy that you explained is they smartest way to invest in RE. I am deffinately going to use this as my investing strategy. I am much more comfortable with leveraging myself 40-50% rather than 70-85%.