THE DEBT HOLY WAR - Max leverage or paid-in-full?

[Greg Scott]

There are very few subjects in real estate investing that seem to generate as much passion as debt, and I’ve seen heated debates on this forum. I thought it would be fun to break it down (and possibly stir things up) because people seem to fall into one of two camps.

In the first camp, there are people are seeking maximum leverage. 

Why do they want that? Well, the simple answer for most people is they don’t have the cash to buy the property outright. Taking on debt may be the only way they can buy and control the property. On the other hand, adding leverage adds financial risk.

In my opinion, one of the riskiest things you can do is put the property into a negative cashflow situation. This means every month, regardless of whether the property is rented or not, you must feed the property. In this scenario, you are gambling that you will always have enough to cover the negative cashflow. In a growing economy these bets seem to work out great as people put on max leverage and a few years later they get massive multiples on their equity. When the economy goes the other way, the market is flooded with the carnage of people that chose that strategy. Too many people are one paycheck away from losing everything, including their rent properties.

This is why I’ve been vocal on how BP started categorizing markets into “Appreciation” and “Cashflow” markets. About 5 years ago there was a heated thread in these forums about Austin, Texas real estate. There were people saying they need not worry about negative cashflow because so many tech jobs were moving there, everything was going to appreciate. Austin was labeled an “Appreciation Market”. I’d love to find that thread and ask those people to share how their strategy worked out for them. I’ll bet it hasn’t gone so well.

Today’s commercial real estate market is demonstrating another risk of leverage. If the market swings, you could end up losing all your equity, even if the property is cashflowing well. There are many apartment operators out there that put 25% down, and once interest rates went up, their property lost more than 25% of its value. They have lost all that equity. Keep in mind, if you paid 100% cash for the deal, you still would have lost all that equity. The problem for many operators is the loan is coming due, and nobody is going to issue a loan for more than 100% of the property’s current market value. In this case, they will lose the property. Since the equity was already gone, the main “loss” is you lose the optionality of regaining that equity as the market improves.

The second camp are people who want to eliminate debt. 

Some people are fearful of having any debt. Some want to maximize cashflow. Some have other reasons. But are their downsides of being debt free?

With all the property databases out there today, yes, you open yourself up to different risks when there is no mortgage. There are fraudsters that target paid-in-full properties. (David Greene came on a BP podcast and shared how one of his debt-free properties in Florida got tied up in a scam and it cost him many thousands of dollars to fix.) After checking your insurance, the first thing a slip-and-fall lawyer is going to look for is how much equity is in the property. And, if nothing else, a paid-in-full property attracts a blizzard of yellow letters, phone calls, and text messages of people wanting to buy your property at a very low price.

Others want to eliminate debt, feeling that a paid-in-full property financially de-risks the investment. There may be truth to that, but only if you have enough cash for contingencies. After all a vacant paid-in-full property still has negative cashflow and sometimes you need big chunks of cash to rehab between tenants or reposition an asset.

I’ll take a third position. 

 I always want debt, I always want cash in the bank, and I must have positive cashflow.

My main philosophy is that if I can’t find a way to get a higher rate of return than the interest rate of a typical mortgage, I shouldn’t be a real estate investor. How hard is it to find a deal that produces a better return than 7%? It may not always be easy, but every day in almost every market, successful real estate investors are doing that.

Why is this important? If an all-cash deal makes 10%, I improve my total returns by taking on debt at 7%. Every dollar of mortgage allows me to improve my total returns. Yes, there is an added financial obligation of paying the mortgage. On the other hand, I get to keep more cash in the bank sitting in reserve for emergencies.

We haven’t even talked yet about after-tax returns, so let’s do that now. Let’s say we have a choice. You can have a $1M paid-in-full asset that makes you $100K in cashflow per year or you can have two $1M assets at 50% leverage that makes you $100K in cashflow per year. The equity and the cashflow are the same. However, one gives you twice the depreciation, so the other gives you a much bigger income tax bill.

The short version for me is debt in an investment is a nuanced situation. An all or nothing discussion is overly simplistic.